HomePreqin AcademyLesson 3: Hedge FundsHedge Fund Fees, Types, and Structures

Hedge Fund Fees, Types, and Structures

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In this section, you'll find out more about how hedge funds are structured today. As the industry has evolved, the expectations from investments have evolved too, meaning structures and fees vary across hedge funds to suit the criteria of investors and fund managers.

Hedge Fund Fees

One of the key features that distinguishes hedge funds from mutual funds is their ‘2/20’ fee structure, comprising two key components:

A management fee: annual fee charged by a manager to cover the operating costs of the investment vehicle. The fee is typically 2% of a fund’s net asset value (NAV) over a 12-month period.
A performance fee: also known as an incentive fee, this second fee is viewed as a reward for positive returns. Performance fees are typically set at 20% of the fund’s profits.

Although the 2/20 structure is the more traditional model used, hedge fund managers are facing mounting pressure to reduce fees. As of 2019, Preqin has observed marginal decreases to the industry’s fee structure, to an average of 1.50% management fee and 19.00% performance fee. To ensure performance fees are not pre-emptively taken, which could trigger investors to exercise a claw-back provision, a hurdle rate and/or high-water mark can be set in place.

Claw-Back Provision

A claw-back provision allows the limited partner to claw back any fees paid during the investment period to equal the original percentage agreement if subsequent losses occur.

Hurdle Rate

A hurdle rate is the minimum rate of return that the hedge fund manager should generate before it is able to charge a performance fee. Hurdle rates are either a fixed or variable rate, often linked to a benchmark interest rate, such as Libor. As you can see in the chart below, there is a certain amount of preferred return required in order to reach the hurdle rate. Once the hurdle rate is reached, there is a period of time when costs associated with the investment are paid. Once the full catch-up is met, the remaining returns enter the 'profit sharing' region, where returns are gained and performance fees can be charged.

High-Water Mark

A high-water mark notes the highest value that an investment fund has ever reached. The high-water mark mechanism means that a hedge fund manager will only be paid fees if the fund value exceeds this level. This ensures that performance fees are only paid on new profits generated by the manager, and that incentives are not paid on profits that simply offset the losses of previous years.

If a fund includes both a hurdle rate and a high-water mark, the manager cannot receive a performance fee unless the fund’s value is above the high-water mark and returns have exceed the hurdle rate.

Hedge Fund Liquidity

The dynamic nature of hedge funds strategies, which we delve into in the next lesson, allows hedge fund activity in basically anything investable. Over time, more and more strategies and fund structures have emerged. Implementing new structures was, in part, the industry’s response for the need to align interest with its investor audience. Liquidity was one of the main attractions for institutional investors, especially for those who'd had experience of the exceedingly long lock ups in the private capital world.

A fund’s liquidity will vary, corresponding with the types of investments the fund manager is pursuing. An event driven fund, for instance, would not benefit from the same liquidity provisions as a long/short equity fund. Some hedge funds may carve out a side pocket to segregate the illiquid investments from the fund’s liquid securities (offered to subsequent investors on a pro-rata basis). Others will elect for higher restrictions around capital accessibility, by decreasing the frequency of periodic withdrawal and increasing notice periods.

While hedge fund managers can offer a fraction of the wait time compared to their closed-end counterparts, their liquidity terms are still binding in comparison to the traditional mutual or exchange-traded fund. So, while a CTA/Managed Futures strategy can be characterized as having a relatively short investment horizon, its redemption frequency is not daily. Money that ‘sticks’ is most desirable – managers can then concentrate more on managing and spend less time dealing with panicky investors.

Explore the types of restrictions that impact liquidity by clicking on the drop-down menu below.

Lock-up Period

A lock-up provision gives the fund manager time to exit any illiquid investments, and, in turn, protect its wider portfolio and limited partners from imbalance.

While a traditional hard lock-up does not permit investors to withdraw capital in the given timeframe, most hedge fund investors prefer the flexibility of a soft or rolling lock-up. In a soft lock-up, the investor may withdraw their investment at the cost of a redemption fee set by the manager, whereas a rolling lock-up allows investors to redeem capital on a designated date. If the investor does not withdraw their money on the given date, they forfeit the right to redeem and must endure an additional lock-up period.

Gate Provision

Gate provisions prevent or limit capital redemptions in a time that could severely cost the fund, or result in forced liquidation. These can be implemented at the fund level (typically set at 20% of the fund’s NAV), or at the investor level (typically up to 25% of an investor’s capital each quarter over four quarters).

Subscription Frequency

A fund’s subscription frequency limits the number of investments you can make within a given time. It is not uncommon to be able to subscribe as frequently as you can redeem, if not more (usually monthly or quarterly). Unlike traditional mutual funds, which has a rather informal ‘subscription’ process, it is custom to submit a subscription application form and wire the money over in time for the transaction to be completed at the start of the following month or quarter.

Maximum Leverage Employed

The concept of maximum leverage employed sets a limit on how much the hedge fund can borrow against its committed capital from investors. This is typically to prevent the fund from over-leveraging and having to carry debt.

Hedge Fund Leverage

How and Why do Hedge Funds Use Leverage?

Leverage is generally described as the use of debt to amplify returns, but at a higher risk profile. Hedge funds use leverage for a few different reasons: to 1) bolster returns at a higher risk with a potentially much higher reward, 2) amplify low-risk strategy returns, 3) reduce risk levels, or for 4) improved liquidity and lower transaction cost reasons.

Type of leverage used depends on hedge fund strategy. A manager would choose to boost returns at a high risk with leverage if they were highly confident in an investment thesis, typically a long bias equity fund. A different manager would choose to boost lower risk returns, such as arbitrage trades, which are usually hedged and have less downside but provide little return without leverage. Leverage with the purpose of risk mitigation is common across all funds. For example, a long/short equity fund would balance out its long exposure with short positions, resulting in less volatility. Liquidity benefits can be directly experienced in the commodities market, where taking positions in derivatives is much more efficient than the commodity itself.

The Mechanics Behind Leverage Tools

The most common explicit leverage method is through shorting. The fund manager can select which securities the fund will sell short and immediately receive cash for their selection. This cash can be used to buy more assets, ultimately resulting in more assets purchased than the fund originally could have bought without the extra cash. The manager must buy the shorted security back later, so there is a risk of price appreciation of the underlying security, which would drain cash in the future.

Another explicit form of leverage is available to hedge funds through their prime broker, most of which can offer credit (buying power to purchase assets) in exchange for a smaller fixed percentage of the fund’s cash/securities and a fee. Implicit leverage can be obtained through the use of derivatives, such as futures, options, forwards, and swaps. Leverage is used to expose the trader to amplified price movements in the underlying security without having to put up the capital that would be needed in the underlying’s market (i.e., buying a call option exposes the buyer to the price movement of 100 shares of an equity, but at a small fraction of the cost). The fund can then put capital saved to work in other ways to generate returns.

Types of Hedge Funds

There are a range of different hedge fund vehicle types and structures available for investment. Fund types vary in order to meet investors’ needs like liquidity, limited liability, and tax exemptions.

Explore the key fund types in the dropdown.

Commingled Fund

commingled fund

Managed Accounts

Managed accounts are vehicles that are sub-advised by a hedge fund manager, which is limited to making investment decisions on behalf of a single investor rather than pooling assets from multiple external investors (as in the commingled structure). Through a managed account the individual investor will own the actual assets being invested in, as opposed to limited partnership interests in a pool of assets.

The benefits of a managed account include:

Reduction in the risk associated with an unbalanced portfolio in a commingled structure due to high redemption frequency of investors.
The investor has full transparency on the assets being managed and may tailor the portfolio according to their specific needs.
The investor can nominate their own service providers as a way of lowering counterparty risk.

Managed accounts often require a sizable capital commitment from an investor due to operational and logistical difficulties for the manager setting this up. This means that managed accounts are typically only available to the largest investors.

Fund of One

A fund of one borrows elements from both the commingled fund structure and a managed account. As the name suggests, a fund of one is a fund, often structured as a limited partnership, with one dedicated investor. The biggest difference between a fund of one and a managed account is in ownership of the assets, for which the fund manager will have ultimate liability.

The fund-of-one structure offers investors some of the benefits of customization associated with a managed account, albeit with some loss of governance, as the trading manager retains control over the fund strategy and the assets invested in.

Listed Fund

A listed fund is a fund that is listed and traded on a stock exchange. Hedge funds are often listed on smaller market exchanges, such as the Irish Stock Exchange, usually in order to provide a degree of regulatory oversight demanded by investors. Listing a fund on an exchange will mean that it is subject to a greater degree of scrutiny, as performance and aggregate asset values must be disclosed in annual reports; however, the portfolio of assets invested in does not need to be disclosed.

Undertakings for Collective Investment in Transferable Securities (UCITS)

UCITS are investment funds that come under the European regulatory framework. UCITS vehicles aim to promote high levels of investor protection through greater transparency of investment activity and, unlike other hedge funds, can therefore be marketed to investors across the EU.

Under this framework, UCITS funds have to offer their investors at least fortnightly liquidity and monthly transparency documentation outlining the strategy and investments of the fund. The underlying investments UCITS funds can make, and the level of leverage they may use, are regulated. The result of these restrictions is that such funds often generate smaller returns than their traditional hedge fund counterparts, although this is somewhat mitigated by a lower fee.

Alternative Mutual Fund

Alternative mutual funds, also known as ‘’40 Act funds’ are vehicles registered as mutual funds under the United States Investment Company Act of 1940. Similar to UCITS, changes to regulations have allowed ’40 Act funds to adopt hedge fund-like strategies in recent years. Alternative mutual funds have to offer their investors daily liquidity and provide periodic transparency documentation. Also, like UCITS funds, these vehicles have restrictions on the underlying investments they can make, as well as a cap on leverage.

Hedge Fund Structures

Hedge funds can be structured in various ways depending on a number of factors, including where the fund is domiciled (the country in which it is registered), where its investors are located, and the fund’s investment criteria.

Master Feeder

A master-feeder structure is commonly used by hedge funds to pool capital raised from US-taxable, US tax-exempt, and non-US investors into one central master fund. The structure generally involves the use of a master fund company (incorporated in a tax-neutral offshore jurisdiction such as the Cayman Islands or Bermuda) into which separate distinct feeder funds invest – an onshore-domiciled feeder fund for US-taxable investors and an offshore-domiciled fund for non-US and US tax-exempt investors. The master fund is responsible for making investments and undertaking all trading activity, but with fees paid by investors at the feeder-fund level.

The master-feeder structure enhances the critical mass of tradable assets and improves economies of scale for the fund, making operations more efficient.

Side-by-side

In a side-by-side domestic structure, US investors typically invest in a limited partnership organized in the US. This fund runs parallel to an offshore structure which follows the same strategy as the domestic fund.

There are certain inherent inefficiencies in managing side-by-side funds, since the manager must allocate trades to both its domestic fund and offshore fund - while trying to achieve equivalent performance returns in both funds.

Standalone

Standalone fund structures invest without ‘feeding’ into, or investing alongside, another vehicle. This is the most common structure for offshore managers with no US presence which expect to gear the fund predominantly toward non-US investors, or only to US tax-exempt investors.

Other Legal Structures

There are other legal structures in hedge funds. These include open-ended investment companies (OEIC): a fund structured to invest in other companies, with the ability to constantly adjust its investment criteria and fund size. SICAV (société d'Investissement à capital variable) is a common fund structure throughout Western Europe. Also, QIF (qualifying investor fund), which is a regulated vehicle aimed at Ireland-based investors, allowing the use of leverage and holding of derivative products.

For a full list of our hedge fund structures, see our Preqin Glossary.

In this lesson, we explored hedge fund fees and how they are split between both management and performance fees. We covered the different aspects of the fee structure, and how rules in place prevent managers from charging too many fees. We explained the time commitment involved in these kinds of investments, and took you through the different types of hedge funds.

Go back: History of the Hedge Fund Industry

Next up: Hedge Fund Strategies