An investment into any hedge fund requires an understanding not just of its strategy and associated risks. Aside from that, an investor should also familiarize themselves with basic terms often found on a hedge fund’s Private Placement Memorandum (PPM) or fact sheet. These are terms stating the fees, expenses, and any special terms with regard to an investment in the fund. While the PPM does explain what these terms meant, they are written by lawyers. Well, suffice it to say, it is in English but yet not quite your English or my English.
In this post, I want to run through some of these terms. But do take note that there are many different variations within the hedge fund industry today. Nevertheless, by and large, they don’t deviate too.
Clearing Up The Air Before Proceeding
To avoid confusion later on, we need to be clear on this - Hedge Fund and its Investment Manager are separate entities. The Hedge Fund is nothing but a legal vehicle that holds assets on behalf of its investors similar to a mutual fund. As an illustration, Franklin Templeton is an Investment Manager and it has multiple funds under its management. These funds, in turn, pay Franklin Templeton fees for its services. For the rest of the article, you may see me mention “Hedge Fund pays this and that”. If you are confused, all you need to remember is this simple thing - you pay everything the hedge fund pays 😄. Because all the assets in the Hedge Fund belong to the investors and any expense is deducted from there.
1. Fund Expenses
For those who think operating a hedge fund should not be any more costlier than trading his or her personal account at home, you are sorely mistaken. I shared this in my prior post on Hedge Fund Startup Expenses. Fund expenses cover items such as commissions, regulatory fees, withholding taxes, interests on borrowed funds, stock loan fees for shorting, fund administration fees, fund audit fees, legal fees, etc. And they also have to pay management and performance fees to the Investment Manager. But these 2 fees are separately calculated after netting off all other expenses for the fund which you will see later. Hence, expense in this article includes everything a Hedge Fund pays other than management and performance fees.
2. High Water Mark (HWM)
A High Water Mark (HWM) is the highest NAV Per Share (NPS) a fund achieved. It is used to calculate performance or incentive fees paid to the Investment Manager which we will talk about in a while. This NPS is usually measured at predefined periods such as at the end of each calendar year. So even though the NPS can be higher intra-year, that doesn't matter when it comes to the HWM.
As an example, I attached a table showing a Fund’s NPS over 2 years. Let’s assume the NPS starts at 1 which also implies a starting HWM of 1. Thereafter, at the end of Year 1, the NPS of 1.07 becomes the new HWM. You might also notice that while the NPS hits a high of 1.15 in April, that is inconsequential as far as how the HWM is measured. Finally at the end of Year 2, as the Fund’s NPS of 0.98 is lower than the prior HWM, the HWM remains at 1.07.
3. Hurdle Rate
Not all hedge funds have hurdle rates. Hurdle rate, when applicable, means the Investment Manager is only entitled to a performance fee on profits they made for the fund over and above the hurdle. Anything below the hurdle rate is not eligible for a performance fee. As a quick example, let's say an investor puts $10,000,000 into a Fund that has a hurdle rate of 5% and charges a 20% performance fee. At the end of the year, the fund makes 20% or $2,000,000 before fees. Without the hurdle, the Investment Manager will get a 20% cut of the $2,000,000 profit which works out to be $400,000. However, with a 5% hurdle, the Investment Manager cannot charge the 20% fee on the first 5% or $500,000 of the profits. Instead, the 20% performance fee is applied only on the next $1,500,000 of the profits giving $300,000.
4. Management Fee (MF)
Hedge funds pay a management fee to their Investment Manager for managing their underlying investments. This fee goes to cover expenses incurred by the Investment Manager. It includes many things such as office rental, utilities, infrastructure, manpower, etc. While a 2% management fee was the historical norm, it can, however, range anywhere from an ultra-low 0% to an outrageously high 5%. Renaissance Medallion Fund, long closed to outside investors, charges a 5% management fee. That said, with their eye-popping performance, they have no lack of investors who will rush to put their money in despite the exorbitant charge. But for the industry in general, hedge fund fees have trended lower as they came under pressure from intense competition and a period of mediocre performance after the 2008 financial crisis.
So how do we calculate the management fee? It is based on the fund’s Gross Asset Value (GAV) at the end of each month. And what is GAV? GAV is the value of the fund net of expenses incurred during the month but before fees are applied. Let’s look at a case of a 2% management fee applied in January.
Example
In this example, I used the actual number of days in the month over the number of actual days in the year as a proportion to compute the management fee for that specific month. Exact terms can vary among funds, so always refer back to the PPM.
5. Performance Fee
This is one of the more distinct features that differentiates hedge funds from mutual funds. Aside from management fees, a hedge fund also pays its Investment Manager a performance fee if targets are met. That can differ from fund to fund, but in most cases, it just means making a profit over the high water mark for the investor. When that happens, the Investment Manager receives a share of the profits made, typically 20%, although that is also on the decline. This fee is adjusted every month i.e. increased when the fund makes more profits and if the fund loses part or all of its profits, the fee is reduced accordingly. But once the year ends, it is cast in concrete and paid out from the fund. The performance period is usually a calendar year, but it can be longer or shorter.
Example
In this example, the Fund started the year with an HWM value (HWM x #Shares) of $10,000,000. It makes $500,000 net of expenses for the first month in January giving us a GAV of $10,500,000. After deducting the applicable management fee of $17,836, the fund is left with $10,482,164 which is $482,164 above the HWM. This translates to a performance fee of $96,433 at the end of January. At this point, this amount is held back but not actually deducted. It is subject to further adjustments till the end of the performance period (end of the year). To see how this works, let’s say the Fund subsequently loses $400,000 including expenses in February.
So at the end of February, the Performance Fee attributable to the Investment Manager reduces to $13,339 and the fund releases back $83,094 of the performance fee accrued. This process continues till the end of the year when any applicable performance fee is crystallized and paid to the Investment Manager. For example, if this is the month of December instead, the $13,339 will be locked in and paid to the Investment Manager. A new HWM is then set in place with the performance fee reset back to zero and the game begins again for the new year.
6. Liquidity
You have probably seen or heard about the term “liquidity”. Investment professionals and the media like to carry it in their mouths wherever they go. It means how easily one can get in and out of an investment. And in a hedge fund's context, that refers to the subscription and redemption terms of a hedge fund. The majority of hedge funds are open-ended funds that issue shares to buyers and redeem shares from sellers. So as far as an investor is concerned, the hedge fund is their only counterparty.
Subscription
Subscription is about how frequently you can invest in the fund, that is if the fund is not already closed to further subscriptions. Typically, subscription terms tend to be more “friendly” than redemption if we discount the Know Your Customer (KYC) and Anti Money Laundering (AML) checks for onboarding new clients. You can usually subscribe at least as frequently as you can redeem, if not more. The more common terms are monthly or quarterly subscription frequencies. And unlike mutual funds, you cannot just subscribe today and expect the transaction to be done the following day. You have to submit a subscription application form and wire the money over before a subscription deadline for the transaction to be completed at the start of the following month or quarter.
Redemption
Buying things is always easy. All you need to do is pay up and you can walk away with the product. Now, try asking for a refund and see if it is that straightforward. The best you can get, and rarely so, is at most as easy as you bought the item. But these added difficulties may not be without rationale.
Investment Managers prefer “sticky” money and for good reasons. As the name implies, these are money that sticks around. This is ideal as managers can then concentrate on managing the investments rather than spend time dealing with redemptions.
Redemption frequencies in hedge funds are usually lower than subscription and tied with more onerous conditions. For instance, you may have a hedge fund that takes in monthly subscriptions but only allows quarterly redemptions. On top of that, ample advance notice have to be given through a redemption notice, and failing that, you may have to wait for the next window. Redemption terms are typically justified through the underlying strategies. For example, an equity long-short with a long-term view horizon will have a lower redemption frequency or even lock-ups (we will see later) than a fund trading liquid futures.
Lock Ups
Hedge funds pursuing less liquid or long-term strategies often impose a lock-up period. This can be a hard or soft lock-up. In a hard lock-up, investors cannot redeem during the lock-up period. And for a soft lock-up, investors can redeem but either in limited amounts and/or with a penalty. A lock-up period of 1 year is fairly common among equity long-short funds. On the other end of the spectrum, lockups can go as far as 5 years or more for funds that deal in private equity.
Gate
This is a special provision that a hedge fund, if specified in the PPM, can exercise should the need arise. Its intent is to act as a brake when redemption exceeds a certain level at any point in time. For large hedge funds in particular, this provides for orderly exits with minimal impact on the market in the event of massive redemptions.
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