Even ardent defenders of hedge fund fee structures must acknowledge the impact a marketplace open to retail investors may have on the status quo. Is the hedge fund 2 and 20 rule going the way of the banking industry’s 3-6-3 rule?

Disruption

It is no revelation that 2 and 20 has been under assault for some time. Average management fees have plummeted 25 percent and the average take on profits has dropped 10 percent, making the two and twenty rule a misnomer. More accurately, it has become the 1.5 and 18 rule.

The erosion of the hedge fund’s traditional fee structure is certainly a response to the lackluster performance of hedge funds relative to benchmark indices, specifically the S&P 500. While arguments can be made that using the S&P 500 as a performance benchmark is a questionable practice, the fact remains that hedge funds, particularly long-short hedge funds, have under-performed the S&P 500 consistently since December, 2010.

Understandably, investors of all stripes have rebelled against a hedge fund fee structure that does not reflect its underwhelming performance.

A Time for Every Purpose

Enter Convoy Investments, LLC, co-founded by Howard Wang and Robert Wu, formerly of Bridgewater Associates, LP.

Convoy has responded to investor concerns over the merits of the 2 and 20 fee structure by eliminating the 20 percent performance fee altogether and reducing the management fee to  1.25 percent. Additionally, the firm has reduced its minimum investment to $500,000 in sharp contrast to the standard required minimum of $1 million.

This will be attractive to a subset of disgruntled institutional investors and well-received by retail investors sitting on the sidelines because of the hefty fees typically associated with a hedge fund investment. Wu and Wang have introduced this novel fee structure at the confluence of an investor rebellion against 2 and 20 conventions, and the rise of the retail investor, easily put-off by what are perceived to be extraordinary fees for otherwise ordinary returns.

Is This the Trend?

Only time will tell if Convoy’s fee structure will divert assets from hedge funds operating on a more traditional fee structure. Like any hedge fund, Convoy’s track record will be the principal driver for investment. There is no fee low enough to attract an investor to an under-performing hedge fund. Convoy has yet to establish a track record but, Howard Wang and Robert Wu have earned their bona fides by virtue of their Bridgewater experience. Time will tell how much they learned from that experience and if it can be translated into returns that will grow the firm’s assets under management.

There are a number of ways hedge funds can differentiate themselves from one another and the fee structure may be the least significant methodology. Performance will always be the principal driver and experienced investors are keenly aware that there is no free lunch. Performance fees are a powerful incentive and the absence of such a fee may, at first blush, seem attractive, it may also be a harbinger of lackluster gains. How Convoy’s fee structure is received and, how it performs relative to its peers, will be an interesting story to watch unfold.

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The retail credit universe is dominated by the FICO score. A consumer with a low FICO score will pay higher interest rates or suffer rejected credit requests. Similarly, a nation’s borrowing power is governed by scores from rating agencies. Moody’s, Standard and Poor’s, and Fitch are major players. High ratings make it possible for governments to borrow at favorable rates, typically through the bond markets. The reverse is true for lower ratings.

Consumer vs. Sovereign Default

When an individual defaults on credit obligations, the consequences are usually severe. Consumers face repossession, foreclosure, legal action, and long-term impairment of their ability to access credit. The ramifications for defaulting sovereign nations are not so clear-cut. Argentina may well be the poster child for sovereign debt default, having reneged on its obligations, no fewer than eight times in its history.

The fact that Argentina has eight defaults under its belt, suggests the repercussions for sovereign default may be inadequate to deter it. While it is true that no sovereign state can prosper absent access to capital markets, Argentina has repeatedly succeeded in post default borrowing efforts.  This fact is apparently not lost on Argentina, in default for the second time in a dozen years and its third default in the past three decades.

Who is to Blame?

Argentina points its finger at “vulture” hedge funds as the principal architect of its current default … but is this accusation accurate? Argentina pledged to accede to U.S. financial laws, but having lost its case in U.S. courts, is reneging on that pledge as well.

The argument could certainly be advanced that Argentinean investment was feckless on the part of hedge funds and others given its prior default record. This does not, however, excuse Argentina from its obligations.

The Pertinent Facts

Argentina’s December, 2001 default was the largest in history involving international bond obligations totaling more than $82 billion. Restructuring agreements were concluded with most creditors, who acquiesced to reductions of up to 70 percent of the actual debt due but, there were ‘holdouts’—notably hedge funds, seeking full repayment of the bonds they hold.

While Argentina has adhered to the repayment terms struck in 2005 and 2010, it has repaid nothing to the holdouts. The suit filed by hedge funds and other holdout creditors was adjudicated in their favor. Simply put, the courts concluded that the terms of the bond sale require that all bondholders be treated equally. Translation: Argentina cannot pay the restructured debt and not repay holdouts.

Lesson Learned … or Not

Sovereign debt repudiations clearly have inadequate deterrents. Brazil and Columbia have seven defaults under their collective belts and Venezuela leads Argentina with nine defaults. Standard and Poor’s documents 84 instances of sovereign default around the globe between 1975 and 2002. Nonetheless, these governments have continued to gain access to credit.

Hedge funds and other private investors would like to be perceived as victims when governments default but are they? A case could be made that these investors arguably facilitate bad behavior, as exhibited by Argentina and other sovereign nations having a track record of default, by making such investments. If these investors are indeed facilitators, then wouldn’t the sovereign nations be victimizers rather than victims?

 

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