Only about one third of outperformance from skill should go to hedge fund managers in the form of fees, with the rest going to the investor, Towers Watson has said.
In a research paper entitled Hedge Fund Investing – Opportunities and Challenges, the consultant argued a better alignment of fee structure is “wholly appropriate” given investors place 100% of their capital at risk. It said for years fee structures have worked in favour of hedge fund managers, in many instances giving them the majority share, but a more equitable split of the skill-based outperformance, or alpha, is a good basis for better-aligned fee structures.
Towers Watson global head of hedge fund research Damien Loveday explained: “In the past limited capacity led to rising hedge fund fees and structures that skewed the alignment of interests between investors and managers. Fee and term negotiations were limited and many managers hid behind most-favoured-nation clauses which were originally designed to protect investors, but became an excuse not to offer concessions. “We believe skilled managers should be rewarded and we do not believe that ‘cheaper is better’. 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,” Loveday said.
According to Towers Watson, the events of 2008 and the subsequent pressures faced by many hedge funds led to a re-evaluation of the value they added and the way this was shared with investors.
It added investors providing sizeable allocations with a long-term investment horizon, such as pension funds, now find themselves in a position of considerable negotiating power, with the traditional ‘2 and 20’ fee model coming under increasing pressure. Loveday added: “Hedge fund managers should be compensated for their skill and not for delivering market returns. 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.”
The firm added it would prefer to see annual management fees, which are often set at 2% of assets, aligned with the operating costs of the firm, rather than being based on assets under management.