Are Hedge Funds Aligned with Their Investors?

Here are two paragraphs from the introduction to “In Sync: How hedge funds achieve alignment with investors to foster long-term strategic partnerships,” a piece from the Alternative Investment Management Association (AIMA):

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.

Every aspect of the GP/LP offering from the fee model and performance incentives to the products offered includes characteristics designed to ensure that when the fund manager does well, the investor does well, and the fund manager only does well when the investor does well.

Before continuing, it is worth reporting that AIMA is “the global representative of the alternative investment industry,” working “to raise media and public awareness of the value of the industry.”  Survey results from 138 fund managers (with an average of $5 billion in assets) are used to buttress the conclusions of the report and further that mission.  The results are some interpretations of “alignment” that investors and independent observers might find questionable — or laughable.

The “fundamentals”

The opening part of the document, titled “Aligning interests: The fundamentals,” begins in this way:

The central pillar for securing a strong alignment of interests between managers and investors remains how much skin they have in the game (i.e., the personal capital invested in the fund by the principals).

While the supporting data was not provided (so the other possible responses could not be viewed):

When asked how they primarily align interests with investors, over three-quarters of fund managers surveyed said it was achieved through having a significant personal investment in their own funds.

A trend toward “broader skin in the game” is discussed — extending ownership beyond the principals as a way to fight the “intensifying war for talent” — and transparency for investors is also examined as a way to provide greater alignment.  As noted, there are positive and negative aspects of more transparency.  (Some managers effectively use greater openness as a selling point.)  The reasons for a given level of transparency ought to be clear to investors, yet often they are not.

The “fundamentals” primer concludes with a section on relationship management which states that “the most important feature for managers seeking to align interests is the desire to create a ‘stickier ticket,’ i.e., create an appealing offering for investors to dissuade them from redeeming their capital.”  Thus, alignment means getting to keep the assets by adding some new attractions, rather than wrestling the elephant in the room.

Fees

Average management fees increased from a similar 2019 survey, driven by managers with over a billion dollars in assets (they went down for smaller managers).  The explanations offered ought to raise some eyebrows:

With costs continuing to rise across the industry (aggravated by a ferocious war for talent, the need to digitise the business, not to mention the relentless pace of regulatory and compliance change), there is a clear sense that a tipping point has been reached regarding the headline fee that fund managers charge to support the operation of their business.  In addition, the strong performance from the industry over the past two years (with hedge funds on average offering the best set of returns over a passive investment/ETFs) has allowed some fund managers to push forward their case to receive higher compensation.

Performance fees were also higher, again because of larger funds, while those on smaller ones declined.  High-water marks continue “to be the dominant mechanism used by investors to help ensure fund managers only get compensated on any net new increases in the fund’s asset value,” although uncommon permutations of them are increasing, including ones that are reset annually or for a multi-year period (rather than continuing perpetually).  Do those indicate greater or lesser alignment with asset owners?

And then there are hurdle rates:

Increasingly, hurdle rates are being considered a prerequisite in any performance compensation arrangements between fund managers and their investors, especially with regard to any new fund launches.

Half of the managers now use hurdle rates, up from a third in 2019.  That would seem to be progress, but “there are many variations to the types of hurdle rates being agreed [on by] fund managers and their investors.”  No data is provided regarding the prevalence of the different kinds of hurdles; it would be instructive to know what types are being used and to what degree (including the faux ones called “soft hurdles”).

This is where the fund-manager-only-does-well-when-the-investor-does-well façade really breaks down.  It is otherwise widely accepted that asset managers should be judged (and rewarded) on whether they outperform a representative index, yet most hedge fund managers continue to be rewarded for beta above a hurdle because of historical precedence.  (It was more defensible years ago, when markets were less efficient.)  Real alignment would look different than that, with some notion of alpha being the appropriate above-hurdle measure.

There are other topics touched upon, including catch-up provisions, clawbacks, and crystallization frequencies.  It’s hard to make the case that the way these provisions are used in the industry provides alignment with the actual owners of the assets.

Preferential terms, tiered management fees, and other forms of “relationship pricing” do offer some improvements under certain conditions, but they work from the general base of misalignment.

(The pass-through of expenses is also covered in the AIMA report.  That will be addressed as part of a subsequent posting on the multi-manager platforms that are currently all the rage.)

Two other short parts of the paper are on product innovation (exclusively looking at co-investment opportunities) and ESG (as evidence of managers “adapting to the changing landscape”).

Context

In surveys where both hedge fund managers and their clients are surveyed, there are large differences in beliefs between them across many of these aspects of purported alignment.  An objective review ought to include both points of view.

Almost all asset owners, even large ones, are price takers when it comes to partnership vehicles, with some exceptions for “relationship pricing.”  Of course, cash flows to hedge funds ebb and flow according to how they are performing (as they do in other product categories).  Many different strategies fall under the hedge fund umbrella, so summarizing performance is hard, but the general progression of mandates and performance over time was accurately characterized by Bob Seawright in an edition of The Better Letter (previously quoted in a Fortnightly):

Gaslighting and poor performance undergird the change in hedge fund marketing over the years.  It went from “We’re going to make a ton of money,” to “We’re going to outperform,” to “We’re going to provide superior risk-adjusted returns,” to “We’re going to provide absolute returns even in down markets,” to “We’re going to provide non-correlated returns.”

Throughout it all, managers (and the AIMA) have been pushing the narrative that hedge funds are uniquely aligned with their investors in ways that lead to superior returns (and getting more aligned over time).  Are they really in sync with investors — or just saying that?