Performance fees: As old as portfolio management itself?

Fees 20 Jan 2009

With 2008 hedge fund performance figures coming in at around -15% to -25%, the inevitable question of hedge fund fees has bubbled back up to the surface.  It often seems that the underlying issue driving the backlash against hedge fund fees isn’t that they are a drag on returns or even that they aren’t commensurate with the value creation anticipated by the investors who agree to pay them.  Instead, it seems the backlash against hedge fund fees is often driven by the sheer size of the largest compensation packages of the most successful managers.

For many, the prototypical “2 and 20” fee structure seems greedy.  And for many, hedge funds exemplify greed.  Therefore, hedge funds must have invented “2 and 20” in the first place.  For example, this recent article by Dow Jones’ David Walker says:

“Hedge funds’ poor performance last year was bad enough to bring into question the fee structure that has been in place since Alfred Jones pioneered the investment vehicles soon after World War II.  He charged investors 2% of assets and 20% of any gains.”

In fact, Jones did not actually charge a management fee at all.  He only charged a 20% performance fee.  And he didn’t even cook up the idea himself.  According to Fortune Magazine’s Carol Loomis, author of a seminal 1966 article on Jones, the king of value investing himself used the same fee structure.  Wrote Loomis:

“…Jones and other general partners are to receive as compensation 20% of any realized profits…made on the limited partners’ money.  This idea is common to all the hedge funds and the idea was not originated with Jones.  Benjamin Graham, for one, had once run a limited partnership along the same lines…”

Walker writes that many modern hedge funds looked at these fees and “decided they weren’t high enough.” While there have been colorful examples of funds charging performance fees higher than 20%, these are few and far between.  Charging a 50% performance fee is basically a “soft close”, not a real fee, since many  investors would have scoffed at such a price.  While investors may not have flocked to the manager charging 50%, the media sure did.  And the result was a windfall of free “super-exclusive” branding for these managers.

Still, some investors have obviously made a free decision to pay this fee.  But it simply cannot be extrapolated across the entire hedge fund industry any more than luxury car prices can be extrapolated across the entire automotive sector.  The fact that I believe a Maybach is over-priced should not be interpreted as an indictment of the Maybach or those that buy them.

In light of last year’s draw downs, valid questions have recently been raised about fees.  Namely: should the time period for performance fee calculations be longer than one year, should there be any fees charged while a  redemption gate is closed, and should the hurdle rate better reflect the tailwinds of “alternative betas” experienced by the fund.  But a blanket criticism of the “2 and 20” structure lacks the necessary nuance to fix these problems.  If the fee were actually “1 and 15 over a hurdle” would that really silence critics?

Jones didn’t charge a management fee.  But David Walker’s article above – which is generally critical of hedge fund fees – cites one consultant who endorses the idea of both a management and performance fee – even suggesting that the appropriate fee level should warrant a lock-up:

“Roger Urwin, global head of investment content at Watson Wyatt, said an appropriate structure might comprise a base fee sufficient to cover fixed costs and research and development and a performance fee that is capped and collected only once the fund has exceeded a predefined return. In return, Mr. Urwin said, investors would lock their money in for longer periods.”

Speaking of lock-ups, here’s a new case study in the fee/lockup debate…The FT reports that London-based Maple Leaf Capital has abandoned plans to lock-up a quarter of its capital and has instead offered to cut its management fee from 2% to 1.5% in exchange for investor support for what the paper calls a “restructuring”.

The FT reports that the performance fee would remain at 20%, so this doesn’t really appear to be much of a cut.  But if the firm is successful in retaining investors, then it becomes more difficult to argue that fees – at least for them – were really “too high” in the first place.

Still, many hedge fund managers may migrate back to the “no-management-fee” Jones model.  The Times recently quoted one expert who predicted that:

“Those surviving hedge funds will go back to how hedge funds were 20 years ago: small, niche players who have their own capital invested with clients and are very focused on making money rather than management fees.”

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