In the depths of the credit crisis, investors began to question hedge funds’ traditional claims to fame. Negative returns undermined the promise of absolute returns across market environments, and a collective downward movement in NAV challenged the notion that hedge funds consistently deliver uncorrelated returns. Questions about fees followed promptly and inexorably from questions about returns; and a collective expectation developed that the traditional “2 and 20” hedge fund fee structure – a 2% management fee and a 20% performance allocation – would come under pressure and emerge from the crisis slimmed down to something like “1 and 10.” But a funny thing happened on the road to recovery: the 2 and 20 model remained more or less intact. Perhaps it was the overall robust returns
of hedge funds from late 2009 through late 2010? Or perhaps it was the argument – difficult to rebut and persuasively made by managers – that reducing fees can lead to a talent
exodus and inadequate infrastructure investment, and thus works to the detriment of investors? Or perhaps it was a combination of these and other factors? But regardless of the reason, the fact remains: according to a recent survey by SEI and Greenwich Associates
(citing data from Hedge Fund Research Inc. (HFRI)), the median management fee for single-manager hedge funds is 1.5% across all major strategies, and 40% of all hedge funds (and 100% of hedge funds following a “macro” strategy) still have a 2% management fee. The SEI survey also found that performance fees typically remain unchanged at 20% for all major strategies. However, fee levels
are just one part of the picture of manager compensation and investor economics. The other major determinant of what investors pay and what managers take home is fee structures
. And unlike fee levels, which have remained relatively stable, fee structures have been subject to considerable negotiation. This article starts by discussing the structure, purpose, taxation and resilience of management fees and performance allocations. The article then discusses in detail eight ways in which investors and managers have negotiated or renegotiated performance allocation structures. The article concludes with a discussion of the role of investor size in negotiating for customized fee terms, and how regulation will impact such negotiations.