The purpose of this article is to crystallize a general view on the share class terms that institutional investors should prefer when investing in hedge fund partnerships.
The information contained herein is drawn from a variety of discussions with institutional investors, asset management firms, and the investment industry at large. With the multitude of strategies, investor types, and heterogeneity across the hedge fund industry, there is no panacea for optimal contract terms in hedge fund investing.
However, the hedge fund industry is at a crossroads where a decade-long sellers’ market for funds, buoyed by excess demand from all investor types, is grinding to a halt due to large performance related losses, structural changes to the investment banking model upon which many firms were created, and the exposure of an asset-liability mismatch (i.e. strategy illiquidity meets investor demand for liquidity) that has created a spiral of redemption pressure and forced selling.
The response of the institutional investor community to an industry reeling from the issues highlighted above will shape the future of the hedge fund business. Managers are under a tremendous amount of stress, from boutique arbitrageurs to “blue chip” hedge funds, and are offering to cooperate with their stable investor base in restructuring the hedge fund business model. The changes taking place will help secure the solvency of the hedge fund industry while stabilizing the prospect of long term active returns available to investors.
This article includes a concrete representation of the share class terms that URS believes to be appropriate for institutional investors in hedge funds (See Table 1). Again, while there is no single “best” contract structure, we feel that these terms are a minimum standard to best align interests and ensure a mutually beneficial relationship over a long-term investment horizon.
Qualitative Assessment of Hedge Fund Terms:
Management fees should be used to cover operating expenses only, and are not appropriate funding sources for staff bonuses, business reinvestment, strategy expansion, or wealth accumulation by partners. Managers should consider implementing a tiered management fee structure, as in the traditional asset management industry, so that large investors do not subsidize an unduly large share of operational costs. An example is included in Table 2.
Asset managers’ incentive to run “asset gathering” businesses instead of “asset management” businesses have been overstretched because of the profitability derived from the industry standard 2% management fee. Assuming economies of scale, costs should fall as managers grow their assets under management. Investors should consider management fee schedules that ratchet down as the firm or strategy AUM increase to certain hurdle rates.
For example, management fees of a single strategy manager might be cut by 25 bps from 1.50% to 1.25% as the fund grows from $1.0 billion to $3.0 billion.
Performance fees should create alignment of incentives through timing mechanisms (e.g. deferments, holdbacks, and/or claw backs), appropriate hurdle rates, and egalitarian terms for all investors. One of the greatest strengths of the hedge fund industry is the alignment of interest that is created with the “pay for performance” carry fee structure. Performance fee terms should be amended to include payment that matches the duration of an investment horizon.
Two examples: 1) performance fees ought to be paid at the end of a lock-up period or 2) a deferred payment schedule where a portion of the performance fee (50%) is paid in year one and the remainder (50%) is paid in the following year. Lastly, managers should not be paid carry for cash returns and investors should recoup at least a portion of management fees paid. All performance fees should be accrued above an appropriate hurdle of T-Bills plus management fees.
Liquidity Risk Subsidy
The current environment highlights a critical concern regarding hedge fund managers’ liquidity management practices. The root of the problem lies in the varying demand for liquidity across investors in comingled hedge fund vehicles. In a simplified case the demand for liquidity is primarily a function of the investor’s expected investment-horizon (e.g. 1 yr, 3, yrs, 10 yrs), premeditated reallocations, and exogenous liquidity pressures unrelated to tactical or strategic investment goals.
Institutional investors have long-term investment horizons that match the duration of their long-term expected liabilities; for example, a public pension fund expects its benefit payouts to continue in perpetuity. On the other end of the spectrum lie non-institutional investors such as Fund of Funds or high-net-worth individuals whose investment horizon is shorter primarily because of their sensitivity to unexpected, immediate liquidity needs. This is best characterized in recent months by fund of funds’ urgent demand for liquidity to meet the needs of their own redeeming investors, a consequence of poor structuring of their own liquidity management provisions.
When heterogeneous investment horizons are pooled in the same fund structure, long horizon investors effectively subsidize the availability of liquidity to short-horizon investors. The costs of this subsidy have been largely dismissed until recently.
First, if managers receive large requests for redemptions, they become forced sellers of assets and the downward pressure on prices is magnified in dislocated markets. While managers can fulfil redemptions with existing cash on hand, paying down cash balances reduces their ability to deploy capital as new opportunities come through the pipeline – a missed opportunity cost to remaining investors. Further, paying down cash and selling quality assets to meet the redemptions of short-term investors leaves long-term investors holding an illiquid pool of assets that is not representative of the mandate to which they subscribed.
Institutional investors should no longer bear the costs of taking undue liquidity risk. Instead, hedge fund managers must structure share class terms that transfer liquidity risk evenly among commingled investors.
While investors should not be unduly deprived of their access to liquidity, managers should smooth maximum allowable redemption pressure over a long period of time to ensure that the liquidity risk premium is not subsidized by long-term investors.
Fund-level gates, investor-level gates, lock-ups (hard and soft), and rolling redemption periods are essential tools for resolving this problem. Fund-level gates may be implemented at a manager’s discretion, while investor-level gates provide an automatic redemption-smoothing mechanism.
Managers should penalize any rescinded redemption requests by resetting the investor’s high water mark and charging a reasonable level of administrative fees to be paid to the fund. Managers may also resolve the problem of liquidity subsidies by creating a separate and distinct commingled fund for long-term institutional investors. In general, investors and managers must agree on proper compensation for liquidity risk, be more attentive to matching asset and liability time horizons, and structure terms to allow funds to weather market dislocations.
As the current situation demonstrates, failure to do so results in a negative feedback loop of redemptions, forced sales and protracted losses, which is costly to investors and hedge fund managers alike.
Leverage and Lack of Transparency
Leverage has been misused, mistimed and mismanaged in ways that have exacerbated problems for hedge funds. Further, a lack of transparency has prevented investors from accurately gauging portfolio risk. Managers should meet or exceed the transparency needs of all investors.
In exchange, investors should be unwavering in their commitment to protecting the confidentiality of that transparency. The use of leverage is an important investment tool but its use should be prudent in application and appropriately disclosed. At a minimum transparency should include the following:
• Audited financial statements
• Fee disclosure
• Schedule of operational costs
• Soft dollar or commission recapture trades
• Disclosure of investor base by institution type, concentration, geography, etc.
• Investor and aggregate fund NAV report (capital account summary)
• Disclosure of portfolio percentage in Tier 3 securities
• Return attribution and long/short exposure by strategy, geography, or sector
• Largest long and short positions by name
• Qualitative strategy commentary that addresses return drivers by name
• Leverage (Gross/NAV) at the fund and strategy level
• Participation in third party risk aggregators
• Estimates of fund, strategy, and firm AUM
• MTD return estimates
• Return attribution