Hedge funds and Private Equity - PES

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The rising number of active hedge funds is due to rising demand for hedge fund products. Yet,
explanations of this ought also to focus on the supply side. Here management fees often seem
to be considerably higher than for instance the fees paid to mutual fund managers. In an ironic
comment on this point, Financial Time journalist Stephen Schurr recently wrote that “It may take
a genius to run a hedge fund successfully on the long haul but it does not take a genius to recognize
that running a hedge fund with a 2 per cent management fee and a 20 percent performance
fee is a better option than slugging it out at a mutual fund” 62 .
Normally, the hedge fund manager will receive both a management fee and a performance fee,
with the latter playing the predominant role. As with other investment funds, the management
fee is computed as a percentage of assets under management. Management fees might typically
be 2 per cent but may range from 0 to 5 per cent. The typical performance fee amounts to
at least 20 per cent of the gains above a specified benchmark over a comparatively short period
of 3 to 12 months.
Usually, the benchmark for the calculation of performance fees is the hedge fund’s net asset
value at the beginning of the measurement period. Yet, sometimes the performance fees are
levied only after a so-called “performance hurdle” such as the short- term interest rate has been
met. It is also not un-common to link the payment of performance fees to so called “high water
marks”. This means that a hedge fund manager does not receive incentive fees unless the value
of the fund exceeds the highest value it has previously achieved. From the point of view of
investors, this measure is intended to link the manager’s interests more closely to those of
investors and to reduce the incentive for managers to seek volatile trades. Thus, if a high water
mark is not used, a fund that ends alternate years at 100 and 110 would generate performance
fees every other year, enriching the manager but not the investors.
Performance fees of the types described here tend to encourage investment strategies that
increase the probability of exceeding comparatively high return benchmarks. Such strategies are
most likely to entail greater risk, risk that – in the advent of failure – could spark a crisis.
Risk taking is also likely to be closely linked with competition in the hedge fund industry. In the
recent decade, the hedge fund market has grown at a staggering pace – in terms of the number
of active hedge funds that we will turn to here and in terms of the assets under management,
which we will return to further below (see table below).
Assets in billions
1000$
900$
800$
700$
600$
500$
400$
300$
200$
100$
Hedge Fund Assets under Management and Number of Hedge Funds, 1950-2005 63
0
1
30
$0,1 $0,8
140
$3
30
$2
100
$20 $35
880 1,100
62 Financial Times (Stephen Schurr) (2006): Hedge funds need to sober up soon, July 3, p. 6.
$50
1,640
$99 $76
63 Source: Hennessee Group and CISDM, http://www.magnum.com/hedgefunds/articles/2005/050101.pdf
and http://cisdm.som.umass.edu/research/pdffiles/benefitsofhedgefunds.pdf (04.01.2007).
2,080
2,800
$97
3,000 3,200
Jan-50 Jan-60 Jan-71 Jan-74 Jan-87 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05
$130
$210
3,500
$221
4,000
$324
4,800
$408
5,500
$564
5,700
7,000
$592
$934
8,050
$795
Assets
in Billions
# of Hedge
Funds