Funds forced to reduce fees and increase transparency
For a new hedge fund to attract investors, it will have to match competitors on fees, expenses and visibility of internal investors
In the dynamic and ever-changing hedge fund industry, it is important for hedge fund managers to be aware of the current trends regarding fund structures and terms to give themselves the best opportunity to effectively market and raise capital from investors. In this article, we highlight some recent trends, as well as terms managers are negotiating with investors to help make fund launches successful.
The standard 2% management fee has been on the decline for a number of years and, according to a 2015 Walkers study, the average management fee for new funds launched in 2015 was between 1.5% and 1.8%. Another reflection of the downward fee pressure managers are facing is the rise in sliding scale management fees, where managers are required to reduce the fee once the AUM of the fund reaches a certain size. The most extreme but, as yet, relatively uncommon example of the changing environment is a hard dollar cap on fees.
The 20% performance fee remains the industry norm for hedge funds but performance fee breaks are increasingly offered in the early stage for large investors. The convergence between hedge funds and private equity funds has also seen hedge fund managers introduce fee terms that have been common in the private equity sector, particularly in funds that invest in less liquid opportunities. These terms include multi-year performance periods, clawbacks and fees paid on realised appreciation.
Investor-level redemption gates continue to be more popular than fund level gates, especially with institutional investors. This is not surprising because if an institutional investor is a large investor in a fund, a fund-wide gate could often be triggered by that investor’s redemption request while smaller investors may be able to fully redeem if no other redemption requests are made.
Consequently, the market prefers to have investor-level gates, usually at the 25% level, so that all investors are treated equally when making redemption requests. Lock-up periods are becoming increasingly popular, with the typical lock-up lasting one year. Some managers have used lock-ups to offset pressure on other fund terms: for example, a manager may offer an investor a lower fee structure in exchange for that investor agreeing to a longer lock-up.
Because of increased pressure on fees, managers have a greater incentive to pass certain expenses to the fund. However, both investors and regulators are scrutinising what expenses are charged.
This heightened scrutiny has resulted in more requests from investors for a detailed breakdown of expenses charged to the fund. A recent survey of 175 managers revealed that 76% of them were providing investors with a detailed breakdown of expenses.
Investors and regulators are particularly focused on compliance expenses, marketing expenses, investment-related travel costs, shadow accounting and research expenses. Accordingly, when launching a fund, mangers need to have a clear expense allocation policy in place and ensure that the fund’s confidential memorandum provides a detailed description of the expenses which will be charged to the fund. Regulators and investors will no longer accept the old practice where expense disclosures were crafted generally and interpretational issues were decided solely by the fund manager.
Side pockets are making a comeback due to managers’ renewed interest in less liquid investments. Because of the way some managers applied side pockets to hold their worst performing or illiquid assets during the financial crisis, some investors have a particular distaste for side pockets. As a result, some managers have offered an opt-in/opt-out feature in connection with side pockets, which allows an investor to elect to opt out of all (but not less than all) of the fund’s side-pocket investments at the time of its initial subscription to the fund.
While such an opt-out is a useful tool to address the concerns of those investors wary of side pockets, it does not provide a solution to deal with an existing investment held by the fund that is subsequently deemed to be illiquid.
Monitoring proprietary capital
External investors are focusing on the difference between the liquidity terms granted to internal investors employed within the manager and external investors.
Larger institutional investors are now demanding that they have the same liquidity terms as internal investors. Additionally, larger institutional clients want to be notified when (or before) the general partner/principal redeems a certain percentage of its investment. In a further effort to demonstrate alignment with the interests of investors, some managers have offered a proportional redemption right. This allows an investor to redeem a proportionate amount from the fund when the general partner/principal makes a redemption.
10th March 2016