Even though it has been two years since the U.S. Federal Reserve started rapidly hiking interest rates, hedge fund managers aren’t more likely to have a hurdle rate in place now than they were during the zero interest-rate policy era.

Yet institutional investors are pushing for change. There’s a strong carry component to many hedge fund strategies, which was less relevant when risk-free rates were essentially zero. However, in the current rate environment, institutional investors are increasingly reluctant to pay hedge fund-type fees on what is essentially cash.

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While most genuine hedge funds pursue a cash positive return objective, only 27 per cent of hedge funds have a hurdle in place as a foundation for their performance-based fees, according to data from bfinance. The practice doesn’t yet show signs of becoming more widespread, even though the risk-free rate has exceeded four per cent for well over a year. However, the winds of change are blowing and in recent months, there have been cases where hedge fund managers have lost out on mandates explicitly because of this issue.

Hedge fund managers’ lack of movement on the hurdle rate subject is mirrored on the private markets side as well. Hurdles are far more commonplace in illiquid asset classes, but despite the increases in rates, their absolute levels have remained largely unchanged since 2022.

A rapid adjustment couldn’t have been expected, of course. New fee structures do require changes to offering documents and at least initially, there was some doubt about whether rates would even remain elevated for the foreseeable future. Views on the latter issue have now settled into a higher for longer consensus. Yet why has the picture still not changed?

There are three typical arguments:

1. “It is a low beta strategy,” “returns are entirely alpha” or “there isn’t an appropriate hurdle rate for us given our strategy.”

This argument is problematic on both a philosophical and a practical level. Philosophically, the risk-free rate does matter. Institutional investors need to justify how they’re spending fees. The fact that assets could be parked in low-risk securities or cash is always relevant.

The second, more practical objection to the argument is that higher risk-free rates do in fact directly benefit hedge funds. Most strategies have a large part of their portfolios invested in cash instruments. Managed futures strategies, for instance, typically put up just 10 to 20 per cent of their portfolio as margin to the futures positions, with the rest of the portfolio in unencumbered cash — invested in T-bills or other short-term instruments that earn interest.

Long-short equity type strategies are similarly cash-rich, with the sale of short positions funding long positions and the rest of the portfolio sitting in cash. Even for strategies that typically hold less cash, such as merger arbitrage, the arbitrage spreads they seek to capture will increase with rising rates. In fact, it’s quite hard to come up with a mainstream hedge fund strategy that doesn’t in some way benefit from the carry of higher rates.

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2. “Our fees are already low” or “we have a high watermark.”

Interestingly, the managers who use hurdle rates tend to be more investor-friendly in other parts of their fee structure. For hedge funds with a hurdle rate, the average base management fee is one per cent. For hedge funds without a hurdle rate, average base fees are higher at 1.3 per cent.

In practice, there has been significant disparity in the extent to which different hedge funds have been subjected to fee pressure. On one side of the spectrum, there are managers that have had to become more aligned and in tune with institutional investors’ wishes in order to encourage fundraising. On the other side, there’s a cohort that has been so popular among institutional investors that they’ve been able to maintain very manager-tilted terms.

3. “Investors won’t rule us out just because we don’t have a hurdle rate.”

A view persists among many asset managers that hurdle rates don’t yet represent a make or break factor in institutional investors’ selection decisions. A March 2024 performance fee hurdle rate investor survey from the Capital Advisory Group at JPMorgan found “while most investors feel strongly that hurdle rates should be in place, very few are willing to forego compelling fund opportunities that lack them.”

Yet recent experience suggests that the mood has shifted and investors are beginning to be much more willing to exclude managers based on this point. The JPMorgan study still found a nuanced picture for those that read on beyond the opening summary. While only three per cent of the 332 institutional investor respondents said they “won’t invest without hurdle rates” at all, an overwhelming 80 per cent said that hurdle rates were important to them. A quarter of respondents have actively approached their existing hedge fund managers about hurdle rates and a third are planning to as well. Complacency, in other words, isn’t recommended.

With heightened institutional investor concerns around hurdle rates and an increasingly competitive capital-raising landscape, it’s important that hedge funds consider the issue with care. Performance fees of 15 to 20 per cent are still high relative to many other asset classes and this fee is supposed to be fair compensation for skill-based alpha generation. Returns under the risk-free rate shouldn’t qualify — in the bfinance view at least — for this treatment.

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