What is a fair fee/lockup structure for a money manager to charge?

[Mephistopheles]

There are great investors who charge fees on all parts of the spectrum. There is Francis Chou and Bruce Berkowitz who charge only 1% in their mutual funds, and obviously no lockup. In the middle of the spectrum there is Pabrai and Buffett in his early days who charge 25% on anything over 6%, with a 1 year lockup. And on the other end there is 2/20, which I believe Ackman and Einhorn charge (though I'm not positive). I've talked with some wonderful, talented fund managers on this board who also charge fees on all parts of the spectrum.

 

I understand that there is no one right answer as to what is fairest, and it may vary depending on other factors such as the AUM, etc. For example, someone who is starting out managing, with less than $1 million may find it necessary to charge heftier fees to support himself in the beginning. Then there are those who work with $100 million or more, who can live a life of luxury simply from a 2% management fee.

 

As you can see, it varies from the perspective of the fund manager. But what about from the perspective of the client? Does it really matter to a client if a manager has $1 million or $100 million in AUM? Probably not so much.

 

I bring up this topic because I dream about all aspects of starting my own fund some day, and I would like to charge a fee that is fair to the client so I can feel satisfied in earning it, and a lockup agreement that allows me to think long term while allowing investors to have access to their money within reasonable time limits.

[peter1234]

If you want to be able to think and invest long term, you want a 1 year or longer lockup. One of the main reasons Ackman listed his fund as a closed end fund was for permanent capital with lockup forever. These lockups apparently scare away many/most prospective investors as well as intermediaries helping you raise money.

 

If you want to attract the most money quicky, have the shortest lockup with daily liquidity. After 1-3 years of good returns you will be flooded with money and after short term under-performance, it will all leave just as you scaled up your operations and got comfortable in your new penthouse. Intermediaries are very attracted to this setup and will find lots of clients and money.

 

Reality is not as black and white as this, but I hope you get the gist. While promoting his book, Spier talks a fair bit about having to deal with fast (in and out) money in the past and now being much happier with more permanent money.

;)

[Ham Hockers]

But what about from the perspective of the client? Does it really matter to a client if a manager has $1 million or $100 million in AUM? Probably not so much.

 

It can absolutely make a difference. Is the manager generating enough fees in a base case that he is reasonably satisfied? In a downside case that runs several years is he making enough to cover his normal living expenses? You want the manager managing your assets and not taking too much time worrying about raising capital.

[Mephistopheles]

If you want to be able to think and invest long term, you want a 1 year or longer lockup. One of the main reasons Ackman listed his fund as a closed end fund was for permanent capital with lockup forever. These lockups apparently scare away many/most prospective investors as well as intermediaries helping you raise money.

 

If you want to attract the most money quicky, have the shortest lockup with daily liquidity. After 1-3 years of good returns you will be flooded with money and after short term under-performance, it will all leave just as you scaled up your operations and got comfortable in your new penthouse. Intermediaries are very attracted to this setup and will find lots of clients and money.

 

Reality is not as black and white as this, but I hope you get the gist. While promoting his book, Spier talks a fair bit about having to deal with fast (in and out) money in the past and now being much happier with more permanent money.

;)

 

Makes sense. I think a lockup is beneficial not only to the manager, but to the client as well in that it protects the client from himself in times of market turmoil.

 

But what about from the perspective of the client? Does it really matter to a client if a manager has $1 million or $100 million in AUM? Probably not so much.

 

It can absolutely make a difference. Is the manager generating enough fees in a base case that he is reasonably satisfied? In a downside case that runs several years is he making enough to cover his normal living expenses? You want the manager managing your assets and not taking too much time worrying about raising capital.

 

That's true. But this is assuming all else is equal (which may not be the case for the reason you point out).

 

Maybe I'm thinking too much into it, but it's difficult for me to reconcile charging more than a super investor like Bruce or Francis. Perhaps I am sensitive to this because it will be all family and friends for me in the beginning.

[ATLValue]

I've been doing some thinking about this subject and one issue I'm confronting as I bootstrap a fund is charging a performance fee. I'm confident that I can raise money from my friends and family but the majority don't qualify as accredited / qualified investors. One solution that I thought about was charging a 3% management fee but refunding 1% if performance was less than 14%, refunding 2% if performance was less than 10%, refunding the full management fee if performance was less than 6%. [similar to Buffet's 0,6,25%]

 

Obviously this is far from ideal but wanted to see if anyone had encountered something similar to this they looked at investing in or starting an investment management business.

 

Thanks

[matts]

I've been doing some thinking about this subject and one issue I'm confronting as I bootstrap a fund is charging a performance fee. I'm confident that I can raise money from my friends and family but the majority don't qualify as accredited / qualified investors. One solution that I thought about was charging a 3% management fee but refunding 1% if performance was less than 14%, refunding 2% if performance was less than 10%, refunding the full management fee if performance was less than 6%. [similar to Buffet's 0,6,25%]

 

Obviously this is far from ideal but wanted to see if anyone had encountered something similar to this they looked at investing in or starting an investment management business.

 

Thanks

 

I'm certainly not a lawyer, but it looks like you just engineered yourself a performance fee structure. I doubt the regulators would have trouble making a case against you if they decided to put any effort in.

[ATLValue]

Yeah I don't think it would be worth the trouble

[Mephistopheles]

I'm not sure how it is in other states, but in NJ, you can charge performance fees to unaccredited investors as long as you don't register with the state as a broker. And as far as I know there isn't much of a purpose to registering with the state besides being able to go around saying that you're "registered in NJ".

 

Nevertheless, my original dilemma is not in regards to performance fee or not, or how to align incentives. It's simply trying to figure what sort of structure is fairest to the client so that you don't rip them off. Is any price okay as long as you can beat the market after fees? Or should it be comparable to what some of the great low cost value investors charge?

[peter1234]

For investors, what matters in the end is performance after fees. And that they actually get to enjoy this performance and not bail out because of volatility.

 

Personally, 25% above 6% with high water mark seems very fair but might be hard for a small emerging manager, especially if you have a few low years at the beginning.

 

Benchmarking yourself to the lowest cost providers will be hard with little money under management. It is only due to their enormous assets that Vanguard can charge a few basis points instead of dozens or hundreds.

[oddballstocks]

I'd just charge 2% flat when you're starting out.  Maybe even 3% flat if your asset base is smaller.  Tell investor that once your AUM grows over a certain point you'll lower your management fee.  You can negotiate with accredited investors individually and work out a performance structure.

 

As a small manager you want to:

1) Make sure you can eat.  Managing capital isn't going to be much fun if you know you can work fewer hours at Costco have health benefits and earn more there.

2) Focus on investing and growing your brand.

 

I don't know of the true breakdown, but I'd say you should probably figure 20-30% of your time will be administrative tasks.  Another 20-30% will be raising money and the other 50% or so finding investments.  Remember you're running a business, businesses need sales, marketing, finance.  If all you do is hole yourself up in a room and invest you will probably be plagued with a small AUM and have trouble meeting life's expenses.

 

It's easier to raise $1m than it is to double $1m.

[Guest longinvestor]

I've been doing some thinking about this subject and one issue I'm confronting as I bootstrap a fund is charging a performance fee. I'm confident that I can raise money from my friends and family but the majority don't qualify as accredited / qualified investors. One solution that I thought about was charging a 3% management fee but refunding 1% if performance was less than 14%, refunding 2% if performance was less than 10%, refunding the full management fee if performance was less than 6%. [similar to Buffet's 0,6,25%]

 

Obviously this is far from ideal but wanted to see if anyone had encountered something similar to this they looked at investing in or starting an investment management business.

 

Thanks

 

Seen from the investee's perspective, this would be fair. This kind of fee structure would allow the investee to make a simple choice: Fee Avoidance or Risk X years with the manager to see if he/she can earn your fee. After all, the world of fee paid managers is not crawling with folks that return 6% or 10%, let alone 14%. Especially if X=>10 years.

 

Wish this would be the norm in the financial industry which is awash with easy fees for little more than a hope of a return. Investees are supposed to gauge the manager solely by reputation. Reputation is relatively easy to market, especially on the internet.

[BG2008]

Some suggestions

 

You can offer more than one share class

 

I think you should ask for lock ups - It automatically filters out the fast money - If someone is willing to lock up their money for 2 years, they are likely taking a long term view on investing with you

 

You have to be realistic with what your third party fund admin is able to provide.  Typically, it is a ton of trouble to give money back, i.e. 3% fee and then reimbursement.  I forgot the exact reason, but it may involve tax reporting.  It creates complication.  What is fair is not market and sometimes you have to offer what's fair will create enough complication that the investors won't invest with you.  There's theory and then there's what's practical.   

 

One thing that I am surprised about is that if you don't charge a management fee, i.e. 0,6,25, people are weary to give you money.  They are worried that if you have sub 6% performance for 2 years, you won't have any income to live on. So, I would encourage that you charge 1, 6, 25. 

 

 

 

[thepupil]

Liquidity structure:

The liquidity structure (lockups, notice periods, gates) of the fund should match the liquidity of the strategy and the sophistication of the LPs/clients.

 

If you offer daily liquidity for a concentrated micro cap strategy where you may own several months volume of a stock, you are exposing your investors to tremendous risk and in that instance "investor friendly" lenient liquidity terms are anything but. On the other hand, if your fund is going to own the likes of  Berkshire, Google, Apple and  other "sell with a click" stocks and simultaneously  have a 3 yr lock up 6 months notice and all kinds of gates, you're going to look like you just want to create impediments to people taking out their money. Obviously those are the two extremes.

 

One solution that is not often used is the minimum management fee guarantee (i.e. I as client agree you to pay 3 yrs of mgt. fee  on the original commitment but can withdraw my money when I want to) or a sliding scale redemption penalty (5% year 1, 2.5% year 2, 0% year 3).

 

As far as mgt. and inventive fees go, the key is alignment of interests and stability of firm, and what works for one client may not work for another.

 

Each component (management fee, hurdle, incentive fee) has its own issues. Too high a management fee and too large the the AUM and the manager's incentive is too preserve capital rather than grow it.  Too low and the manager cannot pay the bills. There is a big variance in terms of strategy. A distressed credit trading oriented firm can't have a 0% management fee (who would pay the army of analysts, traders and lawyers? also hard to attract talent unless you are in a decent city). An already rich guy working from home can.

 

The best management fee structures ensure stability while also disincentivizing growth at any cost by scaling down with AUM. For an individual this may be something like 1%  on the first $10MM. For a more institutional size manager it may the first $100MM. Clients should share in the benefits of scale that comes with a firm's growth, since they definitely get hurt by a decline in richness of opportunity set as managers get bigger.

 

The most important part of the incentive fee is figuring out what the right hurdle is. If you are running a market neutral long short fund that will be very tightly managed in terms of exposure, maybe you can get away with no hurdle, but for everyone else, there should be something that strips away the "beta" of a managers return.

 

A lot of people love the "Buffett Structure" (0, 6, 25). I think the market of the past few years illustrates the flaw of an absolute hurdle. A manager would be paid a TON of money without outperforming. The Russell 2000 went up 37% in 2013. Performance in line with the Russell would deliver 7.75% to the manager in a year like that. I think the most fair thing to do if you go with a strictly absolute hurdle is have a lookback, or multi-year vesting period.

 

Alternatively, you can go with a blend of an absolute hurdle and an index hurdle (0, 20% over 0.5X Russell + 0.5 X 6%). A nice compromise that pays a manager well in the crazy up years but also rewards the manager when he preserves capital (losing 10% instead of 25% deserves an incentive fee which an absolute positive hurdle doesn't do). Or offer different ones to different clients. High net worths may only care about absolute performance. Institutions may care more about long term performance relative to an easily replicable benchmark.

 

I have a lot more thoughts on this because this is kind of what i do , but that's enough bloviating for now

[Grossbaum]

Regarding the fee structure, I am curious as to why it is not more common to see a structure like 1% management fee and 50% performance fee above the S&P500.

 

Perhaps one seemingly unnatural issue for the limited partners would be to pay the manager in a down year. For instance if the S&P was down 20% and the fund was down gross 9% (-10% after mang fee), then the LP's would pay the manager another 5%, so they would be down net 15% versus the market 20%. Although many LP's may have an issue with that, it seems to me quite fair in my mind.

 

And in addition, the S&P returns should act as a "highwater mark" over the years, so a manager doesn't receive a performance fee in a big out performance year if the LP is still net negative to the S&P500 since inception.

 

I suspect the uniqueness of the structure is due to the fact that very few managers would earn a performance fee. Nonetheless, it seems to be an equitable structure to me.

 

[redhots]

Regarding the fee structure, I am curious as to why it is not more common to see a structure like 1% management fee and 50% performance fee above the S&P500.

 

I was wondering the same thing.  Anyone have any insight here?

[thepupil]

highest* I've seen is 40% above S&P. this was one of 6 or so fee structures offered by a manager who was very senior at a multibillion hedge fund and was starting out w/ 20MM of his own money in fund and 5mm of working capital to fund operating expenses (4-5 analysts, IR,rent, etc.) for a few years if they didn't raise money.

 

I think he had an option that was lower %  (like 25 or something) if you locked up for 3 yrs.

 

The reason you don't see this structure often is because

 

1) allocators are adverse to paying such a high %, even if it is for outperformance AND in particular if there is no lookback or if is earned fully over a short period of time (like a year). this creates a lottery payout structure where one year can make someone inordinately wealthy or possibly inspire the manager to take "shoot for the moon" bets. Even with a high water mark, if the fees vest in a year, you pay out a ton for short term performance that may prove illusory. There is also an aversion to paying an incentive on long-only money.

 

2) most managers need a management fee to pay the bills, the math of a management fee + a BIG incentive, even if hurled, is a huge headwind to net returns; you need to have a low or no management fee if you are going to do the "high percentage over good hurdle" route. The example I provided did not need a management fee in this offering since he had several years operating expenses capitalizing his firm and was already worth 8 figures. He also offered a 2% mgt. fee class, I believe.

 

*this does not include the heavily levered trading shops like Rennaissance, SAC, Millennium who charge ungodly fees + expense pass thrus. they are different animals with 100's of employees and teams, more like owning a prop desk of a bank.

 

 

[thepupil]

oh and it takes a very confident manager to have an index hurdle!  If you can raise money at unhurdled fees, why bother with more LP friendly terms?

[Tim Eriksen]

oh and it takes a very confident manager to have an index hurdle!  If you can raise money at unhurdled fees, why bother with more LP friendly terms?

 

To be clear they are friendly if the manager under performs or barely outperforms.  If a fund substantially outperforms (8 percentage points annually or more) they are more expensive.  If you are looking at a smaller fund they typically can do a side letter with whatever fee structure is agreeable to both parties.       

[thepupil]

I'm confused Tim. Assuming the index performance is positive over time, how does an index hurdle result in charging more if outperformance is significant?

 

Structure A: 1% and 20%, no hurdle

 

Structure B: 1% and 20% over index

 

Substantial outperformance year

Index return 5%

Manager return 20%

 

Structure A: 1% mgt fee + 20% * (20% gross) = 4% fee

Structure B  1% mgt fee + 20% * (15% outperformance) = 3% fee

 

Unless the index is negative, isn't structure B always going to pay less (and therefore more LP friendly)

[Tim Eriksen]

I'm confused Tim. Assuming the index performance is positive over time, how does an index hurdle result in charging more if outperformance is significant?

 

Structure A: 1% and 20%, no hurdle

 

Structure B: 1% and 20% over index

 

Substantial outperformance year

Index return 5%

Manager return 20%

 

Structure A: 1% mgt fee + 20% * (20% gross) = 4% fee

Structure B  1% mgt fee + 20% * (15% outperformance) = 3% fee

 

Unless the index is negative, isn't structure B always going to pay less (and therefore more LP friendly)

 

Because the outperformance fee under structure B is typically higher than 20%.  It is often 40%.  Or even 50% if there is no management fee.     

[Philip Morris IV]

One thing that I am surprised about is that if you don't charge a management fee, i.e. 0,6,25, people are weary to give you money.  They are worried that if you have sub 6% performance for 2 years, you won't have any income to live on. So, I would encourage that you charge 1, 6, 25.

 

This is a good point in favor of having a management fee.  Another is that without one, it incentivizes the manager to really crank up the risk.  With 0/6/25, the manager has to break 10% (and possibly HWM) to make just 1%.  With 1/6/25 there isn't the constant pressure to swing so hard or act hastily when downward volatility strikes.

 

WRT lockups, something I don't see mentioned yet is a 'soft' lockup.  In other words, a 2-3% redemption fee that expires and/or scales down to 0% over time.  This I believe accomplishes the best of both worlds in a way -- discourages early withdrawals yet mitigates their impact anyhow, and still allows LPs the option, for a price.  When payable to the fund, it also rewards the more patient LPs, as the exiter's loss is their gain.

[Travis Wiedower]

Do any money managers incorporate a long-term performance-based fee into their structure? I've put thought into it but have never come up with a good way to do it.