In the multifaceted realm of investment management today, the structure of management fees and performance fees is integral to the success of funds. The application of these fee models in fund management and their influence on the dynamic between fund managers and investors are perennial topics of interest in both financial markets and academic circles. Today we aim to offer an in-depth exploration of the roles played by management fees and performance fees in fund management, analyzing how these fees impact the overall performance of funds and investigating which fee structure might be most beneficial for investors.

Summary  

• Management fees are determined based on the fund's size and strategy, typically ranging from 0.75% to 2%. Performance fees are designed to motivate fund managers to strive for superior performance, aligning their interests with those of investors, with a median rate of around 20%.
• In the private equity sphere, a higher fee rate and lower GP ownership do not necessarily equate to lower net investment returns. The more expensive private equity funds are capable of generating sufficiently high returns to counterbalance their elevated fees.
• Regarding hedge funds, the effective performance fee usually stands at 2.5 times the nominal rate. For every dollar of pre-risk-adjusted investment capital earned, investors only receive a return of 36 cents.
• We propose that investors might consider a fee model with lower management fees but higher performance fees. This should be complemented by a review and monitoring period (such as 3 years) along with claw-back clauses incorporated to ensure interest alignment.

Management Fees VS Performance Fees

In the realm of fund management, management fees are typically predicated upon the fund’s scale and its strategic approach, generally oscillating between 0.75% to 2%, with the rates for ETFs potentially dipping as low as 0.03%. These fees principally serve to defray the operational expenditures of the fund, encompassing remuneration for fund managers, administrative costs, and other routine managerial outlays. In contrast, performance fees are levied based on the profits accrued from the investment portfolio surpassing a designated benchmark or a predetermined hurdle rate, often situated between 10% to 20%. Distinct from management fees, performance fees are contingent upon the fund's robust performance, conceived as a reward for the fund manager’s exceptional market outperformance.  

The imposition of management fees assures a consistent revenue stream for fund managers, underpinning the day-to-day functioning of the fund. This consistency is pivotal for the sustenance of long-term investment strategies and the uninterrupted operation of the fund. Nonetheless, management fees may engender an alignment discord between fund managers and investors, particularly in scenarios of subpar fund performance. Given that the accrual of management fees is disconnected from the actual performance of the fund, this might culminate in a dearth of incentive for fund managers to vigorously pursue superior returns.

The ethos behind the performance fee model is to forge a more congruent alignment of interests between fund managers and investors, incentivizing managers to strive for performances that eclipse set benchmarks. When the fund thrives, transcending the stipulated hurdle rate, the manager is consequently rewarded with a supplementary portion of the profits. This incentive schema potentially galvanizes fund managers to embrace more proactive investment strategies aimed at elevating returns. However, a caveat of performance fees is their propensity to incite fund managers towards embracing disproportionate risks in the quest for augmented returns.

Impact on Different Types of Funds

Private Equity Funds

Private Equity (PE) stands as a pivotal player, with investments primarily directed towards unlisted companies or acquiring controlling interests in listed entities for privatization. Characterized by an extended investment horizon, PE is notable for the depth of managerial involvement its practitioners often undertake in their invested companies, with returns accruing predominantly from either public listings or strategic sales of these entities. The sphere of private equity is broadly segmented into Venture Capital (VC), targeting nascent, growth-stage companies, and Buyouts, focused on acquiring majority stakes in more established corporations.

The structural backbone of PE is delineated into General Partners (GPs) and Limited Partners (LPs). GPs take the helm of fund management and investment decision-making, while LPs represent the investors, ranging from institutional entities to individual contributors. The prevailing fee structure in this realm typically adheres to a 2/20/1 model: a 2% management fee based on the Assets Under Management (AUM), a 20% performance fee (Carry) contingent on surpassing a predefined return threshold (such as an 8% preferred return rate), and a 1% GP ownership stake, signifying the GP's vested confidence and alignment of interests with the LPs.

• 2% Management Fee: A fixed annual fee charged to LPs, amounting to 2% of the fund's Assets Under Management (AUM).
• 20% Performance Fee (Carry): The proportion of the fund's profits allocated to GPs, triggered once the fund's returns surpass a predetermined threshold (e.g., an 8% preferred return rate). This fee is realized only after the fund achieves successful investment returns.
• 1% GP Ownership: GPs invest 1% of the total capital in the fund themselves. This investment is considered a commitment, indicating their confidence in the fund's success and aligning their interests with LPs.

Insights gleaned from a comprehensive analysis by Duke University and Ohio State University, encompassing 837 PE funds (cumulatively managing approximately $600 billion in AUM) from 1984 to 2010, confront conventional wisdom. They reveal that higher management fees do not necessarily correlate with diminished net returns. This suggests that pricier private equity funds are capable of generating sufficient overall returns to counterbalance their elevated fees (with average management fees in buyout funds at 1.78% and VC funds at 2.24%, and initial percentage fees in the first fund year typically ranging between 1.5% to 2.5%). Notably, as fund sizes burgeon, the overall compensation structure tends to pivot from performance-based fees to more management-oriented fees.

Funds with lower GP ownership, surprisingly, outperformed, possibly indicating a preference among more adept GPs to diversify their investment portfolios. The landscape of performance fees presents a dichotomy: higher performance fee buyout funds generally exhibit superior performance, while an increase in performance fees within VC funds often correlates with relatively poorer outcomes.

In summary, the dynamics within private equity funds, underpinned by LPs' extensive investment acumen, facilitate a comprehensive understanding of the long-term nature of PE investments and the constrained scope for alternate governance mechanisms. This framework suggests that the heightened compensation for GPs, derived from their capacity to yield excess returns, does not detrimentally impact LP returns despite higher fees and seemingly low correlation of interests. Contrasting this, mutual funds exhibit a negative correlation between higher fees and returns, predominantly ascribed to retail investors’ relatively limited proficiency in fund team selection compared to their counterparts in private equity or hedge funds.

However, a layer of agency tension still persists between GPs and LPs. High-fee private equity funds are frequently subjected to the so-called "waterfall effect," a scenario where fund managers, driven by the pursuit of maintaining or augmenting fee revenues, may resort to strategies that don't entirely converge with the optimal interests of investors:  

• Management Fee Incentive: Fund managers might be incentivized to prolong the fund's active status, thereby extending the duration of management fee accrual.
• Investment Decision-Making: This includes delaying exits from underperforming investments ("zombie investments") or circumventing capital recuperation within certain periods to sustain a higher management fee base.
• Performance Incentives: Implying that fund managers initiate profit distribution only after achieving certain return benchmarks, potentially fostering a propensity for short-term strategic moves to rapidly reach these thresholds.

Hedge Funds

Hedge funds, renowned for their pursuit of positive returns through a mosaic of strategies within the secondary market, often augment their investment potential by employing leverage. Simultaneously, these funds underscore the imperative of capital preservation, adeptly navigating risks with an arsenal of financial instruments, including derivatives like options and futures.

1. Long/Short Equity Strategy: Long undervalued securities while concurrently short overvalued ones.
2. Global Macro Strategy: Investing predicated on macroeconomic analysis of global events, a strategy epitomized by entities like Bridgewater Associates.
3. Market Neutral Strategy: Balancing long and short positions to attenuate portfolio susceptibility to market volatility.
4. Arbitrage Strategy: Exploiting pricing disparities across disparate markets for profit realization.

Hedge funds characteristically target absolute returns, transcending the confines of traditional stock markets to encompass bonds, commodities, and currencies. Compared to PE, they offer enhanced liquidity (average lock-up period 0.8 year), albeit with reduced regulatory oversight and opacity in investment strategies and positions.

Central to the hedge fund ecosystem are fund managers and investors, with managers orchestrating investment strategies and overseeing day-to-day operations, and investors infusing the capital. Fee structures in this domain predominantly follow the "2/20" paradigm – a 2% management fee and a 20% performance fee, manifesting a pronounced inverse correlation between the two.

• Management Fee: Predicated on a fixed percentage of the fund's Assets Under Management (AUM), hedge funds in 2019 averaged a 1.43% management fee, undercutting those of PEs.
• Performance Fee: Tied to a portion of the fund's over-benchmark returns, with the average nominal performance fee in 2019 standing at 16.19%. Many hedge funds adopt the High Water Mark or Hurdle Rate frameworks, ensuring performance fees are warranted only upon surpassing specific benchmarks or prior peaks.

Performance fees serve as the linchpin of hedge fund revenue streams. A 2018 survey by EY highlighted that 83% of hedge fund managers employed high water mark, and 38% the hurdle rate. Funds implementing high water mark-linked performance fees outperform their counterparts by approximately 3% annually on a risk-adjusted basis; those with a hurdle rate outperform by an estimated 4.5%.

• High Water Mark: Managers are entitled to performance fees only when the fund's net asset value surpasses its historical zenith, safeguarding investor interests against repetitive fee accrual due to market fluctuations or transient luck, and ensuring a focus on sustained, long-term performance.
• Hurdle Rate: Establishing a minimum annual or cumulative return target, this mechanism incentivizes managers to balance the quest for higher returns with prudent risk management, averting speculative excesses and aligning the interests of all parties involved.

According to a study led by University of Arizona and Ohio State University, surveying 5,917 hedge funds (average AUM circa $254 million) from 1995 to 2016, found that only 1,217 remain active, with a weighted average quarterly net excess return of 0.77%. The majority of hedge funds opt for a 20% performance fee, while the uniformity of management fees is relatively less pronounced.

A notable asymmetry is observed in the effective performance fee rates of hedge funds, approximately 2.5 times their average contractual rate, translating to an actual performance fee of around 50% rather than 20%. Investors garner only 36 cents for every pre-risk-adjusted dollar earned (the remainder allocated to management and performance fees), a nuance often overlooked. Between 1995 and 2016, investors accrued a total gross profit of $228 billion from hedge funds, paying out $113 billion in performance fees.

Decomposing the disparity between the nominal performance fee rate of 19.0% and the effective rate of 49.6%, fund net losses pushed the effective performance fee rate over 15%, elevating it to 34.5%. Subsequently, investor redemptions and liquidations post-poor performance further escalated the "underwater" performance fees, increasing the effective rate by 8.4% and 6.8%, culminating in a total performance fee of 49.6%.

The projected performance fees in diversified hedge fund portfolios significantly surpass the contractual rates. This stems from the inability of investors to offset gains and losses across funds, and the path-dependent nature of investor and fund manager decisions, undermining the efficacy of high water mark clauses and fee offsets.

Amid rising investor concerns over high hedge fund fees, managers are exploring a shift from the traditional "2 and 20" to a "1 and 30" fee structure, pivoting the focus from management to performance fees. However, a significant portion of these performance fees, in the long run, may not correlate with the actual lifetime performance of the fund, resembling management fees more closely than performance fees.

In the intricate tapestry of fund management, the structures of management and performance fees play a pivotal role. Management fees offer a stable income and operational resources for fund managers, while performance fees incentivize them to surpass benchmarks. However, each fee model carries its inherent drawbacks – management fees can lead to motivational deficiencies among fund managers, and performance fees can encourage undue risk-taking. Hence, comprehending the influence of these fees on manager behaviors and investor returns is of paramount importance.

Balancing Interests in Fund Management

In the intricate dance of fund management, selecting an apt fee structure necessitates a nuanced balance between motivating fund managers and safeguarding investor interests. An effective fee model should incentivize managers to strive for market-beating performances without nudging them towards undue risk-taking. Moreover, the transparency and simplicity of the fee structure play a pivotal role in attracting and retaining investors.

As investment landscapes continually evolve, so does the application of management and performance fees. Fund management firms may find themselves recalibrating their fee structures to align with shifting market dynamics and regulatory landscapes. This recalibration could entail introducing additional motivational mechanisms, such as co-investments with fund managers, or adopting more flexible fee models that better mirror the fund's performance and risk profile.  

Understanding how management and performance fees impact fund manager behavior and investor returns is crucial for any investment strategy. The right fee structure should balance the motivations of fund managers with the interests of investors, taking into account the overall performance of the fund and prevailing market conditions. As financial markets continue to evolve, fund management firms must constantly review and adjust their fee strategies to remain competitive and protect investor interests.

Investment Ideas

There are many different types of fee structures out there to meet the needs of the investors. From our perspective, a fee model encompassing low management fees coupled with higher performance fees, augmented by a review and monitoring period (such as 3 years) and claw-back clauses, can be a prudent choice to ensure alignment of interests. This model not only incentivizes fund managers to pursue alpha for performance rewards but also mandates them to thoroughly evaluate each decision and back it with solid investment rationale. Such a structure aims to strike a delicate balance, fostering a pursuit of superior returns while ensuring each decision is underpinned by a robust investment rationale.