Melvin Capital’s sharp U-turn this week on proposed changes to its performance-fee structure has reignited a debate among hedge funds about how portfolio managers are paid.
For the last three decades, the standard way to tie pay to financial performance was for hedge funds and private equity firms to receive management fees based on the amount of money invested plus a chunky share, usually 20 per cent, of the gains they produce.
Most investors also insist on “high water marks” that bar performance fees until a fund that has lost money returns to net profit.
That system enriched the $4tn industry during years of low volatility and rising markets. Although performance fee levels have slowly drifted lower, relatively few funds have found themselves constrained by such high water marks.
But gyrating prices during the pandemic, the recovery and Russia’s invasion of Ukraine have pushed some funds so deeply into the red that some managers are trying a different approach with their models likely to come under further pressure.
Melvin, for example, which shed 39 per cent last year after betting against meme-stock favourite GameStop and lost a further 20.6 per cent in the first quarter, rapidly backtracked on plans to charge performance fees this week, after investors expressed their anger, with founder Gabe Plotkin admitting he had been “tone deaf”.
Melvin’s mooted, and subsequently withdrawn, proposals to charge the fees to investors who had suffered big losses underscores the need to revamp the way fund managers are paid, said Peter Kraus, former chief executive of AllianceBernstein.
“Investors overvalue not having to pay performance fees,” Kraus said in an interview.
“A high water mark forces the portfolio manager and the team to change their risk appetite in order to earn their way out. [But] when the team is unstable and you are taking on more risk, that is a bad combination,” he warned. “Why would you take the risk when the [fund] is telling you they are going to lose people.”
Kraus’ new firm Aperture Investors is experimenting with ditching high water marks for a clawback structure for its $4.2bn in assets under management. Its portfolio managers ultimately receive 30 per cent of the returns they generate that are above their benchmark index, rather than the absolute returns.
But half of the performance bonus is held in escrow for several years and pays out only if the gains are maintained. That gives the portfolio managers time to recover from deep losses while returning money to investors if the gains prove illusory, Kraus said. The structure also helps with staff retention because the performance fee clock is reset annually.
Such marks also push some fund managers to shut down and start over, crystallising losses for current investors and handing any new gains to a different set of investors. “When you calculate your losses on the firms that go out of business and you never get your money back, that eradicates the value of the high water mark across all the rest” of the other funds, Kraus said.
Some managers have kept such investor protections and gone on to be successful.
When oil trader Pierre Andurand started Andurand Capital in 2013 following the closure of previous fund BlueGold, he allowed investors who stuck with him to keep their high water marks, while he personally funded the firm until it broke even, said a person familiar with the company.
Nevertheless, others in the industry also back a new model for calculating incentive fees, even if few groups have implemented them yet.
Andrew Beer, managing member at New York-based Dynamic Beta Investments, which oversees $850mn in assets and advocates a low-fee approach to hedge fund investing, said performance fees should only be charged over a set level or ‘hurdle’ and should only be charged over the same time period as investors are locked up in the fund for.
“Imagine if a venture capital firm paid itself a billion in incentive fees when WeWork momentarily hit $47bn, and didn’t give a penny back later? Welcome to hedge fund land,” he said.
However, working out the precise details of a performance fee structure — that is considered by investors and the manager to be fair — can be extremely difficult.
“We have had managers come up with new structures which were so complicated that even after spending hours on them we still didn’t fully understand what was going to be paid and when,” said Patrick Ghali, managing partner at Sussex Partners, which advises clients on hedge fund investments.
He added that clawbacks can make sense but investors should make clear they will not support a manager trying to reset high water marks.
Kraus’s critique drew support from financial reform advocacy group Better Markets.
“If large institutions such as pension funds (who supposedly are smart and powerful) want to protect their investors, then they should require hedge fund managers to use (some of) their winnings in good years to cover their losses in bad years,” Dennis Kelleher, chief executive, said in an email.
“If [a fund manager like Melvin’s Gabriel] Plotkin believes what he says about his ability, strategy, and future, then he should be willing to use his money to cover the costs of paying traders until he . . . makes performance fees based on, well, his performance!”
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