Hedge Fund Fees - More Questions
A financial advisor approached me the other day with a question about whether his endowment client should be expected to pay a management fee on assets that are subject to lock-up and likely to be liquidated.He added "I understand that the 20% fee on any profit wouldn't apply since there are no profits but I cannot imagine that paying a management fee of whatever amount on an asset carried at its purchase price, but likely to be worthless at the end of the lock-out period, would be the act of a prudent fiduciary. But perhaps the endowment would be obliged to pay a fee based on the terms of the contract."
While I don't like to answer questions without having adequate information, my immediate immediate response was to say that a lock-up does not necessarily translate to an asset having little or no value.
Being curious about what others would say, I asked two hedge fund experts, Attorney Tim Selby and Attorney Joyce Heinzerling. They have each given me permission to reproduce their answers herein.
According to Attorney Tim Selby:
"It is common practice for a manager to charge a management fee on an illiquid asset. Even though the asset is illiquid, the manager may in fact still be actively managing and monitoring the asset. In private equity funds, the manager will typically reduce the management fee on assets under management once the investment period ends because its activity lessens. This is not, however, a common practice with hedge fund managers who manage an illiquid portion of a fund’s portfolio. Typically they will still charge the full management fee but it will be based on the cost of the investment rather than its fair market value which may not be determinable. Depending on the amount invested by the investor it may be able to negotiate for a reduced fee."
According to Attorney Joyce Heinzerling says:
- Quite ofen a hedge fund manager side-pockets an illiquid investment and when that ocurs, generally speaking, the manager will not typically charge a management fee on the side-pocketed assets. But that is not always the case. I know of several hedge fund managers that continue to charge management fees on side-pocketed assets from back in the 2008-2009 period. That is not a best practice. Ultimately, the fund's Private Placement Memorandum ("PPM") will disclose whether the manager will charge fees on side-pocketed assets. If that language is not included in the PPM, then the manager would have to send a letter to investors stating the intent to charge fees on side-pocketed assets. With that, the hedge fund manager would attest that there is no constituent document language or other legal reasons the prehobits the hedge from manager from proceeding in that direction.
- If the financial advisor is asking about the "fund" being in a lock-up period because liquidity is so bad that it cannot honor redemptions (if they are allowed in the first place), the answer to the fee question should be found in the PPM. The standard practice is to continue to charge a management fee because the manager is tending to portfolio investments in order to gain liquidity. You are correct that one cannot make an assumption about the value of an asset just because it is carried at cost. Even if an asset is illiquid, there is bascially a chance that the asset will eventually reset to a higher value. One cannot assume today that any particular asset will have no value at the end of a lock-up period, whether it is in the case of a side-pocket or a suspension of redemptions.
- All investors are treated the same in these cases, it would not matter that the investor is a endowment versus a pension plan versus a high net worth individual.
When I recounted these answers to the inquiring financial advisor, his response suggested that such terms would be deemed onerous by his client. A natural reaction is to advise all parties involved to carefully review the terms of any investment, hedge fund or not.
Recent studies suggest that pressure on hedge fund and private equity fund manager to lower fees will continue. No doubt discussions will address redemption, valuation and liquidity as well.