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INVESTING/PORTFOLIO STRATEGIES

Texas pension fund taking bold step on fees

'1 or 30' formula at teachers system seeks better alignment with managers

Jonathan P. Koerner
Jonathan P. Koerner said investors have more leverage now on fee structures with hedge funds.

The Teacher Retirement System of Texas is radically changing how it pays for the alpha produced by the hedge funds in which it invests.

The $133.2 billion Austin-based defined benefit plan is the first to adopt a new fee structure developed by its hedge fund consultant, Albourne Partners Ltd. The objective of the fee formula is to ensure that the investor consistently retains 70% of the gross alpha returns of the hedge funds in its portfolio.

The structure is dubbed “1 or 30” by TRS and Albourne because it guarantees that the investor will always pay a 1% management fee to the hedge fund, regardless of performance, but will never pay more than 30% of the gross alpha provided annually by a hedge fund.

If a hedge fund's alpha generation is higher than the management fee during a given time period, the manager must deduct the one percentage point management fee from the 30% (of gross alpha) performance fee, showed a case study Albourne prepared after working with the TRS investment department over the summer on the fee plan.

TRS investment staff will not discuss the progress of the new fee schedule for the pension fund's $5.6 billion non-directional and $5.2 billion directional hedge fund portfolios at this point in its implementation. There are 22 hedge funds in the directional portfolio and 26 in the non-directional portfolio. There are additional hedge funds within the fund's emerging manager program.

“TRS is always trying to innovate in improving alignment with our external money managers. While we are working with Albourne, the case study is not an exact representation of any particular fee schedule,” said Howard J. Goldman, a TRS spokesman, in an e-mail. He declined further comment.

Albourne Partners' involvement with Texas TRS on the hedge fund fee project was “borne out of a common academic interest in finding a way for an investor to consistently retain a larger percentage of the total return from hedge fund investments,” said Jonathan P. Koerner, partner, portfolio analyst and global head of implementation, based in the firm's Norwalk, Conn., office. Mr. Koerner is the author of the TRS case study.

Better fee alignment

The 1-or-30 structure represents an expansion of Albourne's work on behalf of its clients to achieve better fee alignment and transparency, Mr. Koerner said. He added the pressure for the “fee evolution” that's sweeping across the hedge fund industry represents the maturity and sophistication of both public and private pension plan investors.

The hedge fund industry has entered into an era — similar to 2008 — when because of lower returns and other stresses, institutional investors have more leverage to push managers to accept smarter fee structures, Mr. Koerner said.

The 1-or-30 structure is no more complicated than the hedge fund industry's current standard management of a 1% or 2% management fee and 20% performance fee, Mr. Koerner said, noting the new structure offers a “more perfect alignment” between the investor and the manager.

Although Texas TRS is the first pension plan to put the 1-or-30 structure into place, Mr. Koerner said he knows of several other asset owners, which he declined to identify, that are seriously looking at the structure.

Sources said a big question is whether hedge fund managers will go along with what amounts to a fee dictate from Texas TRS and other institutional investors.

Mr. Koerner said he knows of a handful of hedge fund managers, which he declined to name, that have or soon will add a 1-or-30 structure as a separate share class within their commingled funds. “My phone is ringing off the hook,” Mr. Koerner said, in the aftermath of the release of the case study in the first half of December.

TRS investment officials, through Mr. Goldman, declined to say which managers of the 48 strategies in its combined directional/non-directional hedge fund portfolio agreed to the new fee structure or if those firms that don't adopt the new fee regime will be cut.

However, sources who asked not to be identified confirmed that Fir Tree Partners Inc. sent a letter to its existing clients informing them about its new fee arrangement with the Texas fund. Scott Tagliarino, a spokesman for Fir Tree, declined to confirm the fee change or comment further.

Depends on the hedge fund

Whether a hedge fund management company acquiesces to new fee structures like 1 or 30 or other variations depends on which side of the industry's bifurcation the firm lies, sources said.

“Funds that are doing well, that are attracting or are closed to new capital just aren't going to change. They don't have to accept fee demands from investors,” said Stephen L. Nesbitt, CEO of alternative investment consultant Cliffwater LLC, Marina del Rey, Calif.

Cliffwater has been negotiating a 70%-30% alpha split as a worthy objective for fees paid by its clients for some time, but Mr. Nesbitt noted it's a fairly lofty goal.

“Our historical analysis shows that the industry as a whole, measured by the HFRI Fund Weighted index, has produced a roughly 50%-50% alpha split; historical testing of top-quartile hedge funds produces a roughly 70%-30% split. So if Texas TRS only picks top-quartile managers they will avoid a net redemption cost (paying over 30% in aggregate),” he said, adding “we always shoot for 70%, but settle for 60%.”

The 1-or-30 fee structure on alpha produced by traditional long-only managers has been commonplace since 1990, Mr. Nesbitt pointed out, explaining a typical performance structure for a long-only strategy features a very low asset fee (i.e., 20 basis points) plus 20% of the alpha (defined as the return minus asset class benchmark) with carry forwards.

Hedge fund managers who saw the writing on the wall regarding fees started making changes this year, said attorney Steven B. Nadel, a partner in the investment management practice of Seward & Kissel LLP, New York, in an e-mail.

“With respect to fund terms, while the typical hedge fund management fee has been modified significantly since 2008 through lower rates and tiering provisions, the standard incentive (fee) has remained relatively unchanged,” Mr. Nadel wrote, stressing “this year, however, we are seeing a bit more movement on incentive allocation provisions including multiyear incentive allocations with clawbacks and even some hurdles.”

Hedge fund managers are being besieged, to some extent, by investment consultants following marching orders from their clients to find a way to lower costs, sources said.

The CEO of a midsize hedge fund manager said his firm is talking to consultants all the time about fees. “We are open to structures like 1% and 30%. It's an interesting idea that makes sense,” said the CEO, who asked not to be identified.

“Something has to be done about fees. The hedge fund industry is moving from a market with homogenous fixed fees to a new era. It's a free market these days, and a free-market structure means that poorly managed hedge funds or those that will not concede on fees will not survive. 1% or 30% is one iteration of fee structuring,” the source said.

“Hedge fund managers should not get rich on management fees. They should only get rich when they perform and make money for investors. They have to properly align fees to make that happen,” said the source.

A second Albourne paper explains the underlying model of “de-beta'ized” or alpha-only fees on which the 1 or 30 structure is predicated.

This article originally appeared in the December 26, 2016 print issue as, "Texas fund taking bold step on fees".