The business of hedge funds - dynamic choice beyond 2/20

The lifeblood of hedge funds as businesses is their performance pricing proposition through incentive fees. Unfortunately for them, the simple business model of 2% management fee and 20% incentive fees is fast becoming extinct. Pricing is coming down as well as becoming more complex with more pricing alternatives as the hedge fund business becomes more competitive and investors become more sensitive to alpha production. 

New pricing alternatives are more closely aligned with the skill of managers. Investors have shifted to pricing models to take advantage of the growth in benchmarks to minimize paying high fees for beta. The new business proposition for both investor and manager is to align incentives so that the talent performs better as these incentives become more focused. These incentives are aligned if managers receive money for performance and not asset gathering and any incentive payment is tied to alpha production not beta risk-taking. 

Still, the fixed costs of hedge fund management have to be covered with some stable fees. Consequently, a model of squeezing management fees or providing no incentive fees does not help managers who may have limited capacity. This aggressive pricing may in the longer-run hurt investors who want to hold the best managers in their portfolio. Unfortunately, those hit hardest with the trend to new pricing models are newer and smaller managers.

The choice set of fee structures has widened from flat low fixed fees for large allocations to more innovative fee structures like the "1 or 30" concept rolled out by Texas Teacher's pension plan. The 1 or 30 and similar variations reveal the preferences of both manager and investor. The manager who is willing to take the 30% incentive deal places more weight on his ability to deliver strong consistent returns. Those managers that focus on fixed fees, especially after fixed costs are covered, shows a bias toward asset gathering and stability of cash flows not performance.

The pricing negotiations review the preferences and skill confidence of both parties. Using "or" choices, switching choices between fees and incentives, tiered pricing by AUM, hurdles, and benchmarks all provide insight on manager skill as well as their business savvy. This is all positive for the industry as long s the focus is on aligning incentives and not just extracting lower fees.