Stockholm (HedgeNordic) – A coalition of institutional investors, led by the Teacher Retirement System of Texas, is gaining more support, including from Nordic investors, in their demand for hedge funds to implement cash hurdles in incentive fees. Swedish pension insurer PRI Pensionsgaranti and Finnish pension insurance company Ilmarinen are among the new signatories to an open letter titled “Regarding the Usage of Cash Hurdles in Incentive Fee Arrangements,” which calls for cash hurdles before hedge funds can charge incentive fees.

In the decade following the financial crisis, many hedge funds launched without setting cash-based hurdle rates due to the low-interest-rate environment. However, in the current climate of higher interest rates, hedge fund allocators are demanding that managers deliver outperformance over the risk-free rate before collecting performance fees. “We believe incentive payments on true value-add fixes a misalignment that has been present in fee structures throughout the maturation of the hedge fund industry,” the open letter states. “This misalignment has become increasingly evident in recent years, as risk-free rates have reached mid-single digits.”

“Earning cash returns is not the reason institutional LPs invest in hedge funds.”

The letter highlights that hedge funds can collect significant incentive fees based solely on “skill-less” returns generated from short rebates, securities lending, and unencumbered cash. Investors can easily obtain these returns for free outside a hedge fund structure. “Earning cash returns is not the reason institutional LPs invest in hedge funds,” states the letter. Moreover, cash hurdles better promote proper risk-taking, as the financial health of hedge fund managers is dependent on delivering the valuable alpha that investors seek. Initially published on May 30 with just over 30 signatories, the open letter calling for cash hurdles in incentive fee arrangements now boasts nearly 60 signatories, including two Nordic institutional investors.

One of the first Nordic hedge fund investors to actively advocate for implementing cash-based hurdle rates was Norwegian wealth manager Formue, one of the largest hedge fund allocators out of the Nordics. “This topic is gaining traction in virtually every hedge fund meeting. This discussion needs to take place at an industry-wide level,” Cian Walsh, Head of Hedge Funds at Formue, told HedgeNordic earlier this year. Walsh argued that the absence of cash hurdles leads to costly investing and disincentivizes managers from taking risks. “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?” Walsh pondered. “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.”

Cian Walsh, Head of Hedge Funds at Formue

He stressed the need for negotiating with hedge fund managers to introduce cash-based hurdle rates, even for existing funds, to better align incentives. Walsh and his team have been exerting pressure on both existing and new hedge funds to adopt cash-based hurdle rates. 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.

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. “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,” concluded 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.