Makeover for Hedge Fund Fees!

(May 1, 2012) — Only around one-third of outperformance from skill should go to hedge fund managers in the form of fees, says Towers Watson in newly released research unveiling new thinking about investment opportunities in the area.

The consultant, which has about $25 billion in hedge fund assets under advisory, argues that investors should only pay a portion of the alpha that managers generate as opposed to the typical 20% of net new profits.

Towers Watson’s research, titled “Hedge Fund Investing – Opportunities and Challenges,” furthermore noted that fee structures have worked to the advantage of hedge fund managers for years.

According to the firm, only a third of hedge fund manager fees should be based on outperformance, with the rest going to the investor. “In the past limited capacity led to rising hedge fund fees and structures that skewed the alignment of interests between investors and managers,” Damien Loveday, global head of hedge fund research at Towers Watson, said. “Fee and term negotiations were limited and many managers hid behind Most Favoured Nation clauses which were originally designed to protect investors, but which became an excuse not to offer concessions.”

Loveday added that he believed skilled managers should be rewarded, “however, hedge fund terms should be structured to allow for a more reasonable alpha split between the manager and end investor than has previously been the case”.

Following the events of 2008, investors with large hedge fund allocations and a long-term investment horizon have considerable negotiating power, with the traditional 2+20 fee model coming under pressure. “Managers share profits, but there is often no mechanism for them to share losses so there is an incentive to take excessive risk rather than targeting high long-term returns,” said Loveday.

Related article:Are Hedge Funds the Key to a Stable Financial System?