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|User Info||Hedgefunds - 2/20 here to stay; entered at 2009-08-13 18:14:54|
Registered: 2007-07-25 Orange County, CA
By Gerelyn Terzo|
Hedge fund compensation was already becoming a hot topic of discussion within the industry, and the latest earnings report from Och-Ziff Capital Management Group isn’t likely to quiet the chatter.
The $20.7 billion alternative asset manager reported a second quarter loss that was wider than expected this week, and attributed the shortfall in large part to compensation, including bonuses for top traders. The hedge fund firm reported total compensation expense of $47.6 million, which Och-Ziff will pay at the end of the fourth quarter. Bonus payouts are almost 75% higher than the same period a year ago, and more than double the expectation of Jefferies analyst Daniel Fannon. The differential between Jefferies’ estimates of $22.2 million and the payout reflects “year-to-date investment performance and talent retention,” according to Jefferies.
Indeed, Och-Ziff’s AUM have increased 2% since April 1, 2009, while performance has climbed in all four flagship hedge funds. Och-Ziff’s management fees, however, spiraled 42% from the year-ago period. Fee structures will continue to be a topic of discussion among hedge fund managers and their limited partners throughout 2009, according to Jefferies, although Och-Ziff seems to get a pass: “We believe Och-Ziff’s relative strong performance along with the willingness to provide liquidity to LPs during this period will be a strong bargaining chip in future fee discussions,” Fannon says in the report.
While Fannon braces for ongoing fee negotiations, others maintain the traditional 2/20 management and performance fee structure will prevail. Andrew Schneider, managing partner at HedgeCo.net, advised 75 emerging hedge fund managers on structuring a hedge fund year to date. And, while capital introduction progressively improves, he advises that clients implement a 2/20 fee model: a 2% management fee and a 20% performance fee. He says this is predominantly because fees can be lowered at the discretion of a general partner, who can offer investors a discount, but fees cannot so easily be raised. And, without the 2% management fee, the proposition to partner with a hedge fund becomes less compelling for third party marketers and placement agents. “One of the biggest mistakes fund managers make is that they have fees too low,” Schneider says. Of the funds HedgeCo.net structured year to date, 80% are designed with the 2/20 model. “We’re not going back to 1/20. I would do 1/20 or 1.5/10 if a fund manager’s clients were strictly institutional. But 2/20 is still the common fee structure and any fund manager lowering fees is making a mistake,” Schneider says.
According to a recent study developed by Grahall Partners LLC in collaboration with Kleinberg, Kaplan, Wolff & Cohen and UBS, most hedge funds do not have a formal compensation policy in place. And with fees under pressure, this has cut into employee pay. Even though hedge fund performance has stabilized, some funds continue to trade below their high-water mark. This means fund managers are obligated to return a hedge fund to peak-level returns, or attain their high-water mark, before collecting performance fees again. Whether or not employees are to be paid any incentives is up to the GP’s discretion. “In talking to candidates, we’re not seeing most of these founders too eager to dip into their own pockets. As a result, we’re seeing a lot of movement of high quality talent,” says Claude Schwab, practice leader at Heidrick & Struggles.
Schwab recalls that for several years through 2007 when funds were mostly positive, there was a standard band of compensation for any given functional role. “People knew where they stood in terms of salary and bonuses,” he says. “Either hedge funds were competitive within those bands or they lost people. Plain and simple.” For instance, previously, a senior level marketing professional at a large hedge fund who had strong performance could fall within a band of $1 million to $2.5 million.
Now those lines are blurred due largely to the dislocations in hedge fund performance and the broader financial markets. “Today, the compensation question is a harder one to answer. There are multiple bands versus a single band before,” Schwab says. And this is in part driving the “movement” that is unfolding in the industry. “There is a large amount of movement of senior investment professionals to different places, people who are at the top of their game. Some of the best talent will be moving before year’s end and this indicates that people at the top of the hedge fund are not dipping into their own pockets,” Schwab says. According to Laurie Thompson, associate principal at Heidrick & Struggles, it’s unusual for high-level individuals to leave a hedge fund so late in the year with bonuses so close by.
Schwab says two-thirds of hedge fund managers receive formulaic payouts, while the balance receives subjective bonuses. The former go to the most senior of professionals who are more at risk during times of market dislocation because they have an expectation for pay in mind. “Some of those managers who are performing well have to assume that netting risk is going to be an issue. How do you pay people who did well when your firm is under water? We have not seen too many GPs dipping into their own pockets — that will continue to be the exception,” he says.
Grahall has years of experience addressing compensation design for hedge fund clients. Tom Roth, a consultant at Grahall, says there is no “boilerplate” approach to hedge fund pay given the myriad of asset sizes and strategies that characterize hedge funds. One Grahall client that oversees about $1 billion in AUM is considering launching a private-equity fund. “The question they are asking is how do I pay the private-equity guys vis-à-vis the hedge fund guys? They need to work closely together, but the time frames for how private-equity professionals are paid tend to be much longer than they are for hedge funds,” Roth says. Another client is 100% owned by the founder who is now considering extending LP to a key portfolio manager. “The question is, how does the founder bring him into the partnership?,” Roth says. The manager has been with the hedge fund since its inception and currently earns salary and a discretionary bonus. Roth says he may end up with some equity stake in the hedge fund. “Sometimes firms give that equity stake and sometimes they create an opportunity for individuals to purchase shares in the firm. There’s no right or wrong answer for how to do this,” he says. “It depends on the particular circumstances of the firm.”