WTT: Reducing Fees: Actions Speak Louder Than Words

0:05I've been thinking about what it takes for allocators to lower the fee burden charged by managers on the path to increasing net returns. This what Ted's thinking is called reducing fees, actions speak louder than words. Last month, a group of 29 serious institutional investors sent out a proclamation advocating for cash hurdles in hedge fund incentive fee arrangements. Their logic is correct. An asset manager should not receive performance compensation without adding value, and higher interest rates provide a positive return for managers just for showing up. But whether their bark will have any bite depends on their actions, not the words they write.

0:52Let me share a few stories about attempted fee reductions in the past that resulted in a wide range of outcomes. First, in 1994 and early 1995, the Fed hiked interest rates seven times, and the Fed funds rate rose from 3 % to 6%. One institutional investor had the same thought as this group of 29 and discussed the change in environment with each of its hedge fund managers. The managers had different responses. Some agreed and instituted a cost of capital hurdle. Others agreed and changed their terms to have a similar economic effect, like keeping the 20 % incentive fee and eliminating the management fee.

1:36And others did not change terms. This investor responded by redeeming every manager who did not adjust fees. In doing so, its entire hedge fund portfolio had a more favorable fee structure for the long term and performed better than others over time. Next, 10 years ago, a group of institutional investors thought industry standard terms had gotten out of line. They penned a thoughtful one-page letter that highlighted the need for better transparency, liquidity in line with underlying assets, and fees that reflected performance tied to excess returns. They sent the letter broadly to industry publications and discussed it with their managers.

2:21As opposed to the first investor, this group did not redeem its favored managers who failed to comply and saw minimal movement in terms as a result. Their subsequent hedge fund performance has not been noteworthy. Third, in 2017, a savvy allocator did a combination of the two. He created a one or 30 fee structure where managers would receive the greater of a 1 % management fee or 30 % of gross excess returns, offered it to 23 of the fund's managers, 17 accepted, and then publicized the innovation for others to copy. His actions positively impacted both his pool of capital and the industry at large.

3:08That leaves open the question, what action will the signatories of this letter take to make an impact if their managers don't institute a cost of capital hurdle. We used Oldwell Labs, or OWL, to peek into the portfolios of the signatories to this document to get a sense of what's likely to happen. The following are hedge funds held in at least two of these institutions' portfolios. Arrow Street, Bridgewater, Canyon, Citadel, D.E. Shaw, Farallon, Hill House, Hudson Bay, Janker, King Street, Marshall Waste, Farrow, Tilden Park, Two Sigma, and Wellington. Not surprisingly, these large institutions frequently invest in large managers.

3:59Are these managers likely to institute a new cost of capital hurdle based on the advocacy of a few of their clients? Probably not. Are these allocators likely to redeem from their highest profile managers because the managers reject a cost of capital hurdle? Probably not either. A manager's fees, by definition, are never too high or too low. They're simply a market clearing price determined by the supply and demand for their services. For example, very few hedge funds charge more than a 20 % incentive fee. Most charge between 15 % and 20%. That seems to be the price that works for the industry.

4:42One notable fund that charged much more was Renaissance Medallion. It charged a 5 % management fee and 44 % carry and delivered incredible net of fee returns. Its investors were upset when the firm returned outside capital. Large managers have significant market power in negotiating terms with clients. Hedge fund managers can get rich off fees and dilute what otherwise would be excess returns. If allocators believe managers in their portfolio are likely to generate sufficient net returns to meet objectives, inertia, risk, and extra work combine to keep the manager in place. I'll share a little secret.

5:28Any allocator outside of the very largest will never reduce fees investing in the same managers as others. Where terms do adjust in hedge funds, it tends to happen when the bargaining power in the negotiation favors the allocator. You see this with a new fund launch, a significant new investment in a fund, or a topping up after a period of poor performance. These situations can create a misalignment of interest between a manager and allocator, which is ironic coming from a group discussing alignment in the letter. Just like the allocators who prefer managers not to grow, as I described in the investment manager playbook, those instituting cost of capital hurdles only on new investments might want to consider the situation from the manager's perspective.

6:18A new fund requires resources to succeed. A cost of capital hurdle imposed on them but not others puts an obstacle in their way to compete in what is already a challenging business to launch and sustain. I applaud these co-signers for raising awareness of the principle behind incentive compensation, but only with a golf clap.

6:45Their use of the word advocate in the first sentence dilutes the impact of the letter. The hedge fund industry already has a terrific advocacy organization in SBAI. For my golf clap to become a standing ovation,

7:04these powerful investors must shift from advocacy to action. As for the previous attempts to change terms, the first investor was David Swenson. The second group included four of the same names on the current list, who apparently didn't take sufficient action the first time around and are still unhappy with their manager's terms. The third was legendary investor Britt Harris, then CIO at Texas Teachers. Ultimately, investors need to walk the walk, not just talk the talk. Thanks for listening to the show. If you like what you heard, hop on our website at CapitalAllocators.com, where you can access past shows, join our mailing list, and sign up for premium content.

7:49Have a good one, and see you next time.