Fees for hedge funds and private equity: Down to 1.4 and 17; The cost of investing in alternative assets is falling-slowly

Fees for hedge funds and private equity: Down to 1.4 and 17; The cost of investing in alternative assets is falling—slowly

Feb 8th 2014 | From the print edition

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PHOENICIAN merchants kept a fifth of the profits generated from their seafaring adventures and paid out the rest to their financiers. So claimed Alfred Winslow Jones, the manager of the first modern hedge fund, who in the 1950s used the (perhaps apocryphal) precedent to finagle a 20% cut from his backers. Other managers subsequently added a 2% annual charge on the assets they invested to arrive at the “2 and 20” formula that became the standard for both hedge funds and private equity. Investors, who have long suspected that this arrangement enriches managers faster than their clients, are belatedly fighting back. They have succeeded in amending the formula to something more like “1.4 and 17”, at least for newcomers to the business (see chart).

The primary reason for the erosion is the lousy returns that “alternative assets” have brought. Hedge funds as a whole have undershot just about any benchmark in recent years, not least buoyant stockmarkets. Many investors in private equity, for their part, are wondering if they are being adequately rewarded for tying up their cash for a decade or more. Since it is the net return that matters to investors, trimming fees improves a fund’s perceived performance. The most successful ones—which often have their pick of investors—can still charge well above “2 and 20”; for the rest, haggling has become common.

Another factor is the rush of new investors into alternatives, with pension funds, endowments and other institutions now outweighing rich individuals. The new clients are not only savvier; they also write bigger cheques so have more negotiating power. Sovereign-wealth funds, for example, some of which have begun conducting their own buy-outs in-house, simply will not pay “2 and 20”.

It is the 2% “management” fee that is under the most pressure. Such a hefty charge simply to keep the lights on used to be easily glossed over when copper-bottomed investments yielded three times that; it is harder to defend at a time of rock-bottom interest rates. As firms have ballooned in size the management fee has come to represent tens of millions of dollars—far more than the expenses the firms concerned actually incur, no matter how plush their offices. Some investors have taken to examining a fund’s running expenses to make sure its bosses are not getting rich merely by showing up to work.

Performance fees have held up better, a sign that investors are still willing to pay for returns. This is particularly the case in private equity, where most funds have to meet a hurdle, typically set at 8%, below which the managers get nothing. Tweaks around how profits are calculated have also favoured investors: whereas private-equity bosses once got a share of profits made on each investment, they are now more likely to get paid based on the performance of an entire decade-long fund. Not only does this delay their bonuses, it puts them at risk if bumper profits are wiped out by dud deals. Nor can they get rich by levying nebulous “monitoring fees” from the companies they buy and sell, once a way of extracting some extra pocket-money from their activities. If they do, they typically have to pass them on to their investors. Finally, the biggest backers often demand a right to “co-invest” on some deals, putting extra money to work without paying a penny more in fees.

Just four in ten hedge funds now charge a management fee of 2%, according to Preqin, a data provider. Some volunteer discounts for early backers, or to those investors willing to put up with additional barriers to withdrawing their money. A 17% payout is still nothing to sniff at, so few hedge-fund managers are likely to quit. It would take many years of further erosion to deter ambitious newcomers.

 

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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