An exploration of whether constraining fees can maintain/improve outcomes
How many times have you heard the following question (or similar) recently…
“How can they be sure they aren’t going to miss out on some of the best managers if they are taking that approach to fees/costs?”
Many institutional investors (e.g., wealth managers, master trusts etc.) are facing intense cost competition and are having to innovate their way through the challenge when allocating to (particularly private market, less liquid) alternative assets. Over the last 10-20 years, the hedge fund market has been through significant change when it comes to fee structures. This is less obviously the case in the private markets. Let’s consider whether there are any learnings we can take from the hedge fund experience.
We have seen various innovations with respect to private market fee structures recently, including:
– Working on a flat-fee only basis
– Restricting the universe to zero or low fee co-investment opportunities
– Reducing annual management charges and increasing performance fees or carried interest
– “Recategorising” the fees with some component being paid as, for example, origination fees
All the above methods have the potential to create an adverse selection bias, possibly limiting the range/quality of eligible managers, products or deals available. Is it that only time will tell if any of the above approaches prove successful? Perhaps, but we think there is a bit more thinking that can be done up front on this highly topical subject – hedge funds have been through these challenges before! The relevance of adverse selection bias could not be greater currently, with increasing numbers of fee constrained investors (due to regulation and/or intense cost competition) contemplating how to build more diverse, higher returning portfolios including private market exposures.
Below we run through some key considerations:
System sustainability – In many situations, we don’t believe that paying providers zero or very low fees in perpetuity makes sense from a system sustainability perspective. It may be that these fund managers are temporarily supported by other clients paying higher fees for other products. Once these roll off, offering zero fee deals becomes difficult to justify economically and will likely cause meaningful business pressure, especially in capacity-constrained strategies. All of that said, there may be situations where zero or low fees make more sense – for example, this could be for seeding new funds or where a co-investment sits directly alongside a fund investment (where fees are being paid). Critically, it is important to at least understand any potential conflicts of interest when assessing these types of opportunities.
More generally, we think that the fee level agreed should broadly reflect a conservative measure of the potential expected (excess) return, the cost of (or value received for) the services provided and the anticipated capacity. Determining this level is quite a nuanced exercise, but we think these are good rules of thumb as a starting point.
If the fees agreed aren’t reflective of a long-term sustainable system, then we wager that any fee savings made will likely be overwhelmed by adverse selection bias (i.e. managers will ultimately struggle to provide the desired service either in terms of risk/return outcome or indeed, client service/ESG engagement work etc.).
Persistence in performance – The dispersion in outcomes for active managers can be very high in alternative assets and this is often slated as the reason why picking “top quartile” managers is so important. However, there is mixed evidence of persistency in top quartile manager performance. In the Journal of Corporate Finance, the paper by Robert S. Harris, Tim Jenkinson, Steven N. Kaplan and Ruediger Stucke makes for interesting reading on this topic (Has persistence persisted in private equity? Evidence from buyout and venture capital funds – ScienceDirect).
It is also worth bearing in mind how rife survivorship bias is in performance data sets and how difficult performance data can be to interpret given the many ways in which, for example, IRR information can be presented. In other words, it’s not clear that the top quartile managers are actually top quartile managers!
Quantum of fee difference – Let’s consider a worked example – imagine you can select a collection of managers that all charge a 1% flat fee for similar services to a collection of managers all charging 2% + 20% performance fees or carried interest. You would have to be incredibly skilled when selecting the 2% + 20% managers vs. the 1% flat managers to overcome the difference in fees (which is guaranteed to be 1%, is likely to be at least 2% per annum and probably more in the region of 3-4% per annum). Most of the managers would need to perform consistently strongly (with the 1% flat managers being consistently poor performers). This ignores the netting risk problem associated with building portfolios of managers with performance fees (e.g., a scenario where some of managers are paid performance fees or carried interest despite overall returns being dragged down, or into negative territory, due to other managers’ losses).
In the world of hedge funds, things have changed meaningfully over recent years with the typical “2 and 20” structure reserved for only a small portion of the universe. The above worked example hardly seems relevant anymore.
In May 2018, we launched a new sleeve within a strategy at Fulcrum where we invested in flat fee-only UCITS hedge funds. This was at a time when flat fee options were relatively more limited within the hedge fund landscape. The sleeve includes between 5 and 10 managers and is part of a broader strategy investing across other asset classes. We have also been running an unconstrained fund of UCITS hedge funds portfolio during the same time frame, which includes approximately 15-20 managers, most of which are also charging performance fees. The difference in expected fees between these two portfolios is not as high as our worked example above but suffice to say there is a significant difference.
The flat fee portfolio has been slightly more volatile and incurred a slightly larger drawdown during Covid. However, over the whole period, the returns are very similar, with the flat fee portfolio gradually catching up over time (and doing very well over the last 3 years). If we added a few more managers to our flat fee portfolio, we think we might be able to achieve a similar overall long-term Sharpe ratio too, but given this allocation is part of a broader strategy, we are quite happy with the level of diversification provided. Both portfolios were very resilient during the 2022 selloff.
The performance shows a live carve out of the hedge fund component of a representative account (Flat Fee Portfolio) compared to the live performance of another representative account (Unconstrained Portfolio) since May 2018 (the inception of the Flat Fee Portfolio) to September 2024. All returns are in USD. Past performance is not a guide to future performance and future returns are not guaranteed. Source: Fulcrum Asset Management LLP. Returns are net of underlying manager fees but gross of any Fulcrum fees.
This analysis can only be taken anecdotally and is specific to hedge funds. A few key points to take from it:
- The fee levels in both portfolios are significantly below what might be considered typical hedge fund fees. Nevertheless, they are still materially different from zero which reflects our point about system sustainability.
- The flat fee portfolio has been competitive, but we like both portfolios. The analysis gives us some confidence around flat fee-only portfolios from an adverse selection perspective, but also some confidence that the performance fees negotiated are reasonable.
Turning to the private markets, we are curious about the applicability of the worked example and our experience in hedge funds to a space where carried interest is (still) the norm and where ‘2 and 20’ is more common. As DC pension funds consider their next moves, these arrangements will be challenged.
Incentives and alignment – We can see the argument that performance fees or carried interest can provide important incentives for fund managers as they are building their business or looking to exit deals. That said, we think that achieving genuinely aligned interests can be very challenging- e.g., because poorly aligned fee structures can incentivise counter-productive risk-taking behaviour.
Specifically regarding illiquid assets, we assert that timing the exit of a particular deal isn’t an easy thing to do (there is usually another party on the other side looking to buy at a good price) and that not all market participants are motivated primarily by the level of performance fee/carried interest they will earn. In some of our discussions with managers, we have suggested that businesses can use the flat fees they earn to pay individuals appropriate bonuses through prudent financial management over time. In other words, if the incentive of a bonus is a very important incentive for deal exits, this can potentially be intelligently structured by the manager within the flat fee compensation they are receiving. This is a model that has more potential in the private markets where longer-term capital provides a bit more certainty for a manager compared to more liquid hedge funds.
Separately (and something we have written about before), cost-constrained competition can incentivise managers to restructure fees in unorthodox ways, which we would suggest is not particularly helpful for clients. The example of management fees being restructured as origination fees is a perfect example, since it creates an incentive to increase portfolio turnover.
The inclusion of sensibly structured hurdles across certain segments of the hedge fund market has alleviated a number of the issues around adverse selection. Performance hurdles in the private markets are structured differently and we are not convinced they are as helpful as they may appear. This is likely another area to come under scrutiny as the DC pension market moves assets in scale.
Our overriding point here is that it is difficult to discern whether a performance fee-oriented portfolio leads to improved incentives/alignment overall and that the alignment risks of a flat fee portfolio may be mitigated with a bit of thought. As such, we find it hard to argue either way on adverse selection bias from an incentive/alignment perspective. However, we feel that appropriate structuring is critical if one does head down the performance fee/carried interest route.
Picking the duds? – If your approach to fees leads you to selecting a certain cohort of managers that are more financially vulnerable or have higher ‘left tail risk’, then this would certainly be a manifestation of adverse selection bias – perhaps in its purest form! We observe that all manager selection teams experience poor outcomes with some of their investments from time to time – they would not be human if they didn’t. This has happened in fee constrained portfolios and unconstrained portfolios alike. It is often the case that the top quartile performers over short term time periods are niche/sector focused strategies, but we suggest that this is a given due to their volatile nature and that it is also quite likely they are in the bottom quartile over subsequent periods.
Our contention is that robust and detailed due diligence is as important as it has ever been and should be central to any selection decision. We have also seen a significant change in the range of managers willing to work together on new fee structures, including a collection of managers that most would consider to be ‘blue chip names’. Understanding their incentives for doing so perhaps reinforces the need for selectivity and robust due diligence (investment and operational). In the private markets, access and deal sourcing is extremely important, an assessment of which should form a core part of the work done.
Summary
We think that some degree of ‘adverse selection’ is acceptable (or even appropriate) for well-designed, flat fee portfolios where the savings are meaningful and there has been sufficient depth of due diligence supporting the investment thesis. We find it harder to get comfortable taking on these kinds of risks where the design/transparency of the fee structure has been materially compromised, doesn’t reflect long term system sustainability or indeed the value/cost of the services provided. As DC pension funds (in the UK and a number of other geographies) move towards the private markets, finding an appropriate balance in risk sharing should benefit all stakeholders.
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