Fees in hedge funds: What should a vehicle structurer know when assessing these costs?

• This article explains how hedge fund fees impact final results and what types exist.
• The information is aimed at asset managers who want to understand hedge funds fee systems in order to structure investment vehicles with these underlying assets.
• FlexFunds offers an asset securitization program to improve hedge fund liquidity. For more information, do not hesitate to contact our experts.

Designing investment vehicles is one of the most complex disciplines within the financial field. The reason is that dozens of variables and metrics must be considered in order to build products that are properly optimized. And when hedge funds are involved in the equation, one of the most important points to analyze are their fees.

Why does understanding hedge fund fees matter when designing investment vehicles?

Fees directly impact the net profitability of the hedge fund, which is the basis on which the returns of an investment vehicle with this underlying are calculated. The higher the fee, the lower the effective profitability, and vice versa.

The impact on the net profitability of the underlying

As with all investments, the net profitability of a hedge fund will be heavily affected by its fees.

In fact, a report by the National Bureau of Economic Research (NBER) revealed that investors received only 36 cents for every dollar earned from the capital invested in a sample of 5,917 hedge funds studied over 22 years.

This happens for three reasons:

1. Fees are calculated per individual fund. Losses in one fund do not offset gains in another, but managers still collect their performance fees.
2. Investors pay fees when there are profits but do not recover those payments if losses are later recorded. In addition, after negative years, many investors withdraw their capital, limiting their recovery capacity.
3. Funds that accumulate losses often close. Performance fees already collected for past gains are not refunded.

“Over the 22 years studied, the capital invested in the hedge funds in the sample earned gross profits of $228 billion. Hedge fund managers collected incentive fees of $133 billion, out of which $70 billion were residual fees. Extrapolating to the entire hedge fund industry over that period, the researchers estimate that the residual fees amounted to $194 billion,” reported the NBER.

The “2 and 20” model

A large part of the hedge fund fee structure is explained by the famous “2 and 20” model.

This model dictates that a 2% annual management fee is charged on assets under management and a 20% fee is charged on profits.

According to the Corporate Finance Institute (CFI), the fixed 2% rate on total assets under management is used to pay staff salaries, administrative and office expenses, and other operating costs.

Meanwhile, the 20% performance fee serves to reward the main executives and portfolio managers of the hedge fund.

High-water mark and hurdle rate: How do they shape expected returns?

At this point, it is important to understand how the mechanisms high-water mark and hurdle rate work, as they shape the performance fees of hedge funds.

High-water mark

The high-water mark is the maximum historical value reached by an investment or fund. Its main function is to prevent the manager from collecting performance fees if the current value of the fund does not exceed that previous maximum.

If the fund falls in value over a given period, the manager cannot collect another performance fee until the value recovers and surpasses that previous level.

Hurdle rate

The hurdle rate is a minimum return that a fund must exceed in order for the manager to collect a performance fee.

If the fund’s return does not reach this threshold (for example, 4% annually), no incentive is paid, even if there are gains.

Management fee vs. performance fee

When creating investment vehicles with hedge funds as underlying assets, the question arises: which is better—funds with a management fee or those with a performance fee? 

Although each case must be analyzed individually: 

• Management fee: impacts expected returns in any scenario, since it is applied on a fixed basis.
• Performance fee: creates asymmetry because it reduces profits when the fund performs well but does not offer protection in case of losses.

This distortion is clearly relevant when structuring financial instruments whose performance depends on hedge fund growth.

Other costs to consider when selecting hedge funds as underlying assets

In addition to hedge fund fees themselves, other costs must be considered when selecting these investment vehicles as the underlying of a structured product:

• Internal operating costs of the fund.
• Taxes and administrative expenses.
• Audit and legal expenses.
• Leverage costs.
• Evaluation of hedge funds in the due diligence process.

When analyzing a hedge fund to determine whether it is suitable for developing a structured product, different issues must be considered:

Minimum investment

• Indicates the type of investors participating in the fund.
• High minimums usually attract institutional or high-net-worth investors.
• Low minimums suggest a greater presence of retail investors.

Share classes

• Some funds have a single class, while others offer several with different conditions.
• Classes may differ in fee structure, liquidity, and investment mandates.
• Some classes allow investments with lower liquidity, which should be carefully assessed.

Fee conditions

• The industry standard is the “2 and 20” model mentioned above.

Redemption and notice periods

• These vary across funds: redemptions may be monthly, quarterly, or even annually.
• These conditions directly affect both investor and fund liquidity.
• Longer redemption frequencies are not necessarily negative, as they can protect the fund from massive capital outflows.

It is important to remember that hedge funds can be converted into liquid assets with their own ISIN/CUSIP codes through an asset securitization process carried out by FlexFunds.

At FlexFunds, we manage more than USD 1.5 billion in assets under service, with over 500 issuances across more than 30 countries, meeting the expectations of more than 200 international clients.

In addition, we provide a comprehensive service that includes:

• Stock exchange listing.
• Fund accounting.
• Back-office services.
• Net Asset Value (NAV) calculation.
• Corporate administration services. 

To learn more about FlexFunds and our asset securitization process, you can contact our team of experts. We will be glad to assist you!

Sources:

• https://www.nber.org/digest/oct20/bottom-line-hedge-fund-performance-fees
• https://corporatefinanceinstitute.com/resources/career-map/sell-side/capital-markets/2-and-20-hedge-fund-fees/
• https://www.fundssociety.com/es/formate-a-fondo/que-son-high-water-mark-y-hurdle-rate-en-comisiones-variables-de-fondos/
• https://www.investopedia.com/articles/mutualfunds/09/hedge-fund-due-diligence.asp