In Harmony

How hedge funds and investors continue to strike the right note in aligning their interests

AIMA paper (Extract – Part 1 of 2)

The findings from this year’s survey are based not only on what is current practice between hedge funds and investors, but also potential future developments and how these could be best implemented.

Below are the six key takeaways that emerged from this year’s survey:

1. Moving towards a new equilibrium

There is an increasing sense that fund fees and terms between hedge-fund managers and their investors are moving towards a new normal. No longer is the focus solely on fees, rather investors and hedge funds are continuously exploring new ways to negotiate fees and fund terms to reflect a better alignment of interest. Managers are responding to investors’ needs by putting in place arrangements that are more closely aligned both to the requirements of the client and the underlying investment strategy. Fund hurdle rates continue to grow in popularity. Almost 40% of all respondents use fund hurdle rates of varying description, including a pre-agreed alpha hurdle rate, used by 14% of the total number of respondents.

2. Beyond 2 and 20

In recent years, investors and managers have agreed on a variety of new flexible fund fee structures. No longer is it only the case that hedge-fund managers charge the traditional 2 and 20 flat fee structure. Rather than merely reducing the headline fee, hedge-fund managers are examining more equitable compensation arrangements that are beneficial to them and their investors. An emerging trend from this year’s study is tiered fees for investors; as the hedge fund firm grows its assets under management, investors will benefit from a lower fee. 35% of all respondents offer this fee discount to investors.

When it comes to reconciling the most appropriate fee structure being charged to investors, between 20% to 30% of the alpha earned being paid to the hedge fund feels about right. Our discussions with managers and investors reveal a shared belief that the manager share of any alpha earned should be about one third, with the remainder going to the investor.

3. From manager-led products to investor-led solutions

The hedge-fund manager-led product of the past is being replaced with more bespoke investment mandates including co-investment, customised solutions and other value advisory services which best aligns investors’ unique risk and return goals.

Over half of all respondents believe that customised solutions are crucial to driving closer alignment with their investors, a marked increase from the 14% of respondents who offered the same view in our 2016 study.

Hedge-fund investors are now considering co-investing; a popular arrangement with private equity institutional investors. Almost one in five respondents are offering co-investment opportunities, while one in two are open to exploring ways to do this with their investors.

4. Skin in the game

Having ‘skin in the game’ remains the most important demonstration of alignment between hedge-fund managers and investors, as voted by 76% of all respondents. At the founding stage it is not uncommon for fund founders/principals to invest as much as 80% of their capital.

Investors still value hedge-fund managers having ‘skin in the game’ and are still discerning of fees, but now partner with them far more to create bespoke investment solutions through increased transparency, better communication and a responsiveness to investor needs.

5. Sharing the expense

The variety and amount of expense that must be incurred to operate a hedge fund business is increasingly challenging for hedge funds. Investors globally are increasingly sensitive not just to the compensation fee to be paid to the hedge-fund manager, but also to the total costs incurred operating a hedge fund. The findings from this year’s research point to a clear delineation regarding what the hedge fund firm pays and what expenses are paid by its investors (the fund). Hedge-fund managers work with investors to place a cap on any additional expense burden from one-off costs or expenses incurred from launching a new business.

6. Partnering with investors

Both hedge funds and investors stand to benefit from a closer and more aligned partnership. We see the advantages as three-fold. First, as the investor builds more knowledge about the hedge-fund manager, they gain a deeper understanding of how the hedge fund will behave. This will help to avoid short termism that can damage fund performance. Second, the deepening partnership between the hedge-fund manager and investor enables the investor to take advantage of the hedge-fund manager’s unique market insights benefitting their overall portfolio. Third, this closer collaboration can help to deliver new products and services. This is demonstrated by the increased interest in hedge funds developing more bespoke investor solutions and other value advisory services.

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