Warning: Fees Eat Returns
Investors should know that fees in the alternative investments — real estate, private equity, and hedge funds — can consume over 70% of the profits over the long-term.
We need better compensation structure to keep investment managers interest aligned with investors.
What is “2 and 20.”
“Two and 20 is going to make a lot of people rich, and it’s going to make very few investors rich”. Warren Buffett
“2 and 20” is a type of compensation structure that alternative investment managers (real estate, private equity, and hedge funds) typically charge.
It means they charge 2% of asset under management annual management fees to cover the costs of operations and 20% of the profits as an incentive fee to encourage performance.
A Lesson in Sailing
The use of performance fees began in the 16th-century international shipping. The business of international trade was risky business. It was not uncommon to hit rough seas and lose the ship; it’s cargo and the men.
To incentivize shipping enterprises to embark on the long-distance trips that spanned the Pacific and Indian Oceans, a new incentive model was created. The ship’s captain would take a 20% share of the profit from the cargo, to cover costs for the voyage and the risks it entails.
Fast forward to the 1950s…
Alfred Winslow Jones, the father of the hedge fund industry, was the first to use a 20% incentive fee in his hedge fund. His returns were fantastic, earning 670% between 1955 and 1965, the fund returned 670%!
As the decades progressed, emerging hedge funds followed suit and added a fee of 2% of annual asset management to cover their startup and operating costs.
In the alternative investment industry, the “2 and 20” model has become so pervasive that it has become the most widely adopted structure for alternative investments.
“Necessity is not an established fact, but an interpretation” (Friedrich Nietzsche)
So, why are investors willing to forgo such a significant amount of their profits?
Institutional investors, such as pensions, foundations, and endowments, need to grow their assets to meet obligations. Period. Stocks and bonds alone can’t always get them there. Adding alternative investments not only helps them increase those gains. They also are often intended to hedge a portfolio when markets get bumpy.
To gain the most exposure to both the best investment opportunities and highly specialized investment talent/skills, they look to the alternative investment industry. These third parties are in the form of private equity, venture capital, real estate and hedge funds, etc..
In theory, high management and performance fee are needed to pay for highly specialized investment talent and to incentivize those managers to generate higher returns for investors.
Despite mediocre performance, according to 2016 study by Willis Towers Watson, institutional investors have tripled their allocation to alternatives in the last 20 years because they find it hard to meet their return targets through traditional investments.
According to Preqin’s Investor Outlook: Alternative Assets, H2 2017, the alternative investments asset class is now bigger than ever, with a total of $7.7 trillion invested in alternative investments — all of which are marketing great performance to clients.
Thus, in a desperate crusade to find better returns in low return environment investors have succumbed to the belief that they must invest in expensive alternative investment, as one global investment consultant wrote in their report:
…given current bond and equity market valuations after 8 years of stellar returns, the strategic rationale for alternative strategies involving hedge funds remains compelling… investors have been seeking exposure to private market assets to enhance returns, improve income yield and provide better diversification in their portfolios.
It’s all good until it’s not.
Over time, things have gotten a bit convoluted. Weighed down by high fees, complex legal structures, inadequate disclosure and return chasing, investors confront surprisingly poor performance.
Simon Lack wrote in his 2012 book “The Hedge Fund Mirage” that although hedge fund managers have earned some great fortunes, hedge funds investors performed poorly as a group.
In addition to charging high fees, Eileen Appelbaum and Rosemary Batt from the Center for Economic and Policy Research detailed in their 2016 report the many ways private equity managers abuse the variety of fees they collect from investors at the expense of their investors, including:
- Misallocating firm expenses and inappropriately charged them to investors;
- Failing to share income from portfolio company monitoring fees with their investors
- Waiving fiduciary responsibility to pension funds and other LPs;
- Manipulating the value of the portfolio;
- and collecting transaction fees from portfolio companies without registering as broker-dealers as required by law.
In private real estate fee arrangements are complex and varies between investments funds, making it daunting for even sophisticated investors to evaluate performance.
In addition to management fees and performance fees, investors can expect: set-up fees, acquisition fees, disposition fees, development fees financing fees, asset administration fees, maintenance fees and the list goes on and on.
Unpacking “2 and 20”
What might management fees have to do with this? Consider a simple example of a $1000 investment that generates 15% gross annualized return over 30 years with a 2–20 fee structure.
Let’s start by looking at the gross returns.
Before fees, after 30 years the investment grows from $1000 to $66,212. We all know markets never go in a straight line, nor are returns this simple. But, it is clear to see why investors flock to such investments. That $1000 investment, over 30 years, yielded $65,000.
But that’s not usually how it works. The managers charge fees. Using the same example, let’s see what happens when fees are accounted for. Adding 2% management fees, the invest now only grows to $36,117 — about $30,000 less than before. Adding 20% performance fees on top of that reduces the overall growth to only $18,227.
After taking into account the fees, the annualized returns drop from 15% to 10%. That’s huge. That is the impact of fees. Said another way, that is a 70% loss of dollar value due to fees.
As the wind blows
Mark Kritzman, president and chief executive of Windham Capital Management, warned back in 2007 that investment managers that charge 2–20 do not share in investor losses — but they reap a significant share of the profits. He called it the “asymmetry penalty.”
In a great year, a fund manager can earn much money, but in a bad year, they cap their losses. As these fees add up, the appeal of most alternative investments to a portfolio of equities and bonds diminishes.
The Alignment of Interests Association, an organization representing pension funds, endowments, foundations and family offices in the US, said in a report from 2017 that there is:
“…an industry push toward attaining a better alignment of interests between managers and investors through lower fees and better-aligned fee structures that protect investors from downside risk while allowing managers to achieve appropriate compensation for strong returns either in the absolute or relative to a benchmark.”
The time is now…
The overall markets are at a crossroads. Public equities are rising to new levels every day. The bond market yield at the decade’s low. Interest rates are rising, and new tax policies are yet to yield results.
As Ray Dalio, manager of the world’s biggest hedge fund said in a Linkedin blogpost:
“Big picture, the near term looks good and the longer term looks scary”
We are entering a new cycle, and investors must be thoughtful of whether there is a right alignment of interest and economic sharing between them and their alternative managers.
Investors can’t afford to get this wrong.
According to a recent survey of fund managers the most eff effective way to align their interests with those of investors is through having ‘skin in the game’. As fund managers face stiff competition from investors, they are open to designing creative fee structures that meets the needs for the investors. The industry is beginning to realize that it is time for win-win. The industry is beginning to realize that its time to play for a win-win solution.
