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Hedge Fund Reform Finally Pushed By Investors March 29, 2009

Posted by federalist in Finance.
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Two years ago I detailed the misalignment of incentives in the standard hedge fund fee structure and concluded:

It is obvious that this needs to involve delayed vesting of performance fees.  Performance fees should be kept in escrow with a vesting period much longer than one calendar year.  [D]elayed vesting will keep [managers’] skin in the game even if they have a big drawdown.

Sadly, it took last year’s experience of enormous drawdowns and fund failures for the biggest investors to begin to demand this reform.  Finally Calpers, one of the biggest hedge fund investors, has had enough.  WSJ reports it has sent a memo to funds in which it invests outlining its expectations.

One area Calpers is focusing on includes performance fees. Typically they are collected at the end of each year, but Calpers instead wants fees spread out over several years. Calpers also wants clawbacks, which allow clients to recoup fees from previous profitable years after a period of poor performance.

And that’s not all.  In December I highlighted another major problem with traditional hedge funds: opacity.  I predicted major investors would begin to demand transparency into strategies and positions.  This is also part of the Calpers request:

Calpers also wants money managers to disclose every security held in a fund. “The only issue that keeps hedge funds from providing security transparency is their lack of cooperation,” Calpers spokeswoman Pat Macht said in an interview Friday.

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1. federalist - May 19, 2009
2. federalist - June 30, 2009

I didn’t mention Larry Powell’s January memo earlier because I couldn’t find a copy. But now the Utah Retirement Systems Summary of Preferred Hedge Fund Terms is online. It is an excellent and sound proposal for reforming hedge fund fees and structures. Noteworthy:

Asset managers’ incentive to run “asset gathering” businesses instead of “asset management“ businesses have been overstretched because of the profitability derived from the industry standard 2% management fee. Assuming economies of scale, costs should fall as managers grow their assets under management.

Performance fee terms should be amended to include payment that matches the duration of an investment horizon.

When heterogeneous investment horizons are pooled in the same fund structure, long horizon investors effectively subsidize the availability of liquidity to short‐horizon investors. The costs of this subsidy have been largely dismissed until recently. First, if managers receive large requests for redemptions, they become forced sellers of assets and the downward pressure on prices is magnified in dislocated markets. While managers can fulfill redemptions with existing cash on hand, paying down cash balances reduces their ability to deploy capital as new opportunities come through the pipeline – a missed opportunity cost to remaining investors. Further, paying down cash and selling quality assets to meet the redemptions of short‐term investors leaves long‐term investors holding an illiquid pool of assets that is not representative of the mandate to which they subscribed. Institutional investors should no longer bear the costs of taking undue liquidity risk. Instead, hedge fund managers must structure share class terms that transfer liquidity risk evenly among commingled investors.


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