He could see the honey, he could smell the honey, but he couldn’t quite reach the honey. A A Milne, Winnie the Pooh.
Hedge Fund fees are under pressure again. There’s a drumbeat from institutional investors demanding lower fees in light of lackluster performance. So what’s a manager to do?
As a manager, you like performance fees. They are the dream hedge funds are built on. Performance fees give you that positive reward for stellar returns. Managers will argue, and many allocators will agree, that the performance fee aligns their interests with those of the investor. But as Jerry Parker once told me:
If you want to claim you are taking risk alongside the investor, put your money in your system alongside theirs. Jerry Parker, Chesapeake Capital
If performance fees are the dream hedge funds are made of, management fees are the reality. During inevitable drawdowns, it’s the management fee that keeps the lights on. So don’t be tempted to bank it all on performance fees.
There are many potential fee arrangements. Let’s keep it simple and take the two extremes from an allocator’s perspective: management fee only and performance fee only. This will give us insight into the best pricing strategy for a manager to adopt.
Contrary to what you read in the press, many allocators hate the idea of a management fee only. They understand a manager responds to incentives, and management fee only shifts the manager’s focus away from performance towards asset gathering. Plus that management fee will become an intolerable drag during periods of poor performance.
For the allocator, a performance fee only arrangement is not a panacea either. An allocator values the positive skew delivered by hedge fund returns. However, the larger the performance fee the more of the skew they are paying back to the manager! An experienced hedge fund allocator also understands that a manager facing zero revenues in a down year may be tempted to swing for the fences.
So as a manager, what pricing strategy should you adopt? This is a distributive negotiation: the pot of honey is fixed in size and the bees are going to have to fight over it. Everyone knows fees are negotiable: you won’t be eliminated from a search based on your list price.
Don’t set your fees at half the industry norm and expect to get AUM. Set your fees where the industry majors are and expect to get negotiated down.
During fee negotiations, spread the concessions between the management and the performance fees. This recognizes both the allocator’s and manager’s needs. I suggest a hard minimum management fee. But you can be more flexible if you already have good cash flow and spare capacity in your program. If you choose performance fee only, be prepared to tolerate months of low to no revenues during drawdowns.
Finally, when deciding your “list price”, consider the signal you are sending about your program: 0 and 30 smacks of desperation or naiveté, 1 and 0 sounds like beta.
- I would be very interested to hear from both allocators and managers on this topic – how important is this issue to you, what fee structure would you prefer. If I’m way off base here, I want to know!
Pic: Emma Jane Hogbin Westby via Flickr