What's the best performance fee structure for Hedge Funds?

Performance fee

Within the fund universe, earning handsome fees are a fund manager’s raison d’être. The hedge fund industry is premised on the idea that fund managers can utilise their superior investment advice to generate outsized returns for investors, and in turn be rewarded with high fees for their skill. It is therefore not an exaggeration to say that the fund fee structure should be treated on a par with fund performance, and investors should carefully consider both when making decisions about where to allocate their precious capital.

The ‘Two and Twenty’ Fee Structure

Traditionally, hedge funds have opted for a ‘Two and Twenty’ (2/20) fee structure which consists of a 2% management fee and a 20% performance fee. The management fee is a flat fee charged on the total assets under management (AUM) of the fund and is ostensibly leveraged to maintain the operating costs of the fund. The performance fee on the other hand is charged on the profits made by the fund and is used to reward fund managers and traders with bonuses for delivering market-beating performance. So, for example, a fund which has £50 million of assets under management - which have increased in value by £10 million over the past year - will earn a management fee of £1 million and an annual performance fee of £2 million, leading total compensation to equal £3 million.

The commonly-posited justification for the Two and Twenty fee structure is that it strikes a fine balance between safeguarding the financial sustainability of the fund management company whilst also creating incentives for fund managers to deliver strong absolute returns. A flat 2% management fee ensures that the fund can survive an economic downturn if the fund is negatively exposed to pro-cyclical assets, whilst the 20% performance fee ensures that the fund always has an incentive to deliver absolute rather than merely relative returns on investment. If fund managers can deliver extraordinary profits as a result, then paying performance fees to investment managers could very much be a price worth paying  For example, Jim Simons’ Renaissance Technologies generated an average annual return of 71.8% between 1994 and 2014, leading to huge absolute returns for investors in the fund - even when management and performance fees were accounted for.

Criticism of ‘Two and Twenty’

However, in recent years the Two and Twenty fee structure has come under sustained pressure from both investors and financial commentators alike as hedge funds have struggled to generate returns which beat market benchmarks. This has led many to question the wisdom of allowing fund managers to charge high fees for underperforming and inconsistent investment strategies. In particular, the traditional 2% management fee has faced widespread criticism from investors, many of whom believe they are being overcharged by funds which fail to generate the absolute returns which would justify such lucrative levels of compensation. This in turn has prompted a philosophical debate regarding whether the management fee should exclusively cover the fund’s operational costs or whether it should also be used to compensate investment managers. Indeed, some fund managers have been criticised for concentrating on growing the AUM of their fund to inflate management fees at the expense of generating returns for existing investors.

As fund managers have struggled to maintain historical performance and faced increasing competition from the growth of passive investment funds, active funds have started to cut both management and performance fees in order to stymie investor redemptions. According to Barclays, average management fees are nowadays closer to 1.5% of AUM and performance fees are on a downward trajectory, with all but the biggest funds charging between 12% and 18% of profits generated. Fund managers are also increasingly offering fee discounts to investors through side agreements, which allow fund managers to vary investment terms across individual investors. Indeed, it is now commonplace for funds to offer fee breaks to select investors based on the amount of their initial commitment. This allows funds to cater to "legacy investors" who are willing to make investments which substantially increase the fund's AUM.

Alternative Fee Structures

Although cutting fees makes traditional funds more attractive to investors, sophisticated fee structures which tie compensation closer to performance offer an alternative mechanism for improving investor terms. For instance, many funds employ a 'high water mark' to ensure that fund managers are not overpaid in performance fees as a result of a depreciation followed by a compensating appreciation in the net asset value (NAV) of the fund. Without a high water mark, fund managers would earn performance fees twice on the same overall increase in the value of the assets – what is referred to as "double-dipping" - which is regarded by many investors as an inequitable state of affairs. This is usually paired with a complex accounting mechanism called 'equalisation', which ensures all investors retain the same NAV per share. In other words, equalisation relativises the high water mark to each individual investor, preventing new investors from free-riding on paying performance fees due to a pre-investment high water mark.

Moreover, increasing numbers of funds utilise hurdles to ensure that fund managers are not rewarded for performance which fails to exceed that which could have been achieved through a passive investment strategy. The hurdle can either be charged at a flat rate or tied to an appropriate market index, and is used to discount the performance fee such that the fund managers are only rewarded for market-beating performance. Whilst for ‘soft hurdles’, performance fees are charged on the whole return of the fund (provided the hurdle rate is exceeded); for ‘hard hurdles’, fund managers only earn fees on returns in excess of the benchmark rate. For instance, a fund with yearly profits of £10 million, operating a 20% performance fee and a 5% hurdle rate, would earn a £2 million performance fee under a soft hurdle and a £1.5 million performance fee under a hard hurdle regime.

The end of ‘Two and Twenty’?

Therefore, fund managers should think carefully about the best way to structure their fees. Whilst charging lower nominal fees provides a sure-fire way to win over investors, tailoring fees using the more sophisticated mechanisms offered by high water marks and hurdles provides an alternative approach to ensuring that funds remain competitive in a world of increasing investor expectations. Whilst creating and amending sophisticated fee structures has traditionally been a burdensome process - permeated with complex legalese and operational difficulties - next-generation fund service providers offer a digital mechanism for streamlining the entire process. Consequently, it’s never been easier for fund managers to form funds with sophisticated compensation structures and have those structures seamlessly administered. As fund managers continue their retreat from Two and Twenty, funds’ fee structures will only continue to grow in importance.