On February 5, 2020, the Securities and Exchange Commission entered into a Cease and Desist Order with CANNELL CAPITAL, LLC, a Wyoming registered Adviser advising $450mm of assets to private funds and high-net worth individuals. The order maintains that CANNELL from 2014 through October 2019, registered investment adviser CCL failed to establish, maintain, and enforce written policies and procedures reasonably designed, taking into consideration the nature of its business, to prevent the misuse of material nonpublic information. Specifically, CCL failed to follow its written policies and procedures by not maintaining a list of securities that members, officers, and employees (“Covered Persons”) and their family household members were prohibited from trading after the firm came into possession of potential material nonpublic information. Additionally, CCL’s written policies and procedures related to the handling of material nonpublic information were not reasonably designed to prevent misuse of material nonpublic information because they did not address any business-specific risks and lacked any guidance regarding when trading in securities should be restricted. As a result, CCL violated Section 204A of the Advisers Act.
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Hedge funds fees remain under extreme pressure across the industry. This strong trend is driven by declining return expectations from investors, increased competition across the industry, and an increasing share of industry assets controlled by large institutional investors.
Back in 2009, most hedge fund investors took meetings with hedge fund managers they thought had the ability to generate mid-teen returns. Today, historically low interest rates, tight credit spreads and high equity valuations have largely dampened expected returns to high single digits. As a result, many investors believe that the fees historically charged by hedge funds now represent too large a percentage of their gross performance. A recent Eurekahedge survey on North American based hedge funds noted that the average management fee has declined to 1.26% and the average performance fee has declined to 14.81%. The results of this survey raise two very important questions:
1. If these survey results accurately reflect the average fees, are these the fees paid by most hedge fund investors?
2. How can investors take advantage of changing fee structures to generate better investment results?
Does the average investor pay the average fee?
Twenty years ago, all investors generally paid the same fee, regardless of allocation size. Today, most funds will provide a significant fee discount to large allocators. While the definition of ‘large’ varies by firm, it typically starts in the range of $25-100 million. Very few hedge funds have reduced their fees for current or future investors allocating $25 million or less. While those investors have seen a slight decrease in fees, very large allocators (over $100 million) have seen fees decline as much as 25% to 50%. Allocation size has caused a large divergence in the range of fees paid by investors and is responsible for a vast majority of the decline in revenue at the industry level. Of course, individual managers that have experienced a meaningful growth in assets from institutional investors will still find an improvement in overall revenue.
Most of the decline in standard hedge fund fees has come from new fund launches that have gravitated toward a 1.5% and 20% model and away from the 2% and 20% model. We are seeing very little push back at 1.5% and 20% for allocations below $25 million. However, an increasing number of investors of any size are avoiding 2/20 managers, unless the manager has a strong performance record and more demand for the strategy than the capacity they can provide.
How can small and medium size investors take advantage of changing fee structures to generate better investment outcomes?
Importantly, investors should NOT make investment decisions primarily based on fees. Rather, they should continue to use multiple evaluation factors including the quality for the organization, investment team, investment process, risk controls, net return, service providers and fund terms. However, all other things being equal, lower fees will lead to higher net returns and make a fund relatively more attractive. It is important for investors to identify what fees and calculations are reflected in the net performance presented in a hedge fund’s marketing material. As a cautionary note: hedge funds net performance often reflect fees that are not available to smaller investors.
A couple of ways investors can reduce the fee they pay to hedge funds include:
Founders’ shares. Raising assets for smaller hedge funds is difficult. In response, an increasing number of hedge funds with less than $200 million dollars in assets are offering a discounted fee structure called Founders Shares. Founders Shares typically enjoy a 25-50% discount to the fund’s standard fees and are offered until either the hedge fund reaches a certain asset size or a period of time has passed. Once these thresholds are reached, the share class is closed to new investors, but the discount is grandfathered for investors in the Founders Share class. Subsequent investors will be charged the standard, higher fee structure. Focusing on these smaller managers requires more skill and diligence for investors, but can offer significant fee discounts and potentially outsized returns if the right manager is selected.
Asset Aggregation. Many outsourced CIOs, consulting firms, and multi-family offices offer an ‘approved’ or ‘recommended’ list of hedge funds into which their clients invest directly. A recent trend in the industry is for these firms to negotiate a fee discount based on the aggregate assets invested from across their client base. This will, in turn, reduce the fees paid by each of the underlying investors.
How can large investors take advantage of changing fee structures to generate better investment outcomes?
Large, institutionally oriented investors have been the primary beneficiaries of the evolution in hedge fund fee structures. Agecroft estimates these investors are responsible for 80 to 90% of assets of all new hedge fund allocations and are vital to the success of most hedge fund organizations. If these large investors are properly educated and given full flexibility of mandate, they have the potential to achieve significant fee savings and, as a result, higher net returns. Part of this requires a willingness to focus on small and midsized hedge funds, which are much more flexible in negotiating fees. Many large, established firms have difficulty offering a significant discount on fees because they are constrained by the existing client base that typically includes investors with “Most Favored Nation (MFN)” clauses. Offering discounted fees to a new client might end up costing the firm significantly more by having to reduce fees for existing clients protected by an MFN clause. Below are a couple of fee structures from which large investors may benefit:
Schedules that tier fees based on the size of an allocation. This model has been standard practice in the long-only space for decades. By reducing fees for larger allocations through a sliding scale fee schedule made available to all investors, managers can avoid most individual fee negotiations. We expect this type of fee schedule to gain popularity throughout the hedge fund industry over time.
Tailored fee structures to address specific priorities for prospective institutional investors. Most hedge funds are flexible in how fees are structured for large institutional investors, as long as the total fee they will receive is similar over the cycle and there is no conflict with existing MFN clauses. If a manager is comfortable offering the same fee structure to other investors of similar size, they should be open to a variety of fee options that may address investors’ specific needs. When negotiating fee structures, there is usually significantly more pressure on the management fee than the performance fee because investors are more comfortable paying for performance generated by manager skill.
In recent years, there has been a growing trend among investors to distinguish between performance driven by market beta and alpha created through manager skill. Some investors are requesting a performance hurdle as a means to pay a performance fee only on returns generated by manager skill. These performance hurdles are structured in different ways and typically tailored to the underlying strategy. Many hedge funds will consider a hurdle if the investor offers a concession somewhere else, which might translate to a higher performance fee, or a smaller discount on the management fee. One trend we have seen is the 1% or 30% fee structure where a hedge fund receives either a 1% management fee or 30% of performance. In this case, the cumulative management fee paid is treated as a hurdle and subtracted from the performance fee.
Other trends being adopted include institutions willing to lock up their investment for longer periods of time in return for lower fees. In some cases, this also includes a multi-year period over which performance fees are calculated and collected (Performance Crystallization period). This structure reduces the risk of an investor paying a performance fee in one year followed by a draw down the following year.
Hedge Fund Seeding/Acceleration
As it has become increasingly difficult for start-up and smaller hedge funds to raise assets, many are turning to alternative sources of capital. Start-up hedge funds often accept Seed Capital from large allocators (including pension funds, endowment funds, family offices, OCIOs, and others) that agree to make a large locked up allocation in a hedge fund in exchange for a significant fee discount and a percentage of the hedge fund management firm’s revenue. A good benchmark on revenue sharing is 20% to 30% of the firm’s annual revenues with a buy-out clause after year five. Acceleration Capital works similarly, but is committed to an existing hedge fund seeking to ‘accelerate’ asset growth. These arrangements can be highly profitable for institutional investors if the hedge fund is successful raising additional assets well before the buy-out clause becomes effective. Thus for seeding and acceleration allocators, in addition to the quality of the fund, the marketing strategy is an important driver of a successful outcome.
First Loss Programs
First loss programs are the easiest sources of capital from which liquid hedge fund strategies can raise assets, but are also the most risky. They require a managed account into which the hedge fund manager contributes approximately 10-20% of the account balance and the remainder is furnished by the institutional investor’s first loss program. Fee structures can vary broadly across programs, but typically a hedge fund manager retains 50% of the upside performance, but is responsible for 100% of the downside. The separate account allows the institutional investor to monitor the portfolio and begin liquidating based on drawdown trigger points. These programs can generate very good risk adjusted returns if administered properly.
In summary, fee compression across the hedge fund industry is a long-term trend that will change the structure of the industry. It is a vitally important trend to understand - for hedge fund managers to effectively compete and for investors to maximize their net risk adjusted returns.
About the author: Donald A. Steinbrugge, CFA – Founder and CEO, Agecroft Partners
Don is the Founder and CEO of Agecroft Partners, a global hedge fund consulting and marketing firm. Agecroft Partners has won 38 industry awards as the Hedge Fund Marketing Firm of the Year. Don frequently writes white papers on trends he sees in the hedge fund industry, has spoken at over 100 hedge fund conferences, has been quoted in hundreds of articles relative to the hedge fund industry and has done over 100 interviews on business television and radio.
Don is also chairman of Gaining the Edge-Hedge Fund Leadership Conference; consider one of the top conferences in the hedge fund industry. All profits from the conference are donated to charities that benefit children.
The Securities and Exchange Commission today announced charges against a New York-based investment adviser for misleading investors about the management of risk in a mutual fund. CCA and its President and Chief Executive Officer, Jerry Szilagyi, agreed to pay a combined $10.5 million to settle the charges. The SEC also filed a complaint in federal district court in Madison, Wisconsin, against Senior Portfolio Manager, Edward Walczak, for fraudulently misrepresenting how he would manage risk for the fund. CCA advises Mutual Funds and discloses $5.7bn in their most recent Form ADV. Convergence’s risk rating was and is High-Watch.
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