Ep. 56 The Long-Short | Decoding hedge fund and investor alignment

Published: 15 March 2023

The Long-Short is a podcast by the Alternative Investment Management Association, focusing on the very latest insights on the alternative investment industry.

Each episode will examine topical areas of interest from across the alternative investment universe with news, views and analysis delivered by AIMA’s global team, as well as a host of industry experts.

AIMA in partnership with RSM recently published a new report loaded with compelling data points into the fascinating world of fund manager and investor alignment.

This week, Scott Mackey, Partner at RSM, joins us to decode the report's findings and explore the ever-evolving landscape of how hedge funds achieve alignment with investors to foster long-term strategic partnerships.

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Hosts: Tom Kehoe, AIMA, Drew Nicol, AIMA

Guests: Scott Mackey, RSM

Interlude: Lorna Barnard, AIMA


Tom Kehoe, AIMA  00:07

Hello, and welcome back to The Long-Short. I'm your host, Tom Kehoe. I'm delighted to be joined again by my co-host, Drew Nicol. Drew, welcome back.

Drew Nicol, AIMA  00:14

Thank you, Tom. It is great to be back. I was listening to some of the recent (podcast) episodes on my flight home, and it really does sound like I missed out on some great conversations, which I'm quite upset by. But, I'm very happy to be back now.

Tom Kehoe, AIMA  00:26

Today’s episode focuses on an area of alternative investments that is essential for the success of the industry but often doesn't get the attention it deserves. And that's the relationship between fund managers and their investors.

Drew Nicol, AIMA  00:39

So, AIMA in partnership with RSM, has recently published a new report filled with some really fascinating data points that shed some much-needed light on their relationship. The report is called ‘In Sync: How hedge funds achieve alignment with investors to foster long term strategic partnerships’. It's the third in a series of reports looking into this topic that we've done with RSM. The report can also offer some insights into how the main features of the GP LP dynamic, meaning fund managers and investors, have changed since we last published a report in 2019.

To discuss the latest findings, we are delighted to be joined by Scott Mackey, a partner at RSM. specialising in financial services and the investment fund industry. Scott, you're very welcome to The Long-Short.

Scott Mackey, Partner at RSM  01:25

Thank you, Drew. Thank you, Tom. It’s been a little while since we've spoken about this topic but I’m looking forward to a good conversation.

Drew Nicol, AIMA  01:36

Before we dive too deep into the report, Tom, you lead on this for AIMA. So, could you just take us through some of the key findings just to help set the scene?

Tom Kehoe, AIMA  01:45

Yeah, sure, Drew. As you've both mentioned, this is the third in a series of studies that we've done, which examines that GP LP relationship that exists among hedge funds. A couple of thanks, first of all, we collaborated and we will hear the views of our colleague, Scott in a few moments, but we also collaborated with our global research committee which comprises alternative investment fund managers, both large and small, across a variety of strategies, including traditional hedge fund strategies and private credit. And we also collaborated with our Global Investor Board which accounts for some of the world's largest allocators to hedge funds. And so, we'd like to thank them all for their dedication and valuable insights into this research. In total, we surveyed 138 hedge fund managers globally and accounted for just over US$700 billion in assets under management. And separately, we surveyed 35 institutional investors.

Moving to the key takeaways of the report, Drew, I'd list three. The first of these is what we described in the report is the emergence of the modern fee model. So, after years of downward pressure on fees, many investors and fund managers have settled on a new fee model that emphasises rewarding fund managers that can consistently deliver strong performance, albeit with more stringent hurdles to clear. Managers have then, in turn, had to innovate how to charge fees, manage expenses, using new product structures and share classes. And related to fees, of course, is the environment around managing a hedge fund business as a business and that's become more costly. That's associated with higher costs, firms becoming more digitised, the pace of regulatory and compliance change which is relentless what we're experiencing, and the costs associated with meeting the war on talent. And the consequence of that, then is how managers are working with investors in terms of managing their expense base.

Another key point that comes out of the paper is, what we see is arguably the most important feature of the GP LP relationship, what we describe as skin in the game. This is essentially the principle of the fund investing their own personal capital into their fund, which surprisingly to us when we first examined that relationship with hedge funds, we saw as being somewhat unique to hedge funds. And the results of this year's study reassert the definitive form of alignment between the manager and investor, going beyond the fund principle to broader skin in the game.

And finally, we witnessed more innovation on the part of fund managers to win and retain investors with new funds structures, the launch of new products, and specifically, we point to the increasing popularity of co-investment products, and how that's providing an ideal vehicle we think for aligning interests.  Relationships have been further deepened, as well, through strategic knowledge sharing, and sophistic conversations around complex issues which incorporate ESG and responsible reinvestment. So, those are my three key takeaways, Drew.

Drew Nicol, AIMA  05:03

Thanks, Tom. So, extremely meaty report and I'm keen to just jump into all of that. But we probably should take the headline issue first, which is, of course, fees.

Turning to you now, Scott, as Tom mentioned, we've sort of coined the phrase, the modern fee model, to describe what we were defining as a model that is more flexible and offers a greater emphasis on the performance fee, as opposed to the management fee, meaning that managers are only rewarded when they have delivered for investors. So, just taking this back to the headline and how this aligns interests, could you speak to what this does to have a performance fee-led model and how it also allows a situation where some managers are able to negotiate slightly higher fees when they can demonstrate very reliable performance?

Scott Mackey, Partner at RSM  06:01

Yeah, thanks, Drew. Obviously, the concept of a performance fee is not new in and of itself, performance fees have been around for decades at this point, particularly in the hedge fund model. But I think what we have been seeing, particularly we've been seeing around in the US, is that managers are moving away from the more rigid 2% administrative fee or management fee, 20% performance fee model and coming up with some more creative solutions that do promote greater alignment between the LPs and the GPs of a fund.

So, some of the examples that I've seen, as you alluded to, are higher performance fees for outsized returns. So, the performance fee model may be set, lower for more modest returns, somewhere below the 20% model. But for outsized returns, you're going above 20%, it is fairly common for around 25-30%, and even 35%. You know, one of the other examples that I think we've seen in terms of how performance fees have been structured is, is pairing different performance fees with different management fee structures. So, a fund may get split up into different tranches, and the investors have the option of coming in with different fee models, based on how they sign up for the fund. So, for example, they may choose to have a more stable management fee and a lower performance fee, or a relatively modest management fee, or even a 0% management fee, in exchange for a higher performance fee model for the manager.

Tom Kehoe, AIMA  07:46

The debate regarding how hedge fund managers pay for their expenses has also intensified. The results of our study found that the practice of passing true expenses is becoming more common. Scott, would you agree with that? How has the use of pass-through changed over the past number of years?

Scott Mackey, Partner at RSM  08:03

I would say the answer depends. There’s always been flexibility within investor agreements and subscription agreements, I think for GPs to pass discrete fees on to investors. But that said, I think, going back a decade or even longer, the largest fee and the most predominant fee that you would see in the financial statements for a hedge fund would be management fees. I do think there has been some creep, in terms of some very discreet fees that I think are very arguable that they directly benefit the fund, that they pass on to the fund. And as you said, ultimately, those are passed on to the investors.

However, there are some types of fees that I think that are passed on, that were traditionally covered under that management fee arrangement. So, for example, bookkeeping, record keeping fees, before this prevalence of outsourcing, the record-keeping and accounting to fund administrators, most of that function was performed in-house and the costs were borne by the manager and it was covered by the management fee. Those same costs are now oftentimes outsourced to a third-party administrator, very reasonably those firms invest very heavily in technology, people and processes to perform that function. And that fee is a discrete fee and it is quite often recorded and passed on to the fund.

However, you don’t necessarily always see the corresponding decrease in management fees reflect that. So, if you will, you're taking some fees out of the managers' responsibility, creating a direct fee and passing it onto the fund.

Tom Kehoe, AIMA  10:06

And I guess the point that we make in the paper on pass-through is that this is indicative of the environment becoming far more costly. We talk about that relentless pace of regulatory and compliance change, the higher costs associated with firms becoming more digitised, and the increasing costs around the war on talent.

Scott Mackey, Partner at RSM  10:27

Yeah, and I think there is another component that's worthy of consideration for costs for managers, and how those are ultimately passed on to a fund. So, during periods of sustained performance, like we've had over the last 10 years, for example, but during that period, costs have also been increasing pretty significantly for managers. A significant part of that is sourcing talent, talent that's not necessarily coming from traditional areas of the asset management space. So, asset managers are now having to find technologists, data scientists, and people who can create AI (artificial intelligence) programs, they need people who are savvy and fluent and can understand and navigate through cryptocurrency requirements. All these things increase costs. So, as managers are keeping pace with the industry, they're developing products, they're offering products that their investors require, and the high watermark of their costs are most likely going up. And you couple that with inflation, they're definitely going up.

Then you get to an inflexion point, like now, where assets are decreasing, the asset values are going down, and performances stagnating or going down in many cases. So, while costs are up, revenues for managers are coming down either through lower performance fees or lower management fees, coming from a base level of AUM. So, I think we're at an interesting point here, an interesting inflexion point where we go to see maybe another change to cost models moving forward.

Tom Kehoe, AIMA  12:15

But added to that, Scott, what has happened across the industry, is that we've had by and large performance being better over the last couple of years. So, therefore, it feels like managers are more comfortable with making that ask in terms of being compensated better. And we talk about that partial pass-through to becoming more popular. And the push by investors to cut fees further aggravated by rising industry costs has seen some managers then push on a wider variety of costs onto the fund, the two models for this standard are a pass-through model, a partial pass-through, and a full pass-through. And what we're saying is, there are some parts of the industry that are also now charging full pass-through. And that can be as much as three to four times the historical 2% management fee. And then, everyone else, as that environment has become more costly, they're starting to push through expenses, albeit they're capped. That’s the change that we've seen from when we took this research in 2019 to the research that we're reporting on this year.

Many firms, Scott, are also turning to technology, such as automation tools, or having a greater reliance on outsourcing to achieve cost savings. What are you seeing with regard to this development?

Scott Mackey, Partner at RSM  13:43

Certainly, I think it's been a very consistent theme, and not just in the three years since we last spoke, but this has really been over the last decade or even 15 years, the trend to outsourcing components of the back office or middle office of a fund manager has been very strong. And I think there are real reasons for that, that are not just cost-related.

One is the sourcing of talent and the sourcing of resources that are required to run a back office, which is a real undertaking in itself, the cost of developing and maintaining technology for what is very much for outsource record keeping, very much a non-core function for an asset manager, those are very real costs. And so, the ability to, I think, move those costs out and move those functions out and not have to manage them in-house is a great benefit to a lot of managers and it makes a lot of sense. We've been seeing that trend and I expect that to continue.

In terms of investing in technology that's retained in-house, I think that that's also very much a trend that we've seen a lot of. And that's not just isolated to the investment management industry, automation has been a trend across business development over the last 10 years. And all businesses are doing it. Particularly when you're in an industry where you're regulated, you have to, there is high precision in how you have to conduct your business. Automation, the ability to cut back on error, increase accuracy, and also manage fewer people has been a key component for many investment managers.

Lorna Barnard, AIMA  15:54

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Drew Nicol, AIMA  16:38

And of course, it's all not one way in the sense of fund managers being able to maybe let go of some costs and increase fees, obviously assuming that they are performing for their investors. Investors are in themselves demanding something more as part of this new dynamic. And in the first instance, what the data seems to suggest is that greater transparency is at the core of what they are asking for. So, just to put that to you then in the sense of transparency can mean many things to many people, but when we spoke to both managers and investors, when we were going through the data and interrogating it a little bit, it did mean a lot in the sense of it could mean fees, it could mean greater insight into the underlying portfolio. But, the common denominator was that it had to improve, and it had improved a lot since 2019. But there potentially was still further headroom there.

The other element that I found particularly interesting was that previously, if you were a big-ticket investor, then you had greater sway when it came to demanding certain transparency in whatever aspect of that was most important to you. But now the overall thresholds for what is considered high levels of transparency can be demanded by all investors or smaller ticket investors. Could you just talk about sort of, in your experience, how that trend has developed? And if we can expect that to continue to develop?

Scott Mackey, Partner at RSM  18:18

Yeah, sure. I mean, look, I think there's always been a healthy tension between investors and managers, when it comes to transparency, right? I think both sides understand the advantages and disadvantages to each of them of transparency. I think certainly as it regards to fees, and how different fees are charged between different investors within the same manager, that understandably, I think, continues to be an area where investors are seeking more transparency, around fee structures, they're seeking more transparency, in how the costs of running a fund or running a portfolio translate to their costs, and then how are my fees as one investor differentiated from fees of another investor. From a competitive landscape, that's obviously very interesting to investors. But, for managers, disclosing some of these (fees) is giving away somewhat of a competitive advantage.

On the portfolio side, investors, particularly big-ticket investors who are managing complex portfolios, need transparency as to how they're managing their risk, how are they allocating their assets across different managers and where do their risks really lie. So, I think transparency around investing, transparency around the investment products that have been used, we've certainly seen that increase.

I wouldn't say it's all been volunteered. There have been some pressures from regulators, accounting bodies, auditors, I'd have to say, certainly part of that mix. But there has been a general progression towards greater transparency in both those realms. I think it's been really beneficial for investors.

Tom Kehoe, AIMA  20:21

Scott, the paper also goes into the innovation on the part of managers to win and retain investors with launches of new products. As mentioned at the top, we talked about the increasing popularity of co-investment, not just in private markets, but we're also seeing that, and we have examples of it, in public markets, as well. What can you tell us about co-investment? Is it an emerging trend? Or is it more of a permanent shift now, on the part of managers and investors working together?

Scott Mackey, Partner at RSM  20:57

Certainly, a very strong trend, not sure I would categorise it as a permanent trend, it's hard to say anything is permanent in this industry, where you're working in such a fluid environment and actions that you take as a manager to retain a competitive edge are going to change over time.

You’ve certainly seen a prevalence in co-invest vehicles. I think that's driven by a few factors. One is certainly promoting alignment and creating new options for your investors, I think particularly the larger big-ticket investors to gain more exposure to certain positions, that as a manager they may find particularly appealing.

I think another appealing aspect for investors when it comes to co-investment vehicles, is it is becoming less correlated with markets, and taking on greater positions with managers that they trust, which they have a great track record with, but it's becoming harder and harder to beat the market. And so, in some instances, becoming less diversified and less correlated, maybe seen as a way to achieve that.

Drew Nicol, AIMA  22:19

I just want to pull together a few of the themes that we've raised to this point because there was something that struck me in the report, which was this reference to how the overall relationship was described by a fund manager interviewed as being much more of a strategic partnership than it may have been considered in prior years.

From what I'm hearing that sort of comes through, especially given you referencing co-investment there, but there was also this idea of a greater demand for knowledge sharing, and also a desire by both parties to, well, especially on the manager side, to have fees locked into the fund for a longer period. So, this is not some short-term relationship, this is something that will hopefully go on as long as the manager continues to perform. And it seems like the depth of the overall relationship has developed a lot compared to prior years. Was that an accurate description?

Scott Mackey, Partner at RSM  23:22

Yeah, absolutely. I think, going back and looking at the history of how this has evolved is, we had hedge fund managers who, while not new in the early 2000s, were still a relative unknown to a large portion of the investing community. We have the (2008) global financial crisis, and those catastrophic economic events that occurred over a decade ago now, it very much changed the landscape as to how hedge funds and alternative managers had to interact with their clients. No longer were you lucky enough to get into a hedge fund, managers had to pivot to really being able to demonstrate long-term value to be able to create that sticky ticket.

I think that's what we're seeing come through in the paper, some of the activities that are not just around investment management, but around how GPs and LPs interact, how would they come to an arrangement that's mutually beneficial for both of them? I think we've certainly seen that there are those aspects of a strategic relationship, a long-term relationship, developing.

Drew Nicol, AIMA  24:48

So, finally, no conversation around this topic would be complete without a question to do with ESG (environment social governance), which is interrogated somewhat in the report. I think there are some quite interesting results, actually, because it seemed to indicate that there was some disparity in the embrace of ESG amongst hedge funds, despite how ubiquitous a topic it is, especially if you look at the events circuit these days. But could I just put it to you in a broader sense, where do you see us in the journey of ESG adoption? Was there anything that jumped out to you from the data in this aspect of the report?

Scott Mackey, Partner at RSM  25:32

So, are you referring to maybe a lower-than-expected response rate in terms of ESG being a critical or a core part of the business?

Drew Nicol, AIMA  25:43

Well, exactly. It's interesting, really, because, again, just if you were someone who just glanced at the headlines, or had just a passing understanding of the industry or broader financial services, you might think that ESG was everywhere, all of the time. And actually, what the data suggests is that there is a slightly more nuanced conversation going on about where ESG is applicable, and to what extent ESG at any cost, is, in fact, not the top priority for some hedge fund managers, insofar as it is not being pushed or demanded of them by their investors. So, it certainly jumped out to me.

Scott Mackey, Partner at RSM  26:27

Yeah, I think that the lack of enthusiastic response around that may be skewed a little bit by my brethren here in the US. The US investment management industry and I think broadly is not as advanced when it comes to ESG as some other jurisdictions, but certainly, it's on the horizon. There are regulations that are coming into effect, they're coming into effect in the short term, but they're still not as extensive as they are in Europe, for example. But I think, specifically speaking to some of those responses, and bringing it back to the US, there is already a robust market in the investment management space here for ESG products. There are specialised managers who cater for that, and offer ESG, or socially responsible investing models. It leaves some of the other managers who are somewhat unencumbered to leave that component of the management space to those managers.

There's also the fact that there are regulations coming in, and some of them are coming into effect in the near term. And I think there's a little bit of apprehension here about what it's going to take to actually implement those requirements and really embrace the concept of ESG. I think it's very easy to speak a good game, if you will, about being pro-ESG. But when it comes time to actually implement those systems, get the people involved, the right resources, the right expertise, and the right systems, that's actually quite a significant barrier. And I think you may be seeing that some of that sentiment come through in the responses.

Drew Nicol, AIMA  28:24

Finally, then, was there anything in the report that really jumped out to you and surprised you? We've talked about a huge amount there, and it is a very meaty report I should say, for those listening, there is a huge amount of additional detail on each of these topics that we've mentioned, and I really would encourage everybody to give it a read in order to get the juicy data points that are all there. But first, Scott, other than what we've already discussed, was there anything that really took you back?

Scott Mackey, Partner at RSM  28:56

I wouldn’t say took me aback, but when I look at some of the data that's come through, skin in the game, I think was a concept that jumped out at me. There are senior members of fund managers who are required to have to meet minimum investment levels in their own products as a requirement to promote harmony. From my experience in dealing with investment managers for the last 25 years, there are very few of them that don't want to have their money in their own product, I would say they're all very proud of their own product, they all believe in it, and that's why they're doing it. It's also a very convenient place for them to access great talent, to achieve returns while having the control and transparency that you would want as an investor.

So, I perhaps see that one as not such a push, not such a big lift for managers to have their own money in their funds. But, I think in general the findings and the data that came through in the report are pretty much in line with what we're seeing in practicality.

Drew Nicol, AIMA  30:13

That's a really interesting point, actually, because I think it's difficult to come across a more ringing endorsement of the industry than just how common it is for principals and senior employees to have a significant stake in their own fund. I know if I was an investor, that would be the first thing that I would look for and as you say, it can only be reassuring to see that they believe in their own product. Tom, actually, I should put it to you, as well. Was there anything (in the report) that particularly caught your eye?

Tom Kehoe, AIMA  30:42

My biggest surprise was when we did the research on ESG and responsible investment, Scott was saying that he was not that surprised, well, being in this part of the world, in Europe and the UK, everybody talks about ESG and responsible investment. Certainly, that felt like it had big momentum over the last year or two. And for half of all of our respondents to say that they didn't have an ESG mandate, that was the biggest surprise to me. But as Scott alluded to, there's, I guess, an incremental approach to incorporating ESG. There are various facets around why you want to incorporate it but also there are challenges around being able to incorporate ESG. But certainly, that was a big surprise to me, coming from this part of the world. Of course in the US, it's all about DE&I (Diversity, equality and inclusion), less so about ESG. I wonder if we do this report three years’ time when the world has moved on, will that data point change? That remains to be seen.

Scott Mackey, Partner at RSM  31:43

Yeah, Tom, just to add to that. think we all know ESG is coming, I do think that we will see a different response in a few years’ time. And I know RSM and many other participants in the industry believe ESG is coming. There's a significant investment in ESG in the US, I just feel that there’s a slight reluctance, maybe a lack of acceptance of reality, at the moment. But, we'll see, it'd be very interesting, I think, to come back in three years and measure that.

Drew Nicol, AIMA  32:19

I think we're in agreement, that's a strong foundation to meet back here again, in three years’ time, at least, and pick over the bones of the next report.

I think all that's left in the last few minutes is just to thank Scott, and of course, everybody else at RSM who partnered with us on this, as Tom mentioned, there was a huge number of stakeholders involved in getting this report over the line, including AIMA’s Research Committee, our Global Investor Board, and the many other people that contributed their time to do the survey and answer all our questions in hours and hours of interviews that went into putting this together. So, thank you to all those people if they're listening and Scott, thank you for joining us on The Long-Short.

Scott Mackey, Partner at RSM  33:00

Thank you, Drew. Thank you, Tom. And thank you, AIMA, for allowing us to participate in this report.

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