Hedge Fund Compensation May Be Shifting

Another change looms for the hedge fund industry: compensation structures that could make hedge funds more “investor friendly.” Institutional investors are already rewriting the rules, and wealthy investors and family offices are sure to follow.

The traditional hedge fund compensation structure has been “2 and 20”. A 2% management fee on assets under management (AUM) and 20% of the profits above an agreed-upon benchmark. Some of the top stars in the industry have even been known to charge 3/30 or higher.

But in today’s tough fundraising environment, many new funds are compromising on 2/20 in order to attract new investors. Here are some examples of the newer compensation schemes:

– Simple 1.5/15 or even 1/10 (for some separately managed accounts).

– 20% incentive compensation, but only if the return is above 8%.

– 20% incentive fee, but paid only when life-to-date realized P&L reaches a certain percentage of the total P&L. This incents the manager to turn inventory and stay liquid.

– 20% compensation, but 10% gets deferred for 3 years. This structure may have a “claw-back” provision that allows investors to recoup some of the earlier fees if the fund is down significantly.

– 20% compensation, but 15% gets invested in the fund with a lock-up (a period during which an investor can not redeem), and for which for the manager’s money is one year longer than the investors’ lockup.

– 2% management fees, but a portion gets put into an escrow account to be used to retain talent when the fund is down significantly, or to retain the team if the fund needs to be liquidated (or if redemptions are suspended).

– 2% management fee, but all operating expenses are disclosed and anything that hasn’t been spent gets distributed back to investors. This is usually a temporary scheme by a “seed” investor.

– 2/20 for investors under $25 MM, 2/15 for investors between $25 and $50MM, 1.5/15 for investors over $50 MM or seed investors. This type of structure is not new, particularly for seed investors, but it will become more common now.

– 2/20 for investors with quarterly liquidity, 1.5/20 for investors with a one-year lock-up, 1.5/15 for investors with a 2-year lockup.

Many of the new schemes are structured to give those who are serious partners of the fund a break on fees, and to provide certain protections, to better align the interests of managers with that of the investors.

Today, even some of the more established hedge funds are being asked to adjust their fees to keep existing investors happy or to raise new money. This development should create a more stable investor/manager relationship, with investors taking a more active role.

What’s your opinion? Is your firm adjusting compensation rates as well? Add your comments below.

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