Re-aligning fund incentives to improve investor outcomes
There’s an undeniable truth that governs the global economy: incentives matter. Whether it’s performance bonuses, commissions, or equity, any monetary incentive linked to actual results is likely to nudge individuals to go the extra mile.
Another undeniable truth is that the investment industry is full of misaligned incentives, with investment managers typically acting as agents and benefitting more from gains they then risk in potential losses. The traditional “2-and-20” (or “1-and-10″, etc.) model of management and performance fees, for example, provides investment managers with the first claim on distributions via the Management Fee, and a share of the economic gains, via the Performance Fee or Carry, versus the risk that they take (which is typically zero).
Such misalignments often lead to negative results for investors. This can occur either because the manager becomes “fat and lazy” with the profit earned from the management fee, or the manager takes risks to generate a high performance fee without having to suffer if the return is negative. This is especially true for larger investment managers who are more likely to profit based on the management fee alone, or who can have multiple fund offerings, shutting down those that do not succeed.
This lopsided fee structure is falling out of favour. According to research by Eurkahedge, management and performance fees for hedge funds have both been steadily declining since the global financial crisis of 2008. The average management fee has dropped to 1.35% according to EY.
Hedge fund industry AUM percentage breakdown by management fee
Even with falling management and performance fees, and higher hurdles, the fundamental problem of the fee structure being misaligned is not solved. The “1 or 30” structure created by Albourne Partners is a step in the right direction, but when alpha is low or negative, it still gives managers a priority claim on assets, while still incentivizing, or even increasing the incentive, for the manager to take risks.
Until this misalignment is resolved with a fundamental structural rethink, investors will always have to worry about whether their interests are being optimally served.
Skin in the Game
The industry clearly needs a replacement fee structure that better aligns the manager’s interests with their investors. The easiest way to align interests is to ensure that the manager has capital at risk.
Unsurprisingly, fund managers are motivated to perform better when their own money is on the line. Researchers Arpit Gupta and Kunal Sachdeva from the National Bureau of Economic Research analyzed the performance of over 720 hedge funds over the course of the course of five years (2011 through 2016) and found that managers outperformed their peers when their skin was in the game.
“Personal capital commitments better align the incentives of managers and outsiders, providing greater incentives for managers to scale their funds less aggressively in a manner which results in greater returns to investors,” the researchers explained.
Putting Investors First
Alignment is one of Heirloom Investment Management’s core values, and we have always invested our own capital alongside our investors to ensure alignment. However, with our new Heirloom Fixed Return Fund, we have also designed a new fee structure that is designed to increase this alignment further by putting our “money where our mouth is” by giving our investors first claim on any returns, and having our equity layer absorb any losses experienced. We do not earn any fee or other economic benefit until our investors have earned their Fixed Return. We believe that this is a substantial improvement on the typical fee model, eliminating the incentive for us to either sit on our hands, or to take undue risks.
Heirloom’s Fixed Return Fund offers a Fixed Return to investors depending upon their chosen liquidity profile. This compensates longer-term-investors, and those willing to provide the ability for the Fund to take less liquid positions. USD and CAD denominated investors will earn a target 8% Fixed Return for the 6-month notice provision class, while they will earn a target 9.5% for 18-month notice provision and 11.0% for 36-month notice provision. These returns are not guaranteed, but the investors earn any portfolio gains up to their fixed return (which continues to accrete like a high water mark if the gains are not met), while any negative returns are first absorbed by Heirloom’s equity layer.
Heirloom profits by earning any return above investor fixed return, and otherwise earns no management or other fees. Any economics earned by Heirloom must be reinvested into equity of the Fund to absorb potential future losses and can only be redeemed to the extent that Heirloom maintains more than 10% of Fund NAV, providing at least a 10% loss-absorption protection for investors.
The Fixed Return Fund will invest in a diverse portfolio of Heirloom’s best themes/opportunities that are highly diversified and uncorrelated to major asset classes. A key focus is on asset-backed strategies that are anticipated to generate strong cash flows. Underlying liquidity is provided by focusing on shorter to mid-duration investments, staggering them so that principal repayments are regularly received in addition to cash flow, and also maintaining a pool of highly-liquid investments.
This is a fund model that we believe will become more commonplace in the future as the investment industry evolves to greater alignment between investors and managers. It realigns incentives, ensuring that the manager is neither incented to take undue risks or to passively oversee assets that generate a management fee, gives the investors the first share in any economics earned, while also ensuring that the manager receives a fair share of any true “alpha” generated.
We think this will encourage managers to implement strong risk management, to be incentivized to deliver performance, and to stop growing AUM at the point where performance will suffer.
(If you would like to speak with someone at Heirloom to discuss the ideas presented here, or to learn more about the Heirloom Fixed Return Fund, please contact Beth at firstname.lastname@example.org.)
Originally the in-house investment management function for a Canadian single family office, Heirloom offers flexible institutional-quality investment solutions designed specifically to help family offices and high net worth individuals achieve their goals. Its services include advisory over the entire portfolio as a full Outsourced Chief Investment Officer, to offering advice or managing investments in specific themes or asset classes, to offering co-investment opportunities in specific opportunities or themes.
Heirloom’s macro-thematic investment strategy invests across assets classes and geographies, focusing on allocating capital to long-term trends and market dislocations with a heavy focus on risk understanding and control.
Its approach has been used by leading pension plans and sovereign wealth funds for 20+ years. This strategy is supported by extensive academic research and has been advocated by McKinsey as how all investors should manage their money to generate the best risk-adjusted returns over the long-term.
This document is for information purposes only and is not intended as an oﬀer or solicitation to invest. The material in this document is intended only as a reference and should not be relied upon as investment advice or for any other disclosure purposes. This is intended for accredited investors only. Past performance is not indicative of future results and there can be no guarantee that this strategy will achieve its investment objective or returns.
This document is based upon sources of information believed to be reliable but no warranty or representation, expressed or implied, is given as to its accuracy or completeness. All opinions and estimates contained in this document constitute the Heirloom’s judgment as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. We assert that the reader is solely liable for their interpretation and use of any information contained within this document.
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