Stockholm (HedgeNordic) – In the decade following the financial crisis, the low-interest-rate environment enabled many hedge funds to launch without setting cash-based hurdle rates before charging performance fees. However, with interest rates on the rise, hedge fund allocators are increasingly demanding managers to deliver some outperformance over the risk-free rate before collecting performance fees. Norwegian wealth manager Formue, one of the largest hedge fund allocators out of the Nordics, is actively advocating for a change in this fee-charging approach.

Cian Walsh, Head of Hedge Funds at Formue, highlights the growing demand for cash-based hurdle rates among allocators, noting that only about 10 percent of hedge funds currently have them in place based on his observations. “This topic is gaining traction in virtually every hedge fund meeting. This discussion needs to take place at an industry-wide level,” Walsh emphasizes. He points out that most hedge funds launched after 2008, amidst a low-interest-rate environment, do not have cash hurdles in place.

“This topic [of introducing cash-based hurdle rates]is gaining traction in virtually every hedge fund meeting. This discussion needs to take place at an industry-wide level.”

“Apart from the so-called top 15 or 20 hedge funds that had been around before 2008, when interest rates were around five percent, the vast majority of hedge funds launched after 2008 in a zero-rate environment,” elaborates Walsh. “And every single one of those doesn’t have a cash hurdle in place,” he highlights the widespread lack of such mechanisms among newer hedge funds.

The Institutionalization

In the early years of the hedge fund industry, managers primarily attracted money from wealthy individuals, private banking clients, and family offices. Hedge funds boasted considerably higher return streams before, often reaching returns of 25 to 30 percent. “If managers didn’t have a cash hurdle, that didn’t really matter that much at such rates of return,” notes Walsh. Even so, cash-based hurdles were somewhat more prevalent before 2008.

Over the past one or two decades, the investor base in the hedge fund industry started to shift towards institutional players, including corporate and public pension funds and sovereign wealth funds. This shift has shaped a more ‘institutional’ hedge fund industry, leading to the emergence of safer and less volatile investment strategies. “In today’s institutionalized hedge fund world, where generating returns of eight to twelve percent with mid-single-digit volatility is considered good and safe, having a cash hurdle in place is essential,” underscores Walsh, who oversees hedge fund allocations at Formue.

“In today’s institutionalized hedge fund world, where generating returns of eight to twelve percent with mid-single-digit volatility is considered good and safe, having a cash hurdle in place is essential.”

Walsh argues that the absence of cash hurdles results in costly investing and disincentivizes managers from taking risks. “If you have a standard ‘two and 20’ model without a cash hurdle, an investor effectively pays 3-3.5 percent in management fees,” emphasizes Walsh. “This is significant because the investor is paying a 20-25 percent performance fee on a 4.5-5.5 percent cash rate,” he elaborates. “With no cash hurdle, what’s the incentive for the manager to take much risk when collecting performance fees on risk-free returns of 500 basis points?” ponders Walsh. “There is no incentive.”

“With no cash hurdle, what’s the incentive for the manager to take much risk when collecting performance fees on risk-free returns of 500 basis points? There is no incentive.”

He stresses the need for negotiation with hedge fund managers to introduce cash-based hurdle rates, even for existing funds, to align incentives better. With oversight of a $1.3 billion hedge fund allocation, Formue is among the largest hedge fund allocators in the Nordic region, often ranking among the top five investors in many funds. “That gives us significant bargaining power,” notes Walsh. “We are engaging in negotiations with each of our managers individually, pushing them hard on this front,” he says. Walsh and his team are pressuring both existing and new hedge funds to adopt cash-based hurdle rates. “For us, any fund raising capital without a cash hurdle is a deal-breaker,” he emphasizes.

However, Walsh does not advocate for a complete overhaul of existing fee structures. Instead, he encourages managers to introduce new share classes with cash hurdles to better align incentives between managers and investors.  “I don’t mind if they introduce a new share class with a higher performance fee of 25 percent and a cash hurdle, that’s a better situation for us because then the incentives are far more aligned,” says Walsh. “Managers can maintain their existing share class. If they were founded in 2012 without cash-based hurdles, adding it post-establishment may be challenging. That’s not what I’m trying to push,” he notes. 

“What I’m advocating for is the adoption of a cash hurdle now. Introduce a new share class with a cash hurdle…”

“What I’m advocating for is the adoption of a cash hurdle now. Introduce a new share class with a cash hurdle, allowing for an increase in the performance fee where the manager feels it is necessary. This ensures a much better alignment of interests between the manager and the investor,” concludes Walsh. Overall, the push for cash-based hurdles reflects a broader trend in the hedge fund industry toward greater alignment of interests between managers and investors in today’s changing market conditions. Hedge fund allocators such as Formue are vigorously advocating for this change.