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Aon Retirement and Investment Blog

Hedge Fund Fee Structures

Recently, August 2, 2017, Brad Gilbert, Senior Director of Hedge Funds at the Teacher Retirement System of Texas (“Texas TRS”), authored an entry on our blog about Texas TRS’ views on hedge fund fee structures.  In this blog entry, we share Aon Hewitt Investment Consulting’s views on this topic. 
Hedge fund fees, while similar to private equity and real estate fees, are generally high on an absolute basis and relative to other liquid investments.  Investors’ assessment of the value received for those fees varies significantly, but all agree that any reduction in fees is beneficial.  We have recently seen a number of hedge funds reduce their fees due to investor pressure, recent lackluster performance, and other factors.  Even some of the largest and longest tenured hedge funds have lowered their fees in order to attract and retain assets.
One of the more vocal investors leading the charge for changes to hedge fund fees is Texas TRS.  They have come up with an alternative fee structure to the standard 2% management fee and 20% performance fee arrangement that they feel is more equitable and better aligns incentives.  Their goals for this new fee structure are:

  1. Retain more of the “alpha” generated by the funds.
  2. Not pay for the “beta” or market component of the funds’ returns.
  3. Extend the performance alignment benefits of an incentive fee over the life of the investment.
This “1% or 30%” fee structure, described in the blog entry, has a number of attractive features.
  1. It generally lowers the fees that investors pay in low and moderate return environments.
  2. It provides a hurdle rate that can be market based for strategies with market sensitivity.
It extends the performance fee calculation from one year to the life of the investment.

However, this new fee structure does add significant complexity and it requires some customization for each manager based on their specific strategy. The hurdle rate in particular requires careful selection as many hedge funds attempt to hedge or minimize their market exposure. A market based hurdle rate may be appropriate in some cases but a fixed hurdle rate may be more suitable in others.
The appropriate management fee (and other costs) also varies with factors such as capacity, required infrastructure and the level and quality of expected returns.  Investors and managers both benefit when the management fee is sufficiently large enough to maintain a stable fund management business.  The 1% or 30% fee structure offers other potential benefits to the hedge fund manager such as diversification of their revenue stream with multiple fee structures.
Overall we believe that the recent evolution of hedge fund fees is a very positive development for the industry.  Fee reductions and alternative fee schedules can result in higher returns for investors, better incentive alignment, and an increased ability to match fee costs to each investor’s objectives and preferences.
Chris Walvoord leads Aon Hewitt's Global Liquid Alternatives Team and is based in Chicago, IL. 

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