2% & 20% & How Much?!?

By now, almost every finance aficionado knows about the problems in the hedge-fund industry. With almost $3 trillion in assets under management, the industry has been bedeviled by complaints ofunderperformance and high fees. Large institutions that put money into hedge funds are now reversing course, led by endowments and pension funds. Redemptions totaled $20.7 billion in the three months through July, with $5.7 billion withdrawn by investors last month. Ashigh-profile firms have suffered outflows, they have begun cutting employees.

Steve Eisman, profiled in Michael Lewis’s book “The Big Short,” says the next big short is hedge fund fees. Two and 20 — industry parlance for a 2 percent management fee, plus 20 percent of any capital gains — is leading to big investor defections. Amid the outflows, many fund managers are cutting those fees. Paul Tudor Jones told investors he would reduce fees by 10 percent; other funds are following suit.

Although the recent focus has been on 2 and 20, this doesn’t encompass all of the costs of investing in a hedge fund. Less attention gets paid to the third part of that equation: operating charges. Fees and expenses, including for travel and entertainment, are a less visible cost of being a hedge-fund investor. These can add up in a way that is neither transparent nor well understood, and therefore ripe for abuse.

A brief explainer: Hedge funds, along with private-equity and venture-capital funds, are private partnerships, typically with a general partner as the manager of the fund and investors as limited partners. The 2 percent management fee is paid to the general partner managing the fund. Much of the rest of the cost structure is sharedpro rata by the limited partners.

Some of these costs are fairly obvious: Audits, commissions, custodial and prime brokerage costs. However, lots of other fees charged to the investors are more subjective.

Passing along the costs of nonessential expenses such as first-class travel, entertainment and consulting arrangements has caught the attention of the Securities and Exchange Commission.

As far back as 2013, the SEC has been concerned about these, according to the Wall Street Journal:

Many managers of hedge funds and private-equity funds—collectively called “private investment advisers”—had long been largely unregulated and therefore had less oversight in how they billed their investors.

As part of the Dodd-Frank financial law, the SEC now oversees more than 1,500 additional such advisers that were required to register with the agency. In that capacity, the SEC is checking to ensure they are charging their investors reasonable expenses.

“Reasonable” is certainly a subjective word, and there is lots of room for disagreement there.

One attorney who specializes in hedge funds told me that private-placement memorandums and a hedge fund’s founding documents typically contained boilerplate language that used to give the fund a lot of discretion regarding expenses and fees. So long as the investor signed off on the document, the manager was pretty much free to charge whatever they might for expenses.

That is less the case now than it was not too long ago. Funds have started to rein in these expenses, especially among the big funds that must register with the SEC. Today, there is more concern about complying with the newest interpretation of Dodd-Frank rules, even among funds that may be small enough to escape specific SEC regulations. There have been a number of reviews and best practices published by various accounting, consulting and law firms on how to treat expenses (see this, this, this, this, this and this).

Market forces and underperformance have been driving down the most visible part of private-investment cost structure. It looks like market forces, along with the SEC, are also putting pressure on the less-visible portions. It’s one more sign that the hedge-fund industry is a little less rewarding, and probably a lot less fun, than it used to be.

Originally: All the Fun Is Going Out of Hedge Funds