The starting point for the Towers Watson research is that investors place their capital completely at risk when they allocate to a fund. The corollary, the firm asserts, is that only around one-third of the outperformance from skill should go to hedge fund managers in the form of fees, with the rest going to the investor. Towers Watson argues that such an arrangement is a more equitable split of skilled outperformance and a good basis for better-aligned fee structures. In sum, such an arrangement would check what is paid to hedge fund managers who in some cases have received the majority share of what’s generated from skilled outperformance.
“In the past limited capacity led to rising hedge fund fees and structures that skewed the alignment of interests between investors and managers,” says Damien Loveday, global head of hedge fund research at Towers Watson. “Fee and term negotiations were limited and many managers hid behind ‘Most Favoured Nation’ clauses which were originally designed to protect investors, but which became an excuse not to offer concessions.”
The research shows that the events of 2008 and the subsequent pressures faced by many hedge funds led to a re-evaluation of the value they added and how that was shared with investors. In the investment environment that has emerged Towers Watson believes that investors providing sizeable allocations, with a long-term investment horizon, are now in a position of substantial negotiating power. In sum, the traditional 2% and 20% fee model is being challenged by many investors with a good number of managers willing to discuss compromise.
“We believe skilled managers should be rewarded and we do not believe that ‘cheaper is better’,” says Loveday. “However, hedge funds terms should be structured to allow for a more reasonable alpha split between the manager and end investor than has previously been the case.”
Obviously, the annual management fee and the performance fee are important factors in putting alignment in place. But aligning the structures is also important in putting investors on a sound footing in their relationship with hedge fund managers. In this respect, Towers Watson has several recommendations:
– Management fees that properly reflect the position of the business
– Appropriate hurdle rates
– Non-resetting high watermarks (known as a ‘loss carry-forward provision’)
– Extension of the performance fee calculation period
– Clawback provisions
– Reasonable pass through expenses
“Hedge fund managers should be compensated for their skill and not for delivering market returns,” Loveday says. “The separation of these two elements is complex, but in our view worth analysing in detail. The structure of both hedge fund fees and terms has evolved since the financial crisis and we believe that both are equally important in achieving a structure that better aligns interests.”
He adds: “Regarding annual management fees – often set at 2% of assets – we would prefer to see these aligned with the operating costs of the firm, rather than in line with assets under management.”
A changed dynamic
In the research Towers Watson expresses having some sympathy with hedge funds’ desire to retain any perceived informational and analytical advantage through reduced transparency. But this is counterbalanced by the change in the dynamic of the industry. The upshot is that managers will be increasingly called upon to respect the fiduciary reporting requirements of institutional investors and their advisors. While some managers may decry this change, it is crystal clear that demand from institutional investors has pushed the hedge fund sector to new levels of assets. This has occurred against a back drop of severe market volatility and at a time of rising distress in sovereign assets.
In 2003, for example, assets from institutions accounted for only 20% of an industry that HFR estimated had total assets of just over $800 billion. In 2012, assets from institutions, Towers Watson estimates, account for about two-thirds of a sector with AUM of over $2 trillion. This step change in the investor base is thus driving a big change in expectations of what is required from hedge funds as an asset class and as a fund group. Hedge funds, of course, have grasped this. But it remains the case that the bigger shops with assets above $1 billion are better able to handle such demands. For smaller funds and others not willing to meet these expectations, the message from Towers Watson is straightforward.
“The majority of hedge funds will now enter detailed discussions into the risks assumed and significant positions within a fund. However, some continue to offer limited transparency,” Loveday says. “We insist on an appropriate level of transparency in researching and monitoring managers and to encourage this, our entire list of favoured managers has been migrated onto a third-party risk management platform, which allows an independent verification of holdings and analysis of the portfolio risk.”
In the research Towers Watson recommends that, in addition to increased levels of transparency, significant contract negotiation between the investor and the hedge fund manager should extend to several other areas. Among them are:
• Side pockets
• Key man clauses
• Initial lock periods
But Towers Watson does urge investors to remain mindful that the fee concessions offered by managers have an offsetting cost. Most often this will be in the form of reduced liquidity, generally during an initial lock-up period.
“Skill is a scarce commodity and investors should expect to reward managers that are able to produce it consistently,” Loveday says. “Those rewards had become skewed but, since the events of 2008, managers are more responsive to engaging in discussions with investors on fees and terms. Many have moved towards structures that better align the interests of investors and managers, and this has been crucial to the revival and growth of the industry.”
The research also covers other aspects of hedge funds and related investment opportunities, including the growth in managed accounts and UCITS hedge funds. In addition, it turns up attractive prospects for three investment strategies: event driven; managed futures/systematic strategies; and active currency plays. Towers Watson also sees attractive opportunities in alternative beta, including opportunities in reinsurance, emerging market currencies and volatility.
“Despite the economic and financial crises and the resultant extreme volatility and liquidity challenges, we have continued to make significant allocations to a wide range of hedge fund strategies on a fiduciary basis on behalf of our clients,” says Craig Baker, Towers Watson’s global head of investment research. “These strategies have proven to be a value-adding component of the overall portfolio, providing diversity as well as an attractive risk-return proposition, particularly more recently as fee structures have improved.”