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New payment models shake up the hedge-fund industry

The phrase ‘It’s the economy, stupid’ is often regarded as a key factor behind Bill Clinton’s success in the 1992 US presidential election, when he defeated the incumbent, and bookies’ favourite, George Bush Senior. With the US economy mired in recession, Clinton correctly estimated that jobs and income prospects would determine the vote, rather than issues such as foreign policy. (Bush had successfully overseen the 1992 Gulf War.) Hedge funds would do well to heed that lesson and focus on linking fees to performance as investors pay increasing attention to the bottom line.

Abstract computer generated intersecting lines Source: Getty Images

The end of an era

Hedge-fund managers traditionally apply a ‘two and twenty’ (or ‘2 and 20’) fee arrangement, composed of a management fee (2%) and a standard performance or incentive fee of 20% of profits made by the fund above a certain predefined benchmark. That model has proved very lucrative for hedge funds. But it has come under increasing fire from investors. Growing numbers are demanding that hedge funds add a hurdle rate, effectively asking the funds to deliver some outperformance before they start paying for it.

In a survey by BNP Paribas in December 2022 and January 2023, for example, 66% of investors said that hurdle rates were their preferred fee structure. That compares with just 15% a year earlier. BNP Paribas said the rise was likely due to ‘the rising interest rate environment and [the fact] that they have a cash plus return target for their portfolio’. 1

Figure 1: The hedge-fund fees preferred by investors

The hedge-fund fees preferred by investors chart Source: Institutional Investor
The hedge-fund fees preferred by investors chart Source: Institutional Investor

Performance, not growth, is the key

The $3.8 billion hedge fund Aperture Investors provides an example of how some hedge funds are disrupting the industry’s traditional fee-charging regime. Instead of setting fixed fees, the firm operates on a fee structure linked to performance, charging 30% of alpha. That’s higher than the industry standard, but, since inception, about half of Aperture’s funds have delivered alpha above their benchmarks, according to CNBC. 2

The network cited Peter Kraus, the founder of Aperture, as saying: ‘The key problem is very simple. The existing model, in almost all cases, rewards people whether or not they perform.’

Kraus added that the fixed-fee model means that hedge funds earn more money as clients’ assets grow. However, he argued that the performance fee should be connected to performance, as opposed to asset growth.

He explained that ‘asset growth is the enemy of performance’, as ‘it’s harder and harder to perform, the more assets that you manage. So, the fee doesn’t help you – that traditional fee doesn’t help in that regard, because the manager is incentivized to continue to grow assets, and that makes it harder and harder to perform’.

By contrast, Aperture charges what it describes as a very low base fee – equivalent to the fee for investing in an exchange-traded fund (ETF) – and then it only charges a further fee if it beats the index.

Investors also want hedge funds’ interests to be further aligned with their own. That means ‘skin in the game’. Currently, over 90% of fund managers invest their own money into their funds, with the average investment standing at 8% of assets under management (AUM). That’s according to research by the Alternative Investment Management Association (AIMA), in partnership with RSM International, published in February 2023. 3

But clients are now calling for this commitment to include highly skilled investment executives, to ensure they remain focused on delivering for their investors – and to keep them in place amid the intense war for talent in the hedge-fund industry.

Moreover, the survey found that:

‘Every aspect of the GP/LP [General Partner/Limited Partner] offering from the fee model and performance incentives to the products offered includes characteristics designed to ensure that when the fund manager does well, the investor does well, and the fund manager only does well when the investor does well.’

Further innovation in fee models likely

Hedge-fund management fees have been falling for years, and many investors and fund managers are agreeing on new fee models that focus on rewarding fund managers who can consistently deliver strong performance. Further innovation is likely as managers develop new product structures and share classes that offer fee discounts in exchange for longer lock-up periods.


Publication date: 2023-06-22T08:27:00+0100

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