✌️ Welcome to the latest issue of The Informationist, the newsletter that makes you smarter in just a few minutes each week.
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- Fund Structures
- Management Fees
- Performance Fees
- High Watermarks and Hurdles
- Can you invest in one?
Hedge funds/legacy fiat world in decline.
How does one know?
— Dan Tapiero (@DTAPCAP) March 13, 2022
Dan points out here that CEO Changpeng Zhao’s ownership of Binance increased in value more than total sum of the top 25 hedge fund managers’ earnings in 2021.
Still, the top 10 managers alone amassed $19 billion of earnings in 2021. How? Primarily fees, so let’s break down how those work below.
🏦 Fund Structures
Before we dig into fees, let’s first understand how hedge, private equity, and venture capital funds are structured. Unlike a mutual fund or equity in a company, the types of investment funds we are talking about today are actually structured as partnerships. Limited partnerships, to be exact.
This is why you will see the names of the different funds listed with an LP at the end of them, such as Citadel Equity Opportunity Fund LP, or BlackRock Growth Equity Fund LP. Because they are structured as partnerships, they can invest in pretty much anything the fund mandates: short securities, commodities, currencies, derivatives, you name it.
Heck, there are hedge funds out there that stake professional poker players, finance film makers, or even arbitrage winning lottery tickets. If they list it in their offering document, they can do it.
One catch: the SEC limits the total number of investors who can be in each of these partnerships. But we’ll talk more about that in a bit.
💵 Management Fees
The first lick fund managers take is usually in the form of a simple management fee. These vary across fund type and the way managers invest the money. Here’s how it works:
Hedge funds typically charge an annual management fee of 1% of the invested capital of the fund. Investors will wire their entire investment in a fund all up front and at once.
For example, if an investor puts $1,000,000 in a hedge fund, regardless of how the fund performs, he will be charged $10,000 annually. This fee is broken up quarterly and paid in advance. So, $2,500 per quarter, up front.
Private Equity & Venture Capital
Private equity and venture capital funds are a bit different. They normally charge annual management fees of 2% of the total committed capital of the fund. The way it works is this:
If an investor agrees to invest $1,000,000 in a private equity or venture capital fund, this is called the investor’s committed capital. They have agreed (committed) to invest up to $1,000,000, as the manager finds appropriate investments for the fund. This amount immediately begins to be accrue the annual management fee. Same as above, it is quarterly and up front.
But the investor doesn’t send any money yet.
The reason is, unlike public equity focused hedge funds that can invest all your money immediately, private equity and venture capital funds must first identify opportunities, perform due diligence, negotiate terms, etc., all before making an investment. Once they do find an opportunity, they issue what is known as a capital call to their investors. In other words, they call the amount of capital needed for the investment. The investor then wires that amount and waits for the next call.
So basically, if you commit $1,000,000 to a private equity or venture capital fund, you have to keep that amount ready to invest at any moment. Typically, for five to seven years from commitment.
To boil it down for the managers, a $1 billion hedge fund will make $10 million of management fees annually, and the same sized private equity or venture capital fund will accrue $20 million in management fees each year.
Not bad, considering they haven’t even made an investment yet!
🤑 Performance Fees
Now this is where it gets interesting for the managers. All three types of funds here typically charge what is called a performance fee (sometimes also referred to as an incentive fee or carried interest), and this is usually 20% of the profits they have generated on their investments. All three funds charge these fees after management fees have been subtracted.
The timing of how they charge these fees is a bit different, though.
For hedge funds, because they are typically invested in public equities that are market to market (trade on regulated exchanges which all publish opening and closing values for securities), they charge these performance fees annually, regardless of whether the individual investment profits or losses have been realized. So, even for the positions that are still on the books and invested in the market, wherever the position closes for the year is the value used to determine the fund’s profits and losses, and hence, performance fees charged to the investor.
Now you know why we so often see hefty stock market gains going into the last day or two of the year. Some less-than-ethical managers will aggressively buy their own stocks in order to make them close at a higher price and charge investors a higher fee. This is called window dressing, and we see it happen all the time.
At the beginning of the next year, though, the performance fee clock resets and we start all over again.
Private Equity and Venture Capital
As for private equity and venture capital funds, they mark each individual investment according to their estimate of what fair market value would be for the sale of the underlying companies. Then they accrue performance fees annually to show investors what their net gains or losses would be in the event the investments were liquidated at that moment.
As you can imagine, sometimes the underlying investments fluctuate in value wildly, according to economic or company specific impacts. So, in the next year, if the values drop, the manager re-marks the portfolio and re-allocates some or all of the prior accrued performance fees back to the investor.
Let’s talk actual dollars now.
A $1 billion fund that generates a 25% return or $250 million profit for the year (after management fees have been paid), will in turn generate 20% or $50 million of performance fees on those profits.
Including management fees, for a hedge fund, this adds up to $60 million for the year, and for a private equity or venture capital fund, it totals $70 million.
Now imagine being one of the largest hedge funds in the world, like Bridgewater Associates ($105 billion), Man Group ($77 billion), Renaissance Technologies ($58 billion), or Millennium Management ($52 billion).
Using the fee assumptions above, a 25% return on a $50 billion fund adds up to a staggering $3 billion in fees.
Not too bad for a year’s work.
🌊 High Watermarks and Hurdles
Okay, so what happens if a fund loses money one year?
We already answered that for private equity and venture capital funds. They just re-mark their positions and accrued performance fees accordingly. But what about the hedge fund that had great performance last year and is losing money this year?
This is where something called a high watermark comes into play. A high watermark is basically the investor’s highest capital balance from the end of each year. If the investor’s portfolio was marked at $1.2 million at the end of last year, and that’s the most it has ever been worth, then that becomes the investor’s high watermark. The investor will only be charged performance fees above this level going forward.
If the manager then loses money, and the investor’s balance falls below the $1.2 million, then the manager must make that back up before he can start charging performance fees again.
Most private equity and select venture capital funds offer investors what is called a hurdle rate (or preferred return) before they charge performance fees. What this means is that the manager must achieve an annual rate of return equal to the hurdle rate before they can begin charging performance fees.
This rate typically falls in the 7 to 10% range. It helps assure investors that the manager is well incentivized to call their capital and get their money to work in order to keep up with that preferred return clock that is immediately ticking.
🤠 Can you invest in one?
Accredited Investors and Qualified Purchasers
You’ve heard that hedge, private equity, and venture capital funds are only for the rich, and normal everyday people do not have access to and are not even allowed to invest in them. Unfortunately, both of these are fairly true.
Under SEC rules, only those who qualify as accredited investors are legally allowed access to these types of funds, and the fund is limited to a total of 99 investors. In short, you must meet these criteria:
net worth over $1 million, excluding primary residence (individually or with spouse or partner), or
income over $200,000 (individually) or $300,000 (with spouse or partner) in each of the prior two years, and reasonably expect the same for the current year, or
professional criteria, such as a licensed investment professional or a “knowledgeable employee” of the fund.
You can find more details and the exact SEC requirements here.
If the manager is willing to accept even tighter minimum investor qualifications, he can allow up to 499 investors in his fund. The catch is, they must all be Qualified Purchasers instead.
Bottom line, we’re talking over $5 million of investment assets for individuals and $25 million for family offices.
With a limit on number of investors, it’s no surprise then, that fund managers also require a minimum size of investment. Typically, this level is set at $1 million, but for some of the largest and/or most successful funds, they set this minimum at $5 million or more. And unless you meet all these criteria, you are pretty much shut out.
But there is a small loophole.
The SEC does allow funds to accept up to 35 non-accredited investors in order to facilitate a small friends and family pool.
So, by all means, if you are not yet an accredited investor, and the manager is willing to lower the minimum investment for you, pull that string to get into his fund.
That’s it. I hope you feel a little bit smarter knowing about hedge funds, how they make their fees, and feel more empowered to invest in one someday.
As always, feel free to respond to this newsletter with questions or future topics of interest!