Yves Smith on AOI’s Hedge Fund Principles

one dollar bill

This week, the Alignment of Interests Association (AOI) released a set of proposed changes in the way hedge funds do business with their investors, such as pension funds.

AOI, a group to which many pension funds belong, said that hedge funds should only charge performance fees when returns beat benchmarks, and that fee structures should better link fees to long-term performance.

The proposals can be read here.

Yves Smith wrote a post at Naked Capitalism on Thursday weighing in on some of the proposals. The post can be read below.

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By Yves Smith, originally published at Naked Capitalism

Admittedly, some of [AOI’s] ideas sound promising, such as requiring funds to disclose if they have in-house pools not open to outside investors, or if they are subject to non-routine regulatory inquiries. But their key proposals are around fees. As readers probably know from private equity, the devil for this sort of thing lies in the details.

One of this group’s Big Ideas is requiring funds to meet benchmarks before profit shares are paid out, meaning the famed prototypical 20% upside fees. And they do sensibly want those fees to be based on annual rather than monthly or quarterly performance (with more frequent fees, an investor could have a lot of performance fees paid out in the good periods more than offset by underperformance or losses in the bad ones, and not see a settling up until he exited the fund or it was wound up. Longer performance periods reduce the odds of overpayment for blips of impressive results). But private equity funds have long had clawbacks. Yet as we’ve discussed at length, those clawbacks are virtually never paid out in practice. One big reason is the way the clawbacks intersect with tax provisions that serve to vitiate the clawback. It would be perfectly reasonable for hedge funds to ask for provisions similar to those used by private equity funds, with those clever tax attorneys modifying them to the degree possible to make them work just as well, from the perspective of the hedgies, as they do for private equity funds.

Hedge fund investors also want management fees to scale more with the size of fund. Again, that exists now to some degree in private equity funds, with megafunds charging much lower management fees. But it isn’t clear how much the hedge funds investors will gain. Bloomberg reports that the average management fee in the second quarter of this year was 1.5% of assets. That’s lower than typical private equity fees, which according to Eileen Appelbaum’s and Rosemary Batt’s Private Equity at Work still averaged 2%, and for funds over $1 billion, 1.71%. And of course, the fact that hedge fund agreements are treated as confidential, just as private equity agreements are, impedes fee comparisons and tougher bargaining. If this group really wanted to drive a tougher bargain, they’d insist on having the contracts be transparent. That proposal is notably absent.

In keeping, the AOI also calls for better governance. We’ve seen how well that works from private equity land. “Governance” in private equity consists of an advisory board which is chosen by the general partner from among its limited partners. You can bet that the general partners choose the most loyal and clueless investors. The only way one might take oversight arrangements seriously is if these funds had far more independent boards, as is the case with mutual funds.

So while I would be delighted to be proven wrong, history says that there isn’t much reason to expect this effort to get tougher with hedge funds to live up to its billing. And with new investment dollars continuing to pour in despite mediocre performance (assets under management rose 13% in the last year, with roughly half the increase coming from new contributions/a>. As long as investors are putting more money into hedge funds despite dubious performance, there isn’t sufficient negotiating leverage to push for more than token reforms.

 

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Pension Funds: Hedge Funds Should Meet Benchmarks Before Charging Fees

scissors cutting one dollar bill in half

Pension funds and other investors called for changes Tuesday in the way hedge funds charge fees.

The proposed changes were outlined in a statement by the Alignment of Interests Association (AOI), a hedge fund investor group to which many pension funds belong.

The group said that hedge funds should only charge performance fees when returns beat benchmarks, and that fee structures should better link fees to long-term performance.

More details from Bloomberg:

The Teacher Retirement System of Texas and MetLife Inc. are among investors that yesterday called on managers to beat market benchmarks before charging incentive fees in a range of proposals that address investing terms. Funds should base performance fees on generating “alpha,” or gains above benchmark indexes, and impose minimum return levels known as hurdle rates before they start levying the charges, said the Alignment of Interests Association, a group that represents investors in the $2.8 trillion hedge fund industry.

“Some managers are abiding by the principals to some extent but we are hoping to move everyone toward industry best practices,” said Trent Webster, senior investment officer for strategic investments and private equity at the State Board of Administration in Florida. The pension plan, a member of the association, oversees $180 billion, of which $2.5 billion is invested in hedge funds.

[…]

To better link compensation to longer-term performance, the AOI recommended funds implement repayments known as clawbacks, a system in which incentive money can be returned to clients in the event of losses or performance that lags behind benchmarks. The group said performance fees should be paid no more frequently than once a year, rather than on a monthly or quarterly basis as they are at many firms.

AOI also called on the hedge fund industry to lower management fees – or make operating expenses more transparent so higher management fees can be justified. From Bloomberg:

Management fees, which are based on a fund’s assets, should decline as firms amass more capital, the investor group said.

“We need good managers, not asset gatherers,” Webster said. “The incentives are currently skewed.”

[…]

Firms should disclose their operating expenses to investors so they can assess the appropriateness of management fee levels, the group said.

“Management fees should not function to generate profits but rather should be set at a level to cover reasonable operating expenses of a hedge fund manager’s business and investment process,” the AOI said.

The fees should fall or be eliminated if a manager prevents clients from withdrawing money, according to the group.

Hedge funds typically utilize a “2 & 20” fee structure; but in the second quarter of 2014, hedge funds on average were charging “1.5 & 18”.

 

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NYC Comptroller Explains Boardroom Accountability Project in Open Letter

boardroom chair

New York City Comptroller Scott Stringer is pushing corporations to give their biggest investors – often pension funds – more power over corporate boardrooms.

Stringer says pension funds can use their leverage as large shareholders to rein in excessive executive compensation and make corporate boards more diverse.

From a piece written by Stringer in Wednesday’s Daily News:

In partnership with the city’s pension funds, recently launched the Boardroom Accountability Project, a national initiative designed to improve the long-term performance of American companies by giving shareowners the right to nominate directors using the corporate ballot — also known as proxy access.

Proxy access promises to transform corporate elections from rubber-stamp affairs, where one slate of candidates is listed on an official ballot determined entirely by current officeholders, to true tests of merit and independence.

Bringing accountability to the boardroom will have real benefits for the retirement security of millions of Americans, including the 700,000 municipal workers , retirees and their beneficiaries who rely on city pension funds.

A recent report by the CFA Institute, the world’s largest association of investment professionals, concluded that on a marketwide basis, bringing more democracy to the boardroom could increase U.S. market capitalization by up to $140 billion.

We have focused our initial list of 75 companies being targeted around three core issues: those with excessive CEO pay, those with little or no gender or racial diversity on their board, and many of our most carbon-intensive energy companies. They include Urban Outfitters, ExxonMobil, Abercrombie & Fitch and Netflix.

Excessive CEO pay is a problem in itself and can create perverse incentives for management to focus on short-term profits at the expense of long-term value creation. It is also often a sign of a captive board that puts the interests of management ahead of the interests of shareholders.

And while most agree that more diverse boards make better decisions, the pace of change is glacial. In 2006, women made up 11% of S&P 1500 board seats. By last year, that number had barely budged (to 15%), and also as of last year, 56% of S&P 100 companies had no women or minority-group members in their highest-paid senior executive positions.

That’s bad for business, investors and our economy, and we will use our leverage to change it.

Lastly, we know that transitioning the world’s energy production to low-carbon sources is essential if we are to stem the most extreme effects of climate change. But the CEOs of the world’s major energy companies have little incentive to make investments that may reduce earnings today to protect their companies’ long-term prosperity.

In corporate America, the buck stops with the board. As a result, the right of shareowners to nominate and elect truly independent directors that reflect a diversity of viewpoints is critical to ensuring that the interests of long-term shareowners triumph over the pressure for short-term gains that all too often drives decisions at our largest corporations.

Read the whole piece here.