Pricing Shared-Loss Hedge Fund Fee Structures

Abstract

The asset management business is driven by fee structures. In the context of hedge funds, fees have usually been a hybrid combination of two different types, which has coined a well-known business term of "2 and 20". As an attempt to provide better alignment with their investors, in a new context of low interest rates and lukewarm performance, a new type of fund fees has been introduced in the last few years that offers a more symmetric payment structure, which we will refer to as shared loss. In this framework, in return for receiving performance fees, the fund manager provides some downside protection against losses to the investors. We show that the position values of the investor and the hedge fund manager can be formulated as portfolios of options, and discuss issues regarding pricing and fairness of the fee rates, and incentives for both investors and hedge fund managers. In particular, we will be able to show that, from a present value perspective, these fee structures can be set up as being favorable either to the hedge fund manager or to the investor. The paper is based on an arbitrage-free pricing framework. However, if one is to take

Price of liquidity in the reinsurance of fund returns

“…There exists a variety of first-loss variations. In this paper, we are closely following the framework of Djerroud et al (2016). The fund value X t consists of two parts, the manager's part V M (t) and the investor's part V I (t), where X t = V I (t) + V M (t).…”

“…We derive the value of the upfront premium m R as a function of a fund's liquidity by using the fair value approach stated in Djerroud et al (2016), where the fair value for the premium is obtained by setting the present value of the expected payoff equal to the initial investment, i.e. V R (0) = 0.…”

“…However, in other cases, the traditional fee structure produces higher investor utility. Djerroud et al (2016) price the contract using risk-neutral valuation, thereby obtaining the 'fair' level of the performance fee. Bhaduri et al (2018) extend the traditional first-loss principle by introducing a minimum return guarantee in addition to covering the first tranche of losses in a portfolio.…”

Optimal fees in hedge funds with first-loss compensation

“…The "closest" Pareto optimal fee structure in the traditional setting has a 0% management fee and a 20% performance fee, which may explain the current trend of decreasing management fees in hedge funds that use traditional managerial compensation. Furthermore, the first-loss fee structures typically used by hedge funds (with a performance fee around 40% and a first-loss coverage guarantee around 10%, see Djerroud et al (2016), He and Kou (2018)) are not Pareto optimal either. The Pareto optimal first-loss fee structure that maximizes the hedge-fund's Sharpe ratio has a management fee of 5%, a performance fee about 35% and a first-loss coverage guarantee around 25%.…”

On the Valuation of Performance Fees and Their Impact on Asset Managers’ Incentives

“…broker forced deleverage (Buraschi, Kosowski, and Sritrakul 2014), and shared loss (Djerroud et al 2016). 7 While the option theory application to performance fees is well documented, most articles present analysis from the perspective of hedge funds and the like.…”