Hedge fund study shows investors are increasingly dictating fees and fee structures
A growing number of new hedge funds offered by new US based managers implemented management fee structures that decrease as fund assets grow, according to The Seward & Kissel New Hedge Fund Study, an annual study of new hedge funds to the hedge fund industry conducted by Seward & Kissel, the US law firm that set up the first hedge fund ever. In light of this research, COOConnect spoke to Steve Nadel, the lead author, who outlined one of the major reasons behind the study. "We are often asked by our clients about the industry colour, and our research enables us to highlight and contrast the latest trends. Crunching the numbers shows that clear trends are developing even though they are not necessarily visible at first glance."
There are factors at work driving managers to agree fee cuts and innovative approaches to fee structures. "Since 2008 it has been harder to raise capital in the industry,” says Nadel. “Investors have become more sophisticated, more organised and more institutionalised in their approach. They are expecting certain concessions and certain liquidity rights. A lot of managers are now putting tiered management schemes in place, driven by investors’ demands. Not so long ago the Utah pension fund aired their concerns that the management fee was in reality being used as a profit centre. They felt managers were making so much money off the management fee that it was actually a disincentive as they did not need to work as hard."
Several findings within the study signal hedge fund managers’ heightened sensitivity to the needs of investors, and the related imperative to rein in costs. Of all funds studied, 19 per cent adopted a tiered approach to management fees, stepping down to lower rates as assets in the fund surpass pre-established benchmarks - it is estimated that this figure was less than 10 per cent in 2013. The tiered management fee structure recognises and accounts for the efficiencies that can be gained with scale.
When it comes to determining who gets an allocation, Nadel says it is not fee structure alone. "You have to distinguish yourself,” he explains. “Gone are the days with two guys setting up a fund in their garage. The calibre of managers launching is more experienced, more pedigree, and that is one of the big drivers of who gets an allocation. You could be a very good manager but if you are overly aggressive in terms of your fees or your liquidity that may hamper you. Ultimately, it is more what you are selling, whether it is unique and what the economy is looking like. Pedigree and experience coupled with the type of strategy you are running will be assessed alongside the issue of structure."
Meanwhile, lower management fees traded for higher performance fees and/or greater liquidity is not something that Nadel has seen, though he does not rule it out as a bad idea. "I have actually suggested it from time to time. It is not generally seen when a manager sets up their first fund because the management fee pays the rent and the salaries. The performance fee can hopefully be earned, but if you do not make a profit you are not going to have money. But after a successful first fund things can change, and instead of making 2 and 20 managers may change to 1 and 25.” There is a trade-off between lock-ups and fee levels, however. “Overall, lower fees typically signal less liquidity," says Nadel.
The research reveals that all of the funds employing a tiered management fee structure had equity-related strategies, raising the question of whether the trend will spill over into funds with non-equity strategies in future years. In addition, the percentage of all funds using equity strategies increased to 73 per cent in 2014, up from 65 per cent in 2013.
The research suggests that improved operational efficiencies among hedge funds that employ non-equity-based strategies contributed to the virtual elimination of any disparity between the management fees charged by equity-and non-equity-based funds. The average management fee rate charged by non-equity-based funds decreased 12 basis points in 2014, with the rate across all funds converging at 1.7 per cent.
The ability of a fund to resist pressure for lower fees is mostly down to strategy, according to Nadel. "There are some strategies that are capacity constrained,” he says. “If you are at capacity, doing well, and are then asked for lower fees, you are likely to pass. More common is that a lot of the bigger brands that are doing well and have a good track record with money flying in their direction are not going to cave in. They know when they need to, that they can either go out to their existing client base, and/or new prospects, and get more money. The driver of lower fees is supply and demand – it is pure economics."
The popularity of master-feeder structures is increasing. Sponsors of both U.S. and offshore funds set up master-feeder structures over 95 per cent of the time, generally utilising the Section 3(c)(7) exemption. Most offshore funds were established in the Cayman Islands, although other jurisdictions such as Bermuda have begun to re-establish their presence in the industry. "Most of the managers that we see setting up both a US and an offshore fund do set up a master feeder structure," says Nadel. "There are a couple of reasons. One is that you only need to have the one trade ticket as the master does all the trading. The second, especially as we see more and more US corporate pension money coming into the space, is that it can be structured in a hardwired way, so that even though the offshore feeder may be over 25 per cent, because you are now commingling from an Employee Retirement Income Security Act (ERISA) law standpoint, it takes you below 25 per cent and you do not have to worry about the complicated guidelines and requirements for being a risk platform fiduciary. It is therefore very beneficial from an ERISA standpoint."
Another key finding of the study includes the fact that no fund chose to go down the path of engaging in general solicitations and advertising, as is now permitted under new Securities Act Rule 506(c) promulgated pursuant to the JOBS Act. When it comes to assessing the failure of the JOBS Act as a fund-raiser for hedge funds, Nadel sees two major factors. "Those organisations have not been going gangbusters in terms of raising money, though on the flip-side it is a fairly targeted market and a finite pool,” he says. “You are only allowed to go after accredited investors, and the vast majority of the population are not accredited investors - only 6 to 7 per cent of total US households are accredited. That means that conventional advertising such as sending it out on a TV screen is probably a waste of money. The second problem is the bull’s eye that appears on your back if you are a hedge fund operating under the JOBS Act. A combination of the SEC watching you intensely - any slip-up and they will come after you - and various consumer protection groups being equally ready to pounce on any wrongdoing means there is virtually no room for error. Added to that, the lack of publicised success among the funds that have done it so far does not encourage many to follow."
The full version of the study can be accessed here.