Towers Watson Calls For ‘Fairer’ Hedge Fund Fees

May 1 2012 | 11:11am ET

Hedge fund fees should be structured to offer “a more reasonable alpha split” between managers and investors, says a new report from global professional services company Towers Watson.

The report suggests that only one-third of alpha—or “outperformance from skill”— should go to the hedge fund manager; the rest should go to the investors who have placed “100% of their capital at risk.”

Damien Loveday, global head of hedge fund research at Towers Watson, said: “In the past limited capacity led to rising hedge fund fees and structures that skewed the alignment of interests between investors and managers. Fee and term negotiations were limited and many managers hid behind Most Favored Nation clauses which were originally designed to protect investors, but which became an excuse not to offer concessions. We believe skilled managers should be rewarded and we do not believe that ‘cheaper is better.’ However, hedge funds terms should be structured to allow for a more reasonable alpha split between the manager and end investor than has previously been the case.”

The report suggests fall-out from the 2008 crisis is driving a re-think of fee structures by both managers and investors—and has empowered investors, particularly those providing “sizeable allocations,” to demand better terms than the traditional 2 and 20 management and performance fees associated with hedge funds.

Said Loveday: “Hedge fund managers should be compensated for their skill and not for delivering market returns. The separation of these two elements is complex, but in our view worth analyzing in detail. The structure of both hedge fund fees and terms has evolved since the financial crisis and we believe that both are equally important in achieving a structure that better aligns interests.”

Loveday says Towers Watson would prefer to see management fees aligned with the operating costs of the firm, rather than the assets under management and a performance fee structure that meant managers share both profits and losses.
 
“Managers share profits, but there is often no mechanism for them to share losses so there is an incentive to take excessive risk rather than targeting high long-term returns. Structures that contain hurdles, high watermarks and those that defer fees with the ability to claw back in the event of subsequent drawdowns are therefore preferable.”

 


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