Today’s managers are trying to stay ahead of the game as fee pressures continue.
Those launching with USD100 to USD300 million are trying to be investor friendly by offering a founders class where management fees range from 1 per cent 2 per cent on a sliding scale, which moves as the fund’s AUM grows, to attract early stage investors. Funds that reach USD500 million, USD750 million or USD1 billion thresholds would then look to scale down the management fee.
In terms of incentive fees within founders classes, these are being structured anywhere from 20 per cent down to 15 and 12.5 per cent. However, it all depends on the manager, the strategy, and the types of investors they are looking to attract.
What factors to consider when trying to attract new capital?
Securing a seed investor is a huge advantage to any new manager and will shape the way they think about fee structuring.
If the strategy is likely to be expensive to run because of the research costs, IT costs (if it’s a quantitative fund), or perhaps the need to hire a big team, the manager will need to know that they have a minimum AUM confirmed before launching.
What is really important to the founders class is aligning interests with the investor as much as possible. Listen to the investor’s requirements. Investors want to pay lower fees in the founders class, for sure, but at the same time they don’t want the manager to run out of cash after Year 1.
As such, it is a balancing act between the expenses the manager has as a business and how much fee concession they are willing to give to an investor.
In truth, investors aren’t too worried about paying a higher management fee when the manager is still small. They understand there are costs to running a hedge fund business and are often happy to lock up capital for two to three years to give the manager the confidence he has the finances to continue investing in the strategy and the technology to support it.
The time they do worry about it is when the manager has become well established and their returns are not that great.
As long as the manager has a niche, original strategy they can still expect to charge a 1.5 per cent management fee and focus more on doing creative work around the incentive fee.
There is plenty of scope for managers to come up with original fee structures as relate to incentive fees. Hurdles are a common tool and an effective way for the manager to closely align themselves with investors whilst ensuring proper incentives are in place.
A new manager might, for example, decide to take a 10 per cent incentive fee in Year 1 if the fund returns less than 10 per cent. In Year 2, if the fund exceeds the 10 per cent (net) hurdle, the manager can then receive a 20 per cent incentive fee.
Investors respond positively to this. Provided the fund is doing well, no investor is going to complain paying a 20 per cent performance fee. But if the manager is only making 4 or 5 per cent and still expects investors to give 1 or 2 per cent in performance fees, they are going to feel disgruntled. This misalignment of interests can be avoided at the founders class level.
Be careful using fee caps
Some managers might secure a seed investor and be confident of their ability to secure additional capital over the near term and as a result decide in the fund documents to cap the fee expenses in the fund.
This can sometimes backfire on the manager, leading to significant working capital pressure on the management company if the expected asset inflows fail to materialise. If the manager has set the fee cap too low, they might run into difficulties paying staff and keeping the business afloat.
As a rule of thumb, managers should expect to take twice as long to raise half as much capital. If you think you’ll have another USD100 million coming in to the fund in 12 months, be prepared for it to be USD50 million after two years.
Reducing the management fee should not be done too aggressively precisely because it is a slow process raising capital. Being over-confident and setting aggressive fee caps can often be an expensive lesson to learn.
The management fee should not be viewed as something that the manager should be getting rich off of.
As the fund AUM grows, the percentage of the management fee needed to sustain the business falls away. It becomes much easier to reduce the management fee when you’re running a USD500 million fund: 1.5 per cent of USD500 million goes a lot further than 2 per cent of USD50 million.
Tax considerations
In terms of fund performance, from a tax perspective the GP is getting a slice (say 20 per cent) of long-term gains in the form of dividends. But if the manager is located in New York, for example, it might make more sense for the management company to take an incentive fee as opposed to the GP taking a dividend.
If the fee is paid to the management company, it will pay Unincorporated Business Tax (UBT) for the privilege of doing business in New York which is set at 4 per cent. This can be tax deductible for the GP. Also, if they are a New York resident they will get additional tax credit. In very approximate terms, they might only end up paying 2.2 per cent on that income.
Conversely, if an incentive allocation is paid to the GP, rather than a fee paid to the management company, this will be subject to net investment income tax which is 3.8 per cent, for which there is no there’s no tax credit or deduction.
Therefore, assuming it’s a short-term trading strategy, the manager is resident in New York, and he doesn’t have any foreign investors owning part of the management company, might decide that it makes more sense to take a fee, rather an incentive allocation. If, however, the manager is resident in Connecticut, they may not go this route as the income tax rate is higher in New York.
Expenses applied to the fund
Expenses and fees are two sides of a coin. Controlling expenses is a good way for any investor to generate operational alpha. Get prior consent from investors before applying any expenses to the fund. Be on top of the detail. Investors will want to know up front exactly what expenses will be charged to the fund ie research payments.
Some larger legacy funds might have a lower headline fee but when one digs deeper the reality is that the manager is pushing a lot of expenses, unbeknownst to investors, through to the fund. Provided everything is transparent, and there are no hidden surprises, investors will likely not object to fund expenses.
That need for transparency is especially important given that expenses are close to the top of the list in SEC Examinations. The SEC will pull out the financial statements and draw a dotted line to the offering documents to make sure each and every expense is being legitimately charged to the fund.
At the end of the day, don’t cut corners. Hire the right people, think about the bigger picture for where you want to be in five years time and don’t impose a fee cap, no matter how confident you might be for raising capital.
