Negative real interest rates ought to be a boom time for hedge funds and other “reaching for yield” investment strategies, as was the case in the early 2000s. Yet while investors are pouring money into private equity and infrastructure funds, hedge funds are the wallflowers of this investment cycle. As we’ve pointed out often, the basic premise of hedge funds, that they delivered “alpha” or manager outperformance, was already in doubt in 2006. Moreover, it was also far from a secret that if what investors were really getting was a return profile that was not highly correlated with other types of investment, investors could achieve that at far lower cost than the 2% per annum and 20% upside fees that hedge funds typically charged.
In the post crisis era, the shortcomings of hedge funds became even more apparent. Not only were returns underwhelming, but worse, they also became more and more correlated with the stock market. Late 2015 and 2016 has seen a wave of redemptions, with even famous names like Paul Tudor Jones taking hits.
The Financial Times gives an update of the new normal in Hedgistan. The latest development is that investor are increasingly seeking that hedge funds meet certain hurdle rates before the profit share, typically 20%, kicks in. From the Financial Times:
Hedge funds are agreeing to so-called hurdle rates to assuage the sting of underperformance. Some have “hard hurdles,” meaning they must generate typically between 4 and 10 per cent before they are paid, while others must generate a certain percentage above Libor or cash.
“This is here to stay, and in fact it’s going to become more the norm to have these more creative relationships on the fee side,” said Kelsey Deshler, a portfolio manager at Credit Suisse Asset Management.
Long-only equity funds Viking, Maverick and Tybourne employ benchmark hurdles so that investors do not feel they are paying fees simply for tracking the market.
The increasing popularity of hurdle rates reflects a shift in power away from managers, who can command high fees in times of strong performance, to investors, as they pull money out during periods of underperformance…
Investors including Partners Capital, the Orange County Employees Retirement System and New Jersey’s pension have pushed for hurdles.
On the hedge fund side, Sir Chris Hohn’s $11bn The Children’s Investment Fund in London has helped lead the change, adding hurdles about three years ago. Parvus has incentive fees for its long-only fund on European benchmarks since 2004, and in its hedged strategy charges incentive fees every three years.
However, one source for the story gave not exactly accurate information about practices in private equity:
“Unlike PE funds that raise new funds every few years and negotiate the terms of those funds with large investors, hedge funds have been very boilerplate ‘take it or leave it’,” said one person who allocates money to hedge funds. “Hopefully that will change as it gets harder and harder to raise capital.”
As we’ve discussed, and CalPERS confirmed in its private equity workshop last fall, private equity contracts are “take it or leave it” affairs, with serious negotiations limited to at most a few headline items, like the management fee percentage and key man terms. The pattern is for the limited partners to give comments separately on the limited partnership agreement, and the general partner makes concessions on the less consequential issues so that the private equity teams can tell their senior management that they’ve accomplished something. One thing that seriously undermines the ability of limited partners to negotiate is that the endowments like Harvard and Yale, which are perceived to be smarter money, do not negotiate, taking the view that being in the “right” funds is what matters, and thus nickel and diming the general partners is seen as not worth the bother and potentially leading the endowments not to be seen as preferred investors. That might have been a sound idea back in the hoary old days where the most successful managers had good odds of outperforming on their next fund. But now that top quartile fund managers have actually marginally lower odds than a dart throw of outperforming on their next fund, this complacent, clubby attitude is sorely misguided.
Nevertheless, it’s good to see one set of Masters of the Universe being taken to heel, even if awfully slowly and cautiously. Couldn’t happen to a nicer bunch.