Hedge funds need a new fee structure

(breakingviews.com) -- Hedge funds are finally getting their heads above water. The average fund could soon regain the high water mark at which its manager starts minting performance fees again.

In hindsight, though, this fee structure doesn't work well. There are better options.

In most cases, if a hedge fund loses money for investors, the typical 20% performance fee disappears and the fund has to make up losses before it kicks in again -- living, meanwhile, on management fees alone. That's no cause for sympathy -- but it does cut some funds' revenues sharply, potentially making it difficult to retain their best people.

It also skews fund managers' incentives. Traders could lose interest because their high water marks, and hence big bonuses, seem distant. Alternatively, they could feel they've nothing to lose by making big, risky bets in the hope of recouping losses quickly. Neither mindset is good for investors.

The problem loomed large at the end of last year. The average hedge fund lost some 19% from peak to trough, counting only quarter-end data from Hedge Fund Research. Happily, having regained about 17% this year from its lows, the same average fund is now just 5% or so shy of its high water mark.

Some funds are back in the black already, including those managed by Steven Cohen's SAC and listed Och-Ziff Capital Management. Others remain under water -- including the flagship funds of Chicago-based Citadel. These lost more than 50% in 2008. Even gains of more than 50% this year have brought them only about half-way back.

Whatever their current situation, many fund managers see that the simple high water mark idea is flawed. One alternative is what's called the Lone Pine model. Under this structure a hedgie whose fund loses, say, 10% still collects a performance fee as the fund recovers.

But on the way back up to the old peak the usual 20% fee is cut in half, and it stays reduced for another one-and-half-times whatever the loss was -- in this case up to 115% of the old high water mark -- when the full fee kicks back in.

Under this approach investors pay less in fees along the way than they would have done -- and the fund manager's revenue is less volatile, too. It's an improvement on the simpler structure, but shouldn't be the end of the story. Fees that consider several years of performance and do not pay out for illiquid gains make even better sense.

For investors, though, time may be running out -- forcing such changes on the industry will get harder as fund managers' memories of near-drowning recede.