Hedge fund expense due diligence: painting the full picture

By Gordon Barnes

Cambridge Associates

Q2 2013

For institutional investors, understanding what fees and expenses they may be expected to pay to hedge fund managers is critical in making well-informed decisions. However, getting the full picture of the various expenses is rarely easy and requires careful review and analysis during initial and ongoing investment manager due diligence.

There are essentially three levels of fees and expenses paid by hedge fund investors:

1. Investment Advisory Fees paid to the investment manager for its investment management services;

2. Fund Expenses paid at the fund level to service providers, or for other costs associated with maintaining the fund entity;

3. Indirect Costs less transparent costs that can take many forms, but the primary drivers are trading commissions and prime brokerage-related costs.

Investment Advisory Fees

Overview Understanding the issues

There are variations of the standard 1.5/20 hedge fund fee structure that have gained traction in the past several years, such as the modified high-water mark (lower fees in return for longer lock-ups and claw back provisions that effectively charge incentive fees at the end of three years instead of one year). In an effort to stabilize the capital base and align investment manager and investor interests, some managers have lost sight of the original purpose of the management fee: to cover the costs associated with their day-to-day operations, including employee salaries, office space, and infrastructure-related costs (i.e. keeping the lights on).

The performance fee exists to compensate the manager for generating strong investment results; it is essentially an incentive structure to create alignment of interests between managers and investors.

The question that arises today is: Should investment managers be using management fees as a profit center? As firms raise asset levels, economies of scale kick in because the costs associated with running a firm do not move in lockstep with increasing asset levels. There comes a point where a managers infrastructure can handle asset growth without increasing costs, generating significant profit from the management fee alone. This profit-center shift moves focus from the performance fee to the management fee and has the potential to misalign interests.

Due Diligence Ensuring that alignment of interests persists

Outside of evaluating the managers ability to continue performing with increased assets, other factors should be considered as part of the ongoing due diligence process. The portion of management fees reinvested in the funds should be monitored by reviewing year-end fund financial statements and having conversations with the managers Chief Financial Officer. As managers and affiliates add capital, they begin to realign their interests with investors.

It is important to know not only what is put into a fund by the manager, but also what is taken out. Redemption terms should be examined as part of the offering document terms review so investors understand what rights are applied to the manager and whether there are any formal communications or advanced notices to investors that are triggered when the manager plans to redeem capital. It should also be known whether the manager has preferential liquidity terms; is the manager subject to the same withdrawal terms as investors, and if not, why not? Fairness and alignment of interests between managers and investors is a powerful relationship, one that should be measured and monitored on an ongoing basis.

Fund Expenses

Overview Understanding the other costs

Beyond the management fee, the most common costs and fees borne directly by the fund are for annual audit and tax work (for onshore funds), third-party administrator costs, legal fees, and offshore fund directors fees. These expenses are generally considered appropriate; they provide services directly to the fund itself and not to the investment manager. What makes this aspect of expense due diligence crucial is that there are no set standards for what can or cannot be passed through to investors. In fact, fund pass-through expense policies can vary widely from one fund to the next. The language defining these policies is generally buried within fund offering documents and requires careful analysis.

Taking the aforementioned expenses as standard fund expenses, it is important to identify any other costs that can be passed through to fund investors. Given there are no set standards, these expenses could take several forms (research-related expenses, travel associated with investment research, trading systems and technology, legal costs associated with investment deals, marketing expenses, and employee salaries and bonuses). Passing through some of these expenses raises the potential for conflicts of interest. For example, is the manager motivated to keep costs as low as possible if the expenses do not directly affect their bottom line? The opportunity exists to abuse these expenses if they are not tightly controlled and managed. In fund offering documents, expenses that can be passed through to funds should be fully disclosed and provide the appropriate level of detail and clarity.

Another issue concerning expense policies is that there is generally no defined cap or limit on the economic impact that they can have on investor capital. And, even if the pass-through expenses have remained consistent historically, there is nothing to prevent a manager from increasing them as long as they remain within the general guidelines provided in the fund offering documents.

Due Diligence Putting expenses into perspective

It is imperative to understand the nature of fund expenses to ensure that they are reasonable and appropriate compared to the managers peers and industry standards. It is critical that investors truly understand what they are paying for. To do this, the following steps must be taken:

1. A careful review of the expense section in the fund offering documents, noting the types of expenses that are disclosed as eligible to be passed through to investors;

2. A review of past fund audited financial statements, specifically the expense section of the income statement, to determine the historical economic impact to the fund;

3. An evaluation of the managers itemized expense schedule and associated impact on the fund; the total should be reasonably close to the total found within the financial statements.

This information provides additional insight into the overall integrity of the manager. What does an investor do with this information once acquired? Determine the types of expenses the manager charges and whether their associated economic impact is reasonable and appropriate. To quantify this, an investor must consider peer comparisons by determining the universe of managers that have a similar investment strategy, gathering information on what they are charging for pass-through expenses, and analyzing where the manager falls within its particular investment strategy group to determine if it is an outlier, and if so, by how much.

Another characteristic that determines peer group is a managers assets under management. Certain strategies are more expensive to run than others depending on the types of securities and instruments that are used to employ the strategy and the complexity of the business. For example, a fund administrator will not charge the same to provide an equal level of service for a $1 billion straightforward long/short equity manager that it will for a $1 billion multi-strategy manager using complex instruments with high trading volumes. Once the funds are put into peer groups, the manager can be more effectively analyzed. The managers fee and expense structure should also be viewed as a whole; if one manager charges 1.5/20 and another charges 2/20, an investor still does not have the whole picture unless the manager provides the total fund expenses. It is certainly possible to pay more in the aggregate for a fund with a 1.5% management fee than one with 2% due to pass-through expenses, and more analysis is required to uncover the underlying economics.

Indirect Costs

Overview There are even more costs

Other expenses related to investment strategy are indirectly borne by investors. Investors generally have little control over these costs; they are necessary and directly related to day-to-day investment activities. The manager does have some level of influence over them, however. The investor should understand the managers processes and procedures for actively controlling these costs.

Due Diligence Assessing the managers process to oversee and control costs

Executing-broker trading commissions can be one of the larger costs to investors, depending on the strategy. Although it is expected that a manager will buy and sell securities as part of its strategy, a structured process should be in place to ensure that the firm has an effective best-execution plan. Part of this plan usually includes a review of broker commission allocations and oversight of commission charges on an ongoing basis. For example, if an executing brokers commission rates and service are not in-line with expectations, the manager could reduce its business with the broker as motivation for the broker to adjust its rates. As part of the due diligence process, the investment managers approach, controls, and procedures for managing commissions should be reviewed. To do this, additional factors should be considered such as how trades are executed, what the brokers are actually used for (purely execution or provision of research), the types of instruments traded, and the use of electronic and block trading.

Another consideration related to commissions is that it is difficult to quantify the actual impact of the managers use of soft-dollars on investors given the non-transparent nature of this practice. The idea is that a manager may essentially be overpaying for commissions and then receiving a rebate or credit. The credits should be used for general research purposes that are in compliance with regulatory standards (e.g. SEC rule 28e). A discussion with the manager should be conducted on its policies surrounding soft-dollar usage and how the annual budget or credit allocations are monitored and managed.

The hidden costs of prime brokers are another indirect expense sometimes overlooked by investors. Although it is highly difficult for an investor to measure its share of prime brokerage-related costs, a review of the managers policies and practices for obtaining (and maintaining) competitive rates and terms should be conducted. In general, managers should be knowledgeable in this area and understand what their prime brokers receive in order to ensure that the brokers services are in-line with expectations. Not only should managers revisit their prime brokerage agreements on an ongoing basis to ensure they have addressed high risk areas, but the rates should be renegotiated as markets change. One way many managers do this is by strategically employing multiple prime brokers, creating a competitive rate environment.

Trade errors, or failures of the manager to execute a trade as intended or specified, may result in a cost to the fund (losses after reversing the trade) depending on the firms trade error policy. Ideally firms will have a policy that reimburses the fund for trade errors that result in losses, but this is not always the case. It is difficult to quantify future errors, but it is still important to know the managers policy, the insurance coverage in place, and the track record of trade errors in order to be fully informed about the potential costs investors may be subject to in this area.

Conclusion

Hedge fund expense due diligence is a multi-faceted process, both initially and an ongoing basis, and should encompass a review of the managers internal processes for validating, approving, and fairly allocating fund expenses across client accounts and funds.

Expenses are not always easy to quantify, but there are methods to gain greater clarity around what investors are really paying for and whether managers have appropriate procedures in place to control, review, and manage expenses with the best interests of their investors in mind.

It is important to note that expense policies are not set in stone, and investors should not always accept things as they are. A coordinated effort among investors could encourage managers to rethink policies concerning certain expenses that can raise conflict of interest issues or are meaningfully outside expectations in the types of expenses charged and/or the economic impact they have on investor accounts.