Co-Investments, ESG and Fees: How Hedge Funds Are Catering to Investors in 2023

Hedge fund fees remain under pressure and below historic levels. But according to a report published Wednesday by the Alternative Investment Management Association (AIMA) and audit and tax consulting firm RSM, hedge funds and their investors are discovering that when it comes to new fee structures, products, and philosophies, their interests are more aligned than many people might believe.

“When you strip away the lively discourse around the outsized returns that some alternative investment fund managers can generate, the proactive efforts to align their interests with their investors are arguably the most attractive aspect of their offering,” wrote Tom Kehoe, managing director and global head of research and communications at AIMA, and Jonathan Waterman, leader of asset management at RSM US, in the report. Their findings were based on a survey of 138 alternative investment fund managers with an estimated aggregate of $707 billion in assets under management.

According to Kehoe and Waterman, the effort by hedge funds to keep or win the favor of investors is most evident in their fee models. “[The] entwining of the personal prospects of principals and those that entrust their capital to them is baked into the DNA of alternative investment fund structures, and the most successful managers are those that are most in sync with their clients’ demands.”

It’s been that way for a long time. Limited partners are happy to pay more for distinguished performance, so the better a fund performs, the more a fund’s principals can earn.

But at an increasing number of hedge funds, it’s not just the head chefs who are eating what’s on the menu. Now, according to the report, investors expect other key staff members to have some of their own capital in the fund where they work to demonstrate their commitment, although that’s not a particularly onerous request these days, since more investment firms have begun to do that to retain talent.

Of the fund managers surveyed, the average amount of assets under management was $5 billion, up from $3.7 billion in 2019. A quarter of all fund managers surveyed were long-short equity managers, while 14 percent were multi-strategy managers and 13 percent were private credit managers.

A separate survey of 35 institutional investors that allocate to alternative investment funds was also taken, in an effort to get their perspectives on some of the key opportunities available for bringing the interests of the two parties into alignment. The average allocator invested $1.3 billion to alternative funds, and more than half of them allocated more than $2 billion.

Nevertheless, more or deeper employee dedication to a firm isn’t necessarily enough. Fund managers have had to innovate in other ways, too.

According to AIMA and RSM, the return of the 2 percent management fee and 20 percent performance fee model is unlikely. The average management fee that survey respondents charged was 1.39 percent, while the average management fee for the smallest funds was even lower, at 1.18 percent. The group’s total average performance fee was 17.31 percent.

The report said that for future discounts to work, all parties must be open to new product structures (such as investor clawbacks or management fees that have been crystallized in various ways) and share classes that reward longer lock-up periods.

The majority of fund manager respondents (71 percent) are implementing tiered fees, up from about one-third in 2019. “Having a tiered fee arrangement is mutually beneficial to fund managers and investors,” the report said. “For the former, having a larger management fee at the outset of a fund being established can help to meet the operating costs of a business (where the assets of the fund are small). For the latter, tiered pricing allows investors to share the economies of scale as a fund’s assets grow.”

The report said that co-investment vehicles are well-established in private equity, but that hedge funds have begun to use them more often, a trend that could be ideal for aligning interests. Still, only 16 percent of survey respondents chose co-investment opportunities as a way to achieve that.

Hedge funds are also bonding with investors over environmental, social, and governance issues. Allocators have begun to establish ESG requirements for themselves, and asset managers are especially conscious of existing, and potentially expanding, ESG-related regulatory burdens.

“Relationships are being further deepened through strategic knowledge sharing and sophisticated conversations around complex issues incorporating ESG and responsible investment [into] the investment experience, to ensure [that] investors and their managers are aligned,” the report said.