Returns of Alternative Investments

Custom Fee Arrangements

Hedge fund fees are often split into management and incentive fees. For example, a “2 and 20” fee structure implies that a fund manager charges an investor a 2% management fee based on the asset under management (AUM) or committed capital and a 20% incentive fee (performance fee) on the profits.

However, there are variations to quoted fee structures:

1. Fees based on Liquidity Terms and Asset size

Depending on the liquidity terms an investor is willing to accept, hedge funds may charge varying fees – the longer the lockup period, the lower the fees. In addition, investors with large commitments may receive discounts on fees. This also applies to placement agents who introduce other investors. Different fees may be applied to different investors in the same fund. Further, fund managers and investors hold fee-related negotiations via side letters.

2. Founder’s Shares

Fund managers and startups use founder’s class shares to entice early participation. These shares give investors below a specified threshold a lower fee structure. This incentivizes investors to make faster investment commitments.

3. Either/Or Fees

Large investors may negotiate with fund managers on whether to accept management or performance fees. For example, they may either agree to charge a 1.5% management fee that covers expenses during down years or receive a 20% incentive fee above a specified hurdle rate.

Example: Hedge Fund Fees

Let’s now use an example to illustrate this concept.

ABC Hedge Fund has $100M in assets under management at the start of period 1.

• The fund grows to $120 million at the end of period 1.
• At the end of period 2, the fund’s value falls to $90M.
• Period 3 final valuation for the fund’s assets is $140M.

If incentive fees are not calculated based on net management fees, calculate the return to investors at the end of each period given a “2 and 20” fee structure with a high-water mark provision for incentive fees.

Period 1

Fund growth = $120M – $100M = $20M.

Management fee = 2% of assets under management × $120M = $2.4M.

Incentive fee = 20% of growth in fund value = $20M × 20% = $4M.

Total fees for period 1 = $2.4M + $4M = $6.4M.

Return to investors = ($20M – $6.4M)/$100M = 13.6%.

Period 2

Fund growth = $90M – $120M = –$30M.

Management fee = 2% of assets under management × $90M = $1.8M.

No incentive fee will be taken since the fund has not reached the high-water mark of $120M.

Total fees for period 2 = $1.8M.

Return to investors = (-$30M – $1.8M)/$120M = -26.5%.

Period 3

Fund growth = $140M – $90M = $50M.

Management fee in period 3 = 2% of assets under management × $140M = $2.8M.

Management fee = 2% of assets under management × $140M = $2.8M.

Growth over the high-water mark = $140M – $120M = $20M.

Incentive fee = 20% of growth above high-water mark = $20M × 20% = $4M.

Total fees for period 3 = $2.8M + $4M = $6.8M.

Return to investors = ($50M – $6.8M)/$90M = 48%.

Total for the 3 Periods

In this example, we can see that the fund has grown during these 3 periods by:

($140M -$100M)/$100M = 40%.

What we don’t see, which is typical of hedge funds, is that the management has taken out returns:

$2.4M + $4M + $1.8M + $2.8M + $4M = $15M in compensation.

The same investment in an ETF with low (let’s say zero, for the sake of this example) management fees would’ve posted the returns illustrated below for the investor:

($140M + $15M – $100M)/$100M = 55%.

We can see that management fee strongly impacts returns even with high-water marks. The strategies hedge funds use are often more commission-intensive than typical buy-and-hold strategies. Although these investment vehicles offer significant diversification, they can also be costly to non-savvy investors. As a result, some studies have shown that hedge funds underperform the market.

Incentive Fees Net of Management Fee

Note that the incentive fee could also have been calculated based on the net of the management fee. This would have created an extra step in which we would have deducted the management fee before calculating the 20% incentive fee (as highlighted in italics in the following example). For example, in period 1:

Fund growth = $120M – $100M = $20M.

Management fee = 2% of assets under management × $120M = $2.4M.

Incentive fee = 20% of growth in fund value minus management fee = ($20M – $2.4M) × 20% = $3.52M.

Total fees for period 1 = $2.4M + $3.52M = $5.92M.

Return to investors = ($20M – $5.92M)/$100M = 14.08%.

This would have increased the investor’s return.

Alignment of Interest and Survivorship Bias

Many hedge funds do not survive past their first three years because of poor performance, which eventually occasions investor defection. This results in a problem for hedge fund indexes known as survivorship bias. The problem is attributable to the inclusion of only current investment funds in a database and the non-existence of exclusion of the returns of funds.

Backfill bias is another problem where certain surviving hedge funds may be added to hedge fund indexes only after they manifest success and start reporting their returns. These two biases may result in hedge fund indexes only reflecting the performance of funds performing well and not the actual performance of hedge funds.

Question

Assume that XYZ Hedge Fund has €150M in assets under management at the start of period 1. The fund grows to €200 million at the end of period 1. If incentive fees are not calculated based on net management fee, the return to investors at the end of period 1, given a “2 and 20” fee structure, is closest to:

A. 20%.

B. 24%.

C. 25%.

Solution

The correct answer is B.

Fund growth = €200M – €150M = €50M.

Management fee = 2% of assets under management × €200M = €4M.

Incentive fee = 20% of growth in fund value = €50M × 20% = €10M.

Total fees for period 1 = €4M + €10M = €14M.

Return to investors = (€50M – €14M)/€150M = 24%.