According to a recent report released by Hedge Fund Research, Inc.[i] (HFR), there were 136 new hedge fund launches during the first quarter of 2019. While there is still demand from investors to invest their capital in actively managed funds, the nature of how these funds operate is changing at a rapid pace.

With the advancement of technology and availability of information, it has never been easier for investors to invest on their own. These factors, along with other macroeconomic trends, have allowed investors to put the pressure on fund managers to lower fees, provide better liquidity terms, and push for input on trading strategies. In the report mentioned above, HFR noted that the average management fee for new fund launches in Q1 2019 was 1.19% of average net assets, while the average performance fee was 18.79% of fund performance. Lower fee structures are causing current and new funds to rethink their fee structures, providing opportunities to reach new investors and keep current ones happy.

Historically, the most common fee structure in the private fund industry charges investors a 2% management fee for assets under management (AUM) and 20% performance fee on profits made by the fund. As noted above, this structure is obviously evolving. In recent years, we have seen some unique strategies that are pleasing investors and providing flexibility and growth opportunities for fund managers. Below are just a few examples:

Performance Fee Only

The objective of a fund charging only a performance fee is that it rewards asset managers for generating alpha for their investors. While this structure may charge a higher incentive fee (usually 30-50%) versus traditional structures, its goal it to create an incentive to generate the highest returns for investors as possible. Investors are willing to pay higher performance fees knowing that if the fund is not profitable, the fund manager does not receive compensation. The manager can use a portion of the performance fee to fund the operations of the Fund by taking advances of the incentive fee. This structure does have significant downside risks during prolonged periods of underperformance, as the manager would have no source of revenue. This could lead to a fund leveraging itself to continue operations.

Tiered Structure

Under a tiered fee schedule, management fees are higher when a fund begins operations and gradually decrease as the fund increases its AUM. This structure provides flexibility for the fund manager to begin operations and focus on generating long-term growth for their investors. As the net assets increase, the initial investors charged a higher fee have their fee decreased, with potential new investors charged the higher fee. This structure creates equality and rewards loyalty to the Fund. It also creates a foundation for the fund to hit the ground running, producing returns and generating new capital for current investors.

1 or 30 Structure

This fee structure has quickly become popular thanks to the Teacher Retirement System of Texas (TRS). With this structure, the goal is for investors to retain 70% of alpha generated by the fund[ii]. A key difference between this structure and other popular ones is the word “or”. By inserting this word instead of “and”, the manager has an objective in mind – 70% of alpha must return to investors. How the manager gets there, is up to the fund and its investors. A common option is for the manager to take a 1% management fee with a reduction of the same amount to the performance fee so that total fees are capped at 30%. If the 1% management fee exceeds 30% of alpha during the performance period, any performance fee not recouped is carried forward to subsequent years. This structure creates a nice balance between current returns and future operations. It also provides investors with peace of mind that they are garnering their fair share of a fund’s profits.

We can help

When determining the fee structure you would like to use for your fund, there are plenty of factors to consider. Whether you are launching a new fund or rethinking the operations of your current one, Elliott Davis can help answer your questions. Please contact your Elliott Davis advisor or a member of our investment company practice.

[i] https://www.hedgefundresearch.com/sites/default/files/articles/1Q19_HFR_MMIR.pdf
[ii] https://www.fiduciaryinvestors.com/wp-content/uploads/sites/61/2018/09/The-Texas-Teachers%E2%80%99-%E2%80%9C1-or-30%E2%80%9D-fee-structure.pdf