Institutional investors get what they ask for

Some hedge fund managers — including Renaissance, Citadel and Diamondback — are heeding the call from institutional investors, setting up new funds, share classes or better-priced offerings.

Quantitative hedge fund heavyweight Renaissance Technologies Corp., New York, plans to introduce an institutional-only hedge fund within the next two to three months, said Matthew Scanlan, chairman and CEO of Renaissance Institutional Management, the firm's institutional subsidiary.

Another big industry player, Citadel Investment Group LLC, Chicago, this year is introducing a family of single-strategy hedge funds with more modest management charges than those on its flagship Wellington and Kensington multistrategy funds.

The Citadel Global Macro Fund, for example, charges a 2% management fee and a 20% performance fee, while the management fee for the older funds is based on the actual cost of running the fund, which varies from year to year and has strayed well above the industry standard of 2%.

Since the first quarter, institutional investors have been seriously flexing their muscles about everything from hedge fund fees to the length of time their money is locked up. Investors' tolerance for high-priced funds that reward partners of the firm more than the end investor dried up after disappointing performance in the last four months of 2008 extended into this year.

Sources said firms such as Diamondback Capital Management LLC, Stamford, Conn., are among the most recent hedge fund managers to meet institutional investor demand for lower fees by adding a share class that offers a lower fee in exchange for a longer lockup period before investors can redeem their assets.

In March, the $3.5 billion Philadelphia Public Employees Retirement System invested $10 million in Diamondback's long/short equity strategy.

The Philadelphia plan's hedge fund consultant, Jim Vos, CEO and head of research at Aksia LLC, New York, said that he and his staff have been increasingly successful in persuading other hedge fund managers to set up a separate share class on behalf of other institutional clients. The share class is often set up for a single large investor, but then can be used by other investors, Mr. Vos said.

“These share classes are a fair way to cut fees and set up better terms for institutional investors in exchange for longer lockups and larger minimums. It's definitely easier to set up these kinds of arrangements now than in the past,” Mr. Vos said.

A hedge fund executive spoke on condition of anonymity about a new institutional-share class his firm introduced Jan. 1 in its flagship credit fund at the request of some of the fund's largest institutional investors. The new share class offers a 1.5% management fee for large investments, compared with the hedge fund 2% industry standard for smaller commitments.

“Everybody is thinking about terms these days, where they definitely weren't before,” said Jane Buchan, CEO of hedge fund-of-funds manager Pacific Alternative Asset Management Co., Irvine, Calif. “We've found it much easier to negotiate lower fees, transparency and the type of investment vehicle.”

David Hearth, an attorney representing a large number of both institutional hedge fund investors and hedge fund managers, said that “it's something of a misnomer” to label different hedge fund share classes as institutional because in many cases, participation isn't restricted to institutions but the terms — large minimum investments and longer lock-up periods — are what keep other investors away.

One trend Mr. Hearth said is on the rise is hedge fund managers adding share classes that have standardized liquidity terms and fee schedules in order to avoid “investor-by-investor negotiations about side letters and special terms, which is a very cumbersome way to add new investors to a fund.”

Mr. Hearth is a partner in the San Francisco investment management practice of Paul, Hastings, Janofsky & Walker LLP.

Consultant David Gold, a hedge fund specialist in the New York office of Watson Wyatt Worldwide, agreed that multiple share classes have been around for a long time as an easy way for hedge fund managers “to segregate investors and to circumvent (most-favored-nation) issues. In response to supply and demand, hedge funds would open an ERISA share class or a Taft-Hartley class,” he said.

“The difference now is that hedge fund managers are willing to sit down and talk about all of this, which wasn't the case a couple of years ago,” said a managing director at an equity hedge fund manager, who asked not to be identified.

Still, some believe the changes are largely cosmetic, repackaging existing share classes as “institutional” to make them more attractive to pension funds, endowments and foundations.

“A lot of these moves by hedge funds are just a marketing ploy. Many firms have for years offered multiple share classes with different terms depending on the economics of the fee arrangements or on the size of the investment or the nature of the investor or the length of the lockup,” said veteran hedge fund attorney Michael B. Gray, a partner at Neal, Gerber & Eisenberg LLC, Chicago.

When it comes to comparing institutional vs. non-institutional hedge fund share classes “it's really about the sizzle vs. the steak,” said William Crerend, president and CEO of hedge funds-of-funds manager EACM Advisors LLC, Norwalk, Conn. “You need to get under the hood of these vehicles and see whether you really come out better given the terms of the investment,” Mr. Crerend said.

Mr. Crerend also said “there likely will be a spectrum of outcomes” when it comes to the ways that hedge funds satisfy institutional investor needs, ranging from separately managed accounts to single client funds, institutional feeder funds for flagship strategies and institutional share classes.

Marina Lewin, managing director of New York-based BNY Mellon Alternative Investment Services, agreed. She noted that many of her firm's hedge fund clients are “exploring a range of solutions to make investors comfortable with the alignment of interest between the investor and the manager, liquidity, transparency and fee arrangements. Everyone really is looking at offering a spectrum of solutions,” she said.