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ALTERNATIVES

Group seeks level playing field for investors, managers

David Finstad
David Finstad said management fees should ‘not be a significant profit center’ for managers.

Institutional investors issued a manifesto in the form of a comprehensive set of guidelines they drafted to better align the interests of institutional investors and hedge fund managers.

The guidelines, written by institutional hedge fund investors, home in on ways to achieve fairer hedge fund contract terms in three core areas: economic and liquidity terms; documentation; and governance.

Institutional investor industry group Alignment of Interests Association Inc., Austin, Texas, made its new hedge fund investing principles available online — www.altaoi.org — on Dec. 2 in the hope that many asset owners will use the guidelines to negotiate with hedge fund firms.

“We realized that the issues that hedge fund investors both large and small face are common. The AOI principles allow each institutional investor to start a conversation with hedge fund managers with a unified voice,” said Robert Lee III, director of hedge funds, at the $26 billion Employees Retirement System of Texas, Austin, in an interview. Mr. Lee serves on AOI's board and was on the principles' drafting team.

“When we started our direct investment in hedge funds three years ago, we followed principles similar to those just issued by AOI, but the response from hedge fund managers was "no one else is asking us for these things.' The new AOI guidelines take that argument off the table,” Mr. Lee added.

The investment principles resulted from collaboration by a steering committee of 15 institutional hedge fund investors, including Texas ERS. Other participants included the $177.8 billion State Board of Administration of Florida, Tallahassee; $129 billion Teacher Retirement System of Texas and $37.4 billion University of Texas Investment Management Co., both in Austin; C$65.1 billion (US$57.3 billion) Ontario Municipal Employees Retirement System, Toronto; and $2.2 billion Alfred P. Sloan Foundation, New York.

The AOI steering committee has an aggregate $960 billion in assets of which about $75 billion is invested in hedge funds, said Melissa Santaniello in an interview. She is AOI's founder and a board member.

Hedge fund manager Frank Brosens, co-founder and risk manager of Taconic Capital Advisors LP, New York, said in a statement that AOI is “an impressive group of institutions that has, not surprisingly, produced a very thoughtful document.”

“We completely agree with the approach of partnering with our investors in a way that optimizes the alignment of interest and long term economics for our limited partners,” he added.

Taconic managed $8.7 billion as of Dec. 1.

Prominent principles

Prominent among the investor-drafted best practice principles are suggestions for aligning management fees and expenses, performance fees, hedge fund managers' investment in their own strategies, fair liquidity, portfolio transparency and valuation.

Performance fees are one area where hedge fund investors might be penalized if those fees are “crystallized” over too short a time or there isn't a clawback mechanism to get back some of the performance fee when a period of strong returns is followed by a span of poor performance, said David Finstad, director of hedge fund management for OMERS Capital Markets, Toronto, which manages public market securities for the Ontario retirement system, in an e-mailed response to questions about the problems hedge fund investors encounter.

Mr. Finstad used the hypothetical example of an asset owner that remained invested in a hedge fund for four years: “If the manager takes a 10% performance fee after the first year — based on 20% of the fund's 50% gross (return) — the investor can't recoup these performance fees during periods of negative performance.” He went on to stress that “conventional” hedge fund terms can result in an investor “paying a higher effective incentive fee if they don't redeem from an investment at the high-water mark.”

If, however, investment contract terms include a clawback feature or fees aren't charged until after the fourth investment year, “then the investor pays a fair 20% over the entire time period's performance,” Mr. Finstad wrote.

Management fees are another area where inequality between investors and their hedge fund managers is fairly common, Mr. Finstad said.

The AOI investment principles recommend that management fees should cover only the hedge fund's expenses and “not be a significant profit center,” Mr. Finstad said.

Prompted to take action

It was issues like these, combined with the drastic declines experienced in institutional portfolios during the global financial crisis that prompted Ms. Santaniello to invite a group of asset owners to come together in 2009 to talk about their hedge fund portfolios.

AOI was born from that meeting and since has evolved into something of a “grass-roots, underground volunteer group” of like-minded investors who wanted fairer terms from hedge fund managers, Ms. Santaniello said. To date, more than 250 institutional investors have participated in AOI activities.

AOI membership is restricted to hedge fund investors; hedge fund managers are not permitted to join.

“This is the starting point” for better dialogue between investors and hedge fund managers, Ms. Santaniello stressed, noting AOI plans to survey asset owners who have downloaded the hedge fund investment guide to find out which principles worked well for investors and to gauge how much progress those investors made in renegotiating better terms with their hedge fund managers.

Investment consultants and market observers welcomed AOI's efforts to breach the gap between hedge fund investors and managers.

“We believe these recommendations are well-thought-out and most are simple common sense,” said Simon Fludgate, partner at alternative investment consultant Aksia LLC, New York.

“There's nothing really controversial about them, except perhaps the management fee recommendations. Most institutional quality hedge fund managers already have adopted similar practices, so the principles are designed more to speak to the bad actors,” Mr. Fludgate added.

Hedge fund attorney Steven B. Nadel agreed, in an e-mail statement, with Mr. Fludgate that many of AOI's principles have already become “industry standards given the heightened sensitivity relating to protecting investors and treating them fairly.”

However, with regard to some of the proposals relating to management and performance fees, “especially those involving laddering down management fees and creating new performance fees tied to alpha generation, it remains to be seen whether these will become widely accepted, especially as the industry becomes more institutionalized and regulated, which will continue to drive up overhead costs and the demand for top-tier talent,” Mr. Nadel added.

Mr. Nadel is a partner and co-head of the investment management group at Seward & Kissel LLP, New York.

Diverse membership

The fact that the collective membership of AOI is diverse, including endowments, foundations and corporate pension funds as well as the normally more outspoken public pension funds “gives AOI a much wider perspective,” said W. Brian Dana, executive vice president and hedge fund practice leader, at investment consultant Meketa Investment Group Inc., Westwood, Mass.

“This is a natural progression for hedge funds and their institutional investors. The principles are comprehensive, very consulting-like, but flexible, so investors can speak with a unified voice in a variety of situations they may encounter with hedge fund managers,” Mr. Dana said. n

This article originally appeared in the December 8, 2014 print issue as, "Group seeks level playing field for investors, managers".