From HFM Week, Oct 15, 2015
Less Common Expenses Funds Are Levying On Investors
HFMWeek/Convergence investigation highlights the most popular “uncommon” expenses funds are charging
BY CHRIS JOSSELYN
The fund expense practices of hedge funds have come under scrutiny in recent times, not least as regulators have taken a tougher stance on con icts of interest and disingenuous, inconsistent and unclear approaches by managers.
Investors, too, are perhaps paying more attention to the disclosures in Part 2 of Form ADVs before investing in order to avoid being liable for expenses that they may feel are not their business to pay for.
However, new research of SEC data, conducted by data analytics firm Convergence on behalf of HFMWeek, suggests that parts of the hedge fund sector are still not being as consistent in the type of costs they are disclosing as fund expenses as some investors would like them to be.
Investors who have been shown the research have also highlighted the prevalence of expenses that they would consider as being a management company, rather than a fund, expense.
BREAKING DOWN EXPENSES
The research is based on the Form ADVs of more than 2,600 advisers, of which almost half (1,288) are hedge funds. The remainder are private equity funds, real estate funds, venture capital funds, and hybrid funds, which were researched for comparison purposes.
Convergence collected the data by parsing expense disclosures from Part 2 of Form ADVs and creating a dynamic dictionary of term objects that the advisers use to describe their expense disclosures.
Convergence co-president John Phinney says: “After separating the funds into peer groups, we identify what we call ‘common’ and ‘less common’ expense group disclosures among peers in order to determine any unusual tendencies.”
Of the most common expenses, hedge funds had the highest level of advisers disclosing across six of the 10 most frequently used categories, suggesting they disclose more consistently across these common expense groups. The common categories where hedge funds were the top disclosers were audit expenses (100% of the hedge funds analysed disclosed this), fund accounting and administration (92%), general administration (79%), investment related (94%), legal expenses (82%), and performance fees (78%).
For many of these “common expenses”, there is little debate about these being charged to the fund.
“Anything that’s providing a direct service to the fund is clearly a fund expense,” Gordon Barnes, senior director of business risk management at Cambridge Associates, tells HFMWeek.
“The fund auditor clearly should be charged to the fund. Fund administrator, same thing. Legal, organizational costs, the setting up of the fund and ongoing structural maintenance are certainly are a cost of the fund. And directors – they’re representing the fund investors, and that’s clearly a fund expense.
HEDGE FUNDS AND UNCOMMON DISCLOSURES
When it came to less common expenses – often costs traditionally associated with the management company – hedge funds represented the highest percentage of four of the top 10 less common expense categories.
The categories of unusual expense disclosures that were more common in hedge funds than in other asset classes may leave some investors puzzled as to what rationale there is behind charging them to the fund: adviser employee compensation (8.7% of the hedge funds analysed disclosed that they may charge investors for this), data and data management (16.6%), printing expenses (17.9%) and technology (23.8%).
Other ‘less common’ categories include communications expenses, compliance expenses, marketing, pricing and valuation services, subscriptions, and adviser overhead expenses.
“Then you get into things that could be seen as overhead for a business, and there’s a kind of in-between,” explains Cambridge Associates’ Barnes.
“Research is an interesting one; some groups argue that research is [a fund expense] as it provides a benefit to investors to have a Bloomberg terminal and things like that.”
This becomes more ambiguous where managers receive services through “soft dollars”, where brokers provide certain amenities in exchange for the managers directing business their way.
“What’s tricky here is that they could be charged to the fund, in the form of a direct fund expense, or through soft dollars – ultimately it’s being paid by investors because they’re essentially overpaying for commissions and getting credit back from their brokers to spend on certain research related-tools,” adds Barnes.
Most allocators are aware of and comfortable with the concept of soft dollars. However, what they demand is transparency.
Another area that is likely to come on to the radar in future is any charges associated with cash management, given the regulatory pressures on institutions holding cash.
“We’re entering a world where [cash management costs] are going to become a reality and so the additional costs associated with MMFs or cash custody is something that will be absorbed into a fund expense,” Daniel Burdett, senior analyst within Aksia Europe’s ODD team told HFMWeek.
Research-related travel expenses is another ambiguous area. “Travel expenses for the analysts to go see the companies and do due diligence on them – that used to be a lot more common,” says Cambridge Associates’ Barnes.
“With travel, there’s potential conflicts that can arise. At the end of the day, why don’t you just charge a higher management fee? It would be a lot more transparent – if you need this extra travel cost, why don’t you just add 10 basis points to your management fee and be very transparent?”
Regulators are focusing on this as it becomes a greater investor concern. The SEC requires that disclosures be specific in ADV documents, and in 2012 it charged long/short equity hedge fund Lion Capital Management and its manager Hausmann-Alain Banet for using investor funds to pay unauthorised personal and business expenses.
Trade body Aima has also published guidance on hedge fund expense due diligence, in which it highlights that “getting the full picture of the various expenses is rarely easy and requires careful review and analysis during initial and ongoing investment manager due diligence”.
“All of the fees outside of the management fees are generally not disclosed very well,” says Mark Renz, CIO at Florida-headquartered Socius Family Office, which has $200m in AuM and $150m under advisement.
“It’s difficult to break out where a lot of the underlying fees come from – typically they’re buried in financial statements and other disclosures, and even there it’s not always very clear.
“Many people are just starting to wake up to a lot of this. People talk about 2&20, but really it’s not 2&20; it’s far more than two because typically that 2% management fee doesn’t actually cover any of the expenses. You could say it’s an advisory fee, just allocated to the investment managers as pure compensation, but it doesn’t cover any of the expenses – it’s not apples to apples.”
Renz adds that managers have a lot of scope for being creative in categorizing expenses.
“On the partnership side they have a lot of discretion – there’s no best practice or standard practice for disclosing these fees, and there’s a lot of discretion – it’s really up to the manager as to what they want to charge and how they charge it. The statements are so broad that it gives them the latitude to shove whatever they want in there.”
The research suggests that the depth, breadth, and quality of expense disclosure varies widely between managers. However, it does highlight the prevalence of certain expenses many investors would hope to see paid for by the management company being paid at fund level.
Convergence’s John Phinney says: “This could be due to a creeping of expenses to the fund that were previously borne by the adviser because of a trend towards lower management fees and increasing regulatory, compliance and investor expenses or simply an attempt by advisers to create more distinction between expenses related to the investment versus non-investment process.”
This move may also have been triggered by investor activism aimed at lowering fees, according to Phinney. “Advisers are under more fee and expense pressure driven by investor activism and greater regulation and may seek to offset, in part, the negative impact on management fees by charging the funds they advise more expenses that may be considered a cost of the fund,” he explains.
“At the end of the day, it’s not only an issue of transparency, but it’s [also] an issue of consistency,” concludes Socius’s Renz. “There has been something of a change – some managers have been willing to reduce their fees or negotiate – I just don’t think that it has translated over to the expense side.”
Conversely, Cambridge Associates’ Barnes says unusual expenses that many investors think should be charged to the manager, rather than the fund, are more prevalent in older managers “that have been around for 15 to 20 years”, rather than newer vehicles.
He adds: “When they launched this was standard practice, and over time, some of them are still doing it, especially the ones that have great performance, whereas new fund launches over the past couple of years, are pretty much in line.
“These businesses are very profitable, and it’s an expense of doing business. There are certain circumstances where we see a several-billion-dollar fund, and they’re extremely profitable. There’s no reason to be passing through a basis point here and a basis point there of certain overhead expenses – it doesn’t make sense.”