Suddenly, Hedge Fund Fees Seem High

After the average hedge fund failed to keep pace with the S&P 500 in 2006, big investors like CalPERS are starting to complain about fees

The top-performing hedge funds and private equity firms have generated annual returns in excess of 50% during the last few years, easily beating the public markets. Pension funds and other large institutions that put their money into these "alternative investments" pay a steep price to share in those profits. The funds typically charge a management fee as high as 2% of the funds that their limited partners—customers—invest. For top players in the hedge fund game, that means hundreds of millions of dollars in fee income from each new fund.

Now some institutional investors have started to complain, noting that the average hedge fund failed to keep pace with the market in 2006. In February, a senior manager at the $225 billion California Public Employees' Retirement System (CalPERS) said at the Institutional Fund Management conference that hedge fund fees have gotten too steep.

While hedge funds are commonly perceived as more risky than the stock market, they're actually supposed to carry less risk, producing relatively consistent results in both bull and bear markets. CalPERS Chief Investment Officer Russell Read said many hedge funds charge too much without delivering high enough returns or low enough risk. "We have no problem paying high-performance fees for a manager's selection, but we find taking on average market risk inherently unsatisfying," Read told attendees at the Geneva conference. CalPERS, the largest U.S. pension fund, said Read wasn't available for further comment on the issue.

Applying Pressure to Funds

A hedge fund typically charges investors a management fee of 1.5% to 2%, and takes 15% to 20% of profits the fund generates. An index fund's management fee, by contrast, is typically just hundredths of 1%. The prominent Vanguard 500 Index Fund (VFINX) has an expense ratio of just 0.18%, for example.

That disparity can be justified in years when hedge funds beat the broader market. But that didn't happen in 2006. A CalPERS spokesman said that the plan's $4.3 billion in hedge fund investments generated a return of 13.4% for the year. That was slightly ahead of the average hedge fund return of 13%, but just below the 13.6% return the Standard & Poor's 500-stock index generated in 2006.

Despite the fact that the average hedge fund lagged the broad market, the top funds remain wildly profitable for their investors. Senior managers of the top 25 funds took home an average of $363 million in 2006, according to a study by Institutional Investor. James Simons, the head of Renaissance Technologies, earned $1.5 billion last year.

Different Rules for Top Performers

In public, fee payers such as pension funds aren't talking about that issue too often. But the market is slowly beginning to apply other sorts of pressure on hedge funds (see, 6/6/05, "A Fee Frenzy for Hedge Funds"). Investment banks such as Goldman Sachs (GS), Merrill Lynch (MER), and Morgan Stanley (MS) have introduced lower-priced investment vehicles that may compete for some hedge fund business. Goldman, for example, introduced a product in Europe last fall called the Absolute Return Tracker, an investment vehicle for pension funds and other large institutional investors.

The tracker uses an algorithm to analyze the returns of hedge fund strategies across a variety of asset classes, such as equities, commodities, and credit. "The Absolute Return Tracker is not designed to track hedge fund returns very closely, but it is expected to display returns over time that resemble some of the patterns of hedge funds as a broad asset class," Goldman spokesman Michael DuVally said. Goldman had no comment on the price or return. Goldman is planning to introduce the product to the U.S. market soon, a step that could put more competitive pressure on hedge funds.

Private equity funds face pressure, too. "We believe there is a real need for the industry to reassess the fee and carry structure—and that the first firms to do so will reap some major rewards," says Mark O'Hare, managing director of Private Equity Intelligence, a research firm based in London.

Some Shops Trimming Fees

But private equity managers feel that top-performing funds can justify their fees. "There's still more demand for top-performing funds than there is supply," says Steve Persky, co-founder of Dalton Investments, a $1.1 billion fund focused on Japan. "Investors are looking for returns. That's what drives things, not fees."

In some cases, private equity shops are trimming fees as a response to the sheer size of many new funds. The Blackstone Group, which is in the process of issuing about $4 billion worth of stock in its management company to the public, charges a management fee closer to 1%, industry experts say. Blackstone's latest fund is so big, at $20 billion, that the typical 2% management fee can't be sustained. But as management fees come down, private equity firms may take a larger slice of profits on their investments. Private equity giant Bain Capital Partners is exploring the idea of taking 25% of its profits on future funds and splitting the remaining 75% among its investors, according to an industry executive familiar with the matter. A Bain spokeswoman declined to discuss fees, but said the Boston company is not currently raising any investment funds. Bain completed a $10 billion fund last year.

Adding to the pressures on the industry, there's now talk in Congress of raising the tax rate for private equity profits, which have soared (see, 10/8/06, "Private Equity Keeps Booming"). They currently are taxed at the capital gains rate of 15%, but Senator Chuck Grassley (R-Iowa) has raised the idea of taxing such gains as regular income, a move that could boost the rate to about 40%. "He's exploring the idea," says spokeswoman Jill Kozeny.

Could Raise Billions

Grassley is the ranking member of the Senate Finance Committee, which is hunting for ways to boost tax revenue without raising marginal tax rates, industry insiders say. A reclassification of private equity profits could bring in billions of additional dollars without tripping public alarms of a widespread tax increase. Grassley wasn't immediately available for comment.

Private equity firms are alarmed, to say the least. "We're taking the idea very seriously," says Doug Lowenstein, head of the Private Equity Council, an industry trade group. Attorneys say, however, that such a change would be difficult to implement, and tough to justify. "It would be difficult to tax private equity partnerships as regular income without changing the tax classification of other kinds of partnerships, from real estate ventures to dental and accounting groups," says Robert Kennedy, a partner with law firm Jones Day in New York.

Once regarded as useful supplements to mainstream investments, private equity firms and hedge funds now sit in the mainstream of institutional investing. But success always comes with a price.

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