| Illustration by Ed Johnson. |
The Teacher Retirement System of Texas has long been considered a trailblazer among institutional investors in hedge funds. Now the $133.2 billion pension fund is again wading into new territory, in hopes of solving one of the toughest problems in the business: fees.
TRS made waves after alternative-investment consulting firm Albourne Partners revealed in a December white paper that it had been working on a novel hedge fund fee model with the pension fund. The 1-or-30 approach is designed to ensure that the investor gets 70 percent of the economics from its hedge fund investment, while recognizing the need to pay a performance fee to asset managers in lean times. Under the proposed fee model, the management fee gets paid back to the investor through a discount on the performance fees (applied over time if the hedge fund fails to perform in any given year), and TRS will pay performance fees only after reaching an agreed-upon hurdle rate. The maximum that a manager can make is 30 percent of the alpha, or performance after the benchmark, minus the 1 percent management fee. (The pension fund declined to comment for this report.)
Albourne portfolio analyst Jonathan Koerner, who wrote the paper, says his phone has been ringing with people interested in the novel approach. “It is getting a lot of buzz right now,” he says.
In the paper Koerner observes that charging a 30 percent performance fee based only on alpha could pose significant business risk to a manager during prolonged periods of underperformance, as managers could be forced to operate with neither management nor performance fee income. To eliminate this risk, Koerner writes, “the ‘1 or 30’ structure guarantees regular management fee income to the manager on a consistent ongoing basis, identical to current traditional management fee mechanics. A reduction of the same amount is then made to the performance fee to return total fees to equilibrium at 30% of alpha.”
Albourne’s 1-or-30 push is part of a broader initiative by the firm to bring greater transparency to the issue of fees and performance for hedge funds and their investors. Koerner says a number of funds have agreed to offer a 1-or-30 fee. Some managers are offering the new fee structure as a separate share class for investors. As for managers who insist on sticking with a 2-and-20 or 1.5-and-20 management and performance fee — the industry standard for much of the past 25 years — Koerner wonders what that says about their opinions of their own ability to deliver true alpha.
TRS has not disclosed exactly how the pension system will apply its new fee approach; the plan invests in 30 hedge funds. But the proposal is a clear indication that the pension system, headed by CIO Britt Harris — who in 2005 briefly served as CEO of the world’s largest hedge fund manager, Bridgewater Associates — has not fallen out of love with hedge funds, even as it seeks to find a pathway to better economics for investors. This contrasts with a number of large state and public pension plans that are either pulling out of hedge funds entirely or significantly scaling back their hedge fund commitment.
Those that remain committed to hedge funds have, almost across the board, raised questions about fees. The $15.8 billion Illinois State Board of Investment is another fund that has made clear it is only willing to invest in and pay for hedge funds that it believes are providing true alpha. Other plans are reducing fees by cutting the number of their funds, as Illinois has done, but writing larger tickets and giving more discretion to managers, with the managers in turn operating on a fee model that is far reduced from the traditional 2 percent management fee and 20 percent performance fee.
