Texas Teachers wants cash hurdles for hedge fund fees. Now the pension fund has almost 60 allies in the industry.

Institutional investors, led by the $202 billion Texas Teacher Retirement System, Austin, are gaining more allies in their demand that hedge funds implement cash hurdles in incentive fees.

The pension fund's open letter arguing that a “misalignment” in fee structures between investors and hedge fund managers has become more evident in an environment where cash is returning over 5% was first published on May 30 with a total of just over 30 signatories.

The pension fund's effort is continuing to gain steam and the number of signatories has almost doubled in the weeks since, with almost 60 groups signing on, according to an updated version of the letter viewed by Pensions & Investments.

New signatories to the letter that states, “earning cash returns is not the reason institutional LPs invest in hedge funds,” include the $77 billion Los Angeles County Employees Retirement Association, the $16.7 billion New Mexico Educational Retirement Board and Canada’s over $6 billion TTC Pension Plan.

SECOR Asset Management, the Smithsonian Institution and Soros Fund Management are also among the new signatories.

Three additional consultants — Meketa Investment Group, NEPC and Cambridge Associates — have also signed on, bringing the total to six.

Almost universally, investors have been coming forward and thanking TRS for putting the letter out, said Joel Hinkhouse, director of external public markets at TRS, in an interview.

Many investors described facing situations where they would broach the fee topic with hedge fund managers, in an environment where cash is returning about 5.25%, and be told that they were the only ones asking for such an arrangement, he said.

“If you are a hedge fund and return 5.25%, you have not made us alpha,” Hinkhouse said. “So, you should not take a carry for that. It is not tenable long term.”

Over the course of the last two and a half years, TRS has only hired one hedge fund manager in the market-neutral space without a cash hurdle, Hinkhouse said.

And TRS is putting its money where its mouth is on this issue. So far this calendar year, the system has terminated two market-neutral hedge fund managers and has replaced one, and is in the process of replacing the other, with managers who are willing to implement the cash hurdle in fee arrangements, Hinkhouse said. He declined to name the managers. At the start of the year, 25% of market-neutral hedge funds in TRS’ portfolio had a cash hurdle; today that’s closer to 40%, he added.

Hinkhouse said the pension fund already has hurdles in place for its long-biased hedge fund portfolio. "TRS no longer employs any long-biased hedge funds that do not either employ a beta or hard hurdle before taking carry," he said.

TRS had approximately $20 billion in hedge fund assets as of March 31, a spokesperson confirmed.

Hinkhouse said the reaction from hedge fund managers to the letter has been mixed.

“One thing that is very rare is that someone doesn’t get the point” the letter is arguing, he added.

Jase Auby, chief investment officer of Texas Teachers, told its July 18 investment management committee meeting that the new initiative to advocate for the use of cash hurdles is a follow-up to a similar initiative they launched in 2016 around the hedge fund fee structure that became known as 1-or-30.

Typical fee structures for hedge funds have ranged from a 2% management fee and a 20% performance rate annually or even higher.

“At that time, we advocated to change that to 1% instead of 2% and then make it an ‘or’ rather than an ‘and’ and do 30% of the profits. At that time in 2016, that proposal was very well received, and I’ll note that at that time cash was at about zero so the concept of having a cash hurdle was not as necessary as it is today,” said Auby.

“However, as we know, cash is up to about 5.25% and so we really saw the need to reapproach the industry and engage in an effort to include meaningful hurdles into the calculation of hedge fund returns," he said.

Auby said approximately two-thirds of TRS’ hedge fund AUM and a little more than half of their managers adopted the 2016 proposal to change to a 1-or-30 structure.

The new cash hurdle effort represents TRS advocating for a risk-appropriate guide, Auby said.

“For hedge funds, which are not supposed to have any residual market risk, their risk-adjusted hurdle is actually the risk-free rate: cash. So, by approaching the industry as a whole and advocating for a cash hurdle, we’re in fact advocating for a risk-appropriate guide,” he said.

'No one else is asking'

John Claisse, CEO of consultant Albourne and one of the letter’s original signatories, said that over the last 18 months, investors have been bringing up cash hurdles as a priority and growing frustrated that managers would bat back the issue saying no one else was asking.

There was a desire to have a “unified voice,” he said.

“Investors, when they do have these conversations, can point to the fact that they’re not alone,” Claisse said.

Albourne, which has over 340 clients with over $700 billion invested in alternatives as of July 1, has been part of the effort and Claisse said they’ve reached out to several hundred limited partners on the letter.

Many have said they support the effort, but some may have policies in place preventing them from signing an open letter or had concerns over it appearing to be a mandate, he said.

But, the signatures gathered represent a “global voice,” Claisse said. Groups from the U.S., Canada, Europe, Latin America, South America and Asia are all represented.

Albourne, which was part of the development of 1-or-30 fee structure, has long been focused on the shape of fees, Claisse said.

“We’re really focused on the shape of fees, so that you arrive at a win-win between an LP and a GP, so that when the manager performs really well, they get paid just as well, if not better, but if they go for a period of lower return that the LP is not left effectively creating a kind of a profit center for a level of return that they can get elsewhere for free,” he said.

While the conversation is just kicking off, the reality is every manager needs to reflect on if they are at the stage in their business that they could implement this and if so, how they would do so, Claisse said.

The idea for the letter came about during a team off-site where everyone brings one idea for better alpha and operations, Hinkhouse said. A teammate said, “we should get cash hurdles with all our market-neutral managers” and TRS decided to move forward during the first quarter, with TRS’ public markets director Steven Wilson penning the one-page letter.

“It was clear immediately that everyone had been thinking about this alone,” and without the safety in numbers, hedge funds could refuse, Hinkhouse said.

Can't work with all managers

Hinkhouse admits the cash hurdle fee arrangements are not something that can happen with all hedge fund managers, especially top performers and the industry’s well-established players that are usually closed to new investors and able to command the fees and terms they want.

But for a “large center section of the portfolio,” especially hedge funds that want to grow, they are willing to make the alignment, he added.

Some investors have argued there should always be demands that hedge funds implement cash hurdles in fee arrangements.

Hinkhouse admits it’s a fair comment, but said that while many institutions were allocating in the 2010s, cash rates were 25 basis points and many allocators would not have held up negotiations over such a small amount.

“Cash was ignored because it was minuscule. Now it’s not and everyone understands it better, so it’s time to take action to correct it and make the industry better,” he said.

For Albourne’s Claisse, the letter is “a step to try and provide support to LPs in those negotiations, because they can say, ‘we’re not alone.’”

Moving forward, TRS plans to continue speaking about the issue at industry events hoping to make the conversation a baseline.

“This is the time to do it. It’s painful to pay a 5% carry on your hedge funds right now,” Hinkhouse said.

Rob Kozlowski contributed to this story.