Led by Texas Teachers, pension funds and consultants press hedge funds to use cash hurdles with fees

Institutional investors, including some of the largest pension funds, are calling on hedge funds to adopt cash hurdles in their incentive fee arrangements as a best practice standard for the industry, arguing that hedge funds are collecting “significant incentive fees based solely on skill-less returns generated from short rebate, securities lending, unencumbered cash.”

The open letter was published May 30 and addresses members of the hedge fund industry. It was signed by more than 25 institutional investors, including pension funds, endowments, sovereign wealth funds as well as a few consultants and says the “long-term health of the industry is dependent on a healthy alignment of interests between GPs and LPs” and that the misalignment has become “increasingly evident in recent years, as riskfree rates have reached mid-single digits.”

The $187.1 billion Texas Teacher Retirement System, Austin, initiated the effort, and the letter was signed by groups including the $37.6 billion Texas Employees Retirement System, Austin; $48.3 billion Indiana Public Retirement System, Indianapolis; and $111.5 billion Virginia Retirement System, Richmond, as well as consultants Aksia, Albourne Partners and Verus.

The signatory group encourages other institutional hedge fund investors to sign onto the open letter going forward by reaching out to their consultant or to the pension fund directly, a Texas Teachers spokesperson told Pensions & Investments in an email.

The hedge fund industry has long been well-known for charging high fees with a traditional 2% management fee and 20% incentive fee structure. That 2-and-20 structure has come down on average over the years, but there are still exceptions. And large multistrategy hedge funds charge high fees using a pass-through fee structure.

The letter argues that earning cash returns is not why institutional investors invest in hedge funds and that such returns are “easily obtainable … outside of a hedge fund structure for free.”

The letter offers an example stating that in 2023, a $1 billion market-neutral hedge fund could have earned about $52 million, or 5.25% returns, by holding cash. And if that same fund charged a 20% incentive fee on absolute returns, it would have “taken home” $10.5 million in compensation “for taking zero risk.”

The signatories state that they know implementing cash hurdles will mean “adjustments to fee schedules and operational procedures within funds” but that “the long-term benefits of proper alignment vastly outweigh short-term challenges.”

In a note Albourne sent to clients ahead of the letter’s publication seen by Pensions & Investments, the consultant wrote, “We recognize that investors acting alone often struggle to engage GPs around this issue, often being told ‘no-one else is asking for this.’ This ‘divide and conquer’ strategy is getting old, and we believe that presenting a unified voice will empower all investors when they raise this issue with their managers.”