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 into account the value to the business that investor capital brings to a fund, which is not part of our framework, it is possible to create a situation where both investors as well as asset managers win.