In late December the Teacher Retirement System of Texas sent ripples throughout the hedge fund industry after alternative investment consultancy Albourne Partners released a white paper disclosing a novel hedge fund fee model that it has been working on with the $133.2 billion, Austin, Texas-based pension fund.
The approach — called 1 or 30 — is designed to ensure that the investor gets 70 percent of the economics from its hedge fund investment, while recognizing the need to pay a performance fee to asset managers in lean times. Under the proposed fee model, the management fee gets paid back through a discount to the performance fees (applied over time if the hedge fund fails to perform in any given year), and Texas will pay performance fees only after reaching an agreed-upon hurdle rate. The maximum that a manager can make is 30 percent of the alpha, or performance after the benchmark, minus the one percent management fee.
“The simplest way to consistently meet an investor’s 70% alpha share objective would be a fee structure with no management fee and a 30% performance fee, paid only on alpha. Such a fee structure, however, could result in significant business risk to the manager during any prolonged period of underperformance — as there could be long periods without any certain revenue for the manager from either management or performance fees,” wrote Albourne portfolio analyst Jonathan Koerner in the paper. To eliminate this risk, “the ‘1 or 30’ structure guarantees regular management fee income to the manager on a consistent ongoing basis, identical to current traditional management fee mechanics. A reduction of the same amount is then made to the performance fee to return total fees to equilibrium at 30% of alpha.”
TRS has not disclosed exactly how the pension system will apply its new fee approach; the plan currently invests in 30 hedge funds. But the proposal is a clear indication that the pension system, headed up by CIO Britt Harris — who briefly served as CEO of the world’s largest hedge fund manager, Bridgewater Associates — has not fallen out of love with hedge funds, even as it seeks to find a pathway to better economics for investors.
This contrasts with a number of state an pubic pension plans — most notably CalPERS in California, the New York City Employees Retirement System, and state pension systems in Rhode Island and New Jersey — that are either pulling out of hedge funds entirely or significantly scaling back their hedge fund commitment. Many of these states and cites have felt significant pressure from unions to eliminate hedge funds, arguing that these investment vehicles take money from Main Street workers to pad the pockets of managers in the form of high fees.
Texas, however, has come under far less pressure to exit hedge funds, despite the fact that the state has one of the largest pools of defined benefit pension assets in the country. This may be partly because the influence of unions in state level politics is less, particularly for those groups in the organized labor movement, including teachers unions (which have given particular scrutiny to hedge funds).
Another factor is how much influence pension trustees, or lawmakers, can have over investment and asset allocation decisions. In the case of New York City, for example, the influence of trustees can be great, while other plans — including a number that remain committed to hedge funds — have fewer stake holders with direct power to influence investment decisions.
Public plans and other large funds that remain committed to hedge funds have, almost across the board, raised questions about fees, however. The $15.8 Illinois State Board of Investment is another fund that has made clear it is only willing to invest in, and pay for, hedge funds that it believes are providing true alpha. Other plans are reducing fees by cutting their number of funds, as Illinois has done, but writing larger tickets and giving more discretion to managers, with the managers in turn operating on a fee model that is far reduced from the two percent management fee and 20 percent performance fee that had been the standard for hedge fund managers throughout much of the industry’s existence and maturation. Some mangers, specifically Israel Englander’s Millennium Management and Ken Griffin’s Citadel, still charge operating expenses to investors in some or all of their funds.
An investment consultant who spoke with Institutional Investor commended the idea of adding a hurdle rate to fee payments, as the Albourne/TRS model does, and generally commended the “1 or 30” approach.
That said, the consultant suggested the hurdles Albourne is using — which vary depending on the strategy — are quite low and could be easily met by managers. A manager being judged against the “1 or 30” model could still make a performance fee in a year when its strategy lost money, if the benchmark performed even worse. Nether TRS or Albourne responded to a request for comment.
