Last week I went with my wife to see “Fifty Shades of Grey”, the latest box-office hit about a college graduate, Anastasia, and her relationship with billionaire CEO Christian Grey. Grey attempts to cajole her into signing a contract that formalizes her role as a “submissive” in the relationship. It’s probably not what the director intended, but the film got me thinking about the kind of contracts that investors sign when they hand their money to hedge funds (it was a long film, okay…). Here is how most of these contracts go:
The Client and the Manager agree and acknowledge that all that occurs under the terms of this contract will be consensual, confidential, and subject to the agreed limits and safety procedures set out in this contract
The Client will maintain a quiet and respectful bearing in the presence of the Manager.
The Manager may trade excessively, adopt highly leveraged positions and engage in esoteric bets as he sees fit, for his own personal enjoyment, or for any other reason, which he is not obliged to provide.
The Client consents to paying away 2% of the fund each and every year, regardless of how the fund performs.
The Client consents to paying away 20% of profits earned, regardless of whether these profits were earned as a result of market moves or the Manager’s skill.
The Client will accept chronic underperformance, redemption penalties, lock-ins and excessive fees without hesitation, enquiry or complaint.
The safeword “redemption” will be used to bring to the attention of the Manager that the Client cannot tolerate any further fees. When this word is said the Manager will wind up what’s left of the fund, take his fees and relocate to the Cayman Islands.
The client is getting a pretty raw deal here. Like poor Anastasia you might be inclined to ask “What’s in it for me?” When you sit down and work through the fee structure of a hedge fund, you realize just how one-sided it really is. Performance fees are the worst type of fees, because they only apply one way: You pay these fees when the fund performs but you don’t get them paid back to you when the fund underperforms. It’s the old heads I win, tails you lose bet. Many funds have a “High Watermark” which means that if the fund underperforms, it won’t collect performance fees until it returns to the previous high. This is all well and good, but it assumes that the manager will deliver on the mandate over the long haul. It’s not much comfort when the funds are underperforming and you have no realistic prospect of ever getting back to that previous high.