Hedge Fund Fees and Liquidity - Setting it Straight

The current fallout associated with DB Zwirn is causing a renewed focus on both mark-to-market practices and, by association, pay-for-performance practices. The way it's being depicted in the media it's almost as if someone woke up and realized, "Hey, if hedge funds have illiquid investments kind of like private equity firms, then shouldn't they get paid like private equity firms (e.g., upon realization)?" 

I've been beating this drum for a long, long time, because if you've spent much time in the industry and have experience with both liquid and illiquid assets it becomes very clear, very quickly that there is an inherent conflict. How, exactly, can a manager justify a quarterly mark on a fundamentally illiquid position and deem it fair to get paid on an upward revision in value? You can't eat that revision, you can't monetize it, yet somehow you should get compensated for it? Interestingly, these are often the same managers who squawk about being judged on a quarterly basis when their strategy is fundamentally long-term. Why should one really be surprised about this asymmetry - heads I win, tails I don't lose. It is this ego and greed that drives many - but clearly not all - good hedge fund managers.

I actually think I wrote a pretty good post on this issue last year, with the following paragraphs being particularly relevant to the current media frenzy:

If positions are held for trading, meaning that short-term assets are being funded with short-term liabilities, then you've got to use either market prices or prices privately received from, say, five dealers, who are quoting based upon taking the bid (or at least the mid) side of the trade. And these are the prices that should be used for both NAV and performance fee calculations for funds, and carrying values for banks and other kinds of asset managers. Let me repeat: if the asset is a trading asset funded with short-term trading liabilities, then you need true marks. No marking to model. Period. Because as we all know, models don't begin to reflect the realities of financial distress, and are inevitably skewed in favor of the manager, if not intentionally then at least subliminally because managers, by definition, tend to love their positions.

Conversely, if positions are held for investment, it must be demonstrated that such investments are funded with liabilities of like or longer duration. This way, an investor can take comfort in knowing that while the values used might not be market-based, the manager can ride out adverse market conditions and not be forced to liquidate at the worst time. However, investment assets should not attract performance compensation until they are sold, and Management must provide clear documentation as to the process used to value these assets for NAV calculation purposes. This necessarily sets a higher return threshold for investment assets relative to trading assets, as should be the case: if one is giving up liquidity and the ability to collect quarterly performance compensation, then the expected return on these assets better be huge. This is where Management's view comes into play. This approach treats investment assets as if they were private equity in nature, being funded with long-term liabilities and attracting performance fees only when sold.

It all seems brutally straight-forward to me. It always has. But in an industry where the words "hedge fund" have come to mean a fairly standard set of terms and conditions - 2% management fee, 20% performance fee, fees paid quarterly - investors have gotten locked into a compensation paradigm that no longer fits portfolios that have become increasingly chocka-block with illiquid assets. Theoretically, in a perfect world, I'd argue that managers should get paid on positions as they get closed out, whether they are held for one day or five years. This eliminates the impact of marks on compensation, offers 100% transparency and truly aligns the motives of managers and investors. Sure, record keeping would suck, but this can be figured out. I'd be interested in the arguments contrary to this position, except those which say "The best managers simply won't accept this." Over time things can change but it depends upon investor resolve and insight, two things that have clearly been lacking in this latest wave of hedge fund melt-downs.

Comments

[Matt]

This was an interesting post. I aggree that there is a fee difference between hedge funds PE investments and PE funds. However, these PE hedge funds investments are frequently in side pocket investments that investors have the option to jump into.

[luisawoods]

I'm hesitant to jump in to this discussion, because I'm a novice in this area. You bring forward an excellent point, though and I really appreciate you raising the subject. People compensated on the assessed value of illiquid assets have a strong motive to generate creative ways to boost the value of those assets, right? very potentially to the long-term detriment of investors who place their trust in them. I hope those valuations are a good deal less arbitrary and manipulable that I suspect. but they also have a strong motive to avoid long-term investing if they get paid only on liquidation of the asset, don't they? both of these approaches seem broken to me. Are their other models that have been proposed?

[Roger]

Rob, I think the effects could be tectonic, but it would have to be a very high-profile manager to herald in such a change. I think, at the limit, my proposal is what will happen way, way down the line, but that change will be very, very slow in coming. However, if a big and successful hedge fund swinger said, "This industry is broken. We've got to fix it and here is how" and proactively gave up comp to "do the right thing," it could shake up the industry. But this will happen when I run the point for the Lakers.

[Martin B.]

Interesting viewpoint. My only concern here is that if a manager get compensated only for closed positions, and not for unrealized gains, isn't it tempting for an unsuccessful manager to liquidate winners and keep loosers until no new position can be financed? I guess the NAV of the fund would show this and the investors would think about redeeming...

[David Merkel]

Well said, sir. As a risk manager I say you have nailed the issue on liquidity risk. Many financial disasters come from financing illiquid assets with liquid liabilities.

[Rob]

I'm not going to give you the contrary argument that you were looking for but instead wanted to toss in a related question - what do you think would be the result of a hedge fund setting up the compensation model that you described?

If the "market" (those looking to invest in hedge fund type vehicles) found as much value as one would imagine in matching up compensation with results then the fund that did this first *could* realize an amazing flow of funds into it. Once other managers started getting heat, the rest of the market could possibly get pushed into the model.

The next question would be - what would the traditional players do when they saw this new model upsetting their cushy lifestyle? It's not out of the realm of possibility that they could team up and drive that fund out of business - forcing them to take losses to big to absorb.

r.