There has been a bubbling up of new ideas on fees for money managers. These discussions are focusing on the conceptual framework for fees in order to change the thinking of both managers and investors. A battle to just lower fees between large investors and managers is a lose-lose situation. Managers who do their job well are frustrated with these discussions and investors feel they are disadvantaged when managers underperform. See the latest piece from my friend Angelo Calvello, Your Fees Are Bull%$&. The capital rental concept should be explored further.
This new fee thinking believes that managers should perceive themselves as renting the capital of investors. Managers are providing a service but unlike other services, investors have to relinquish their capital in order to receive the service. Hedge funds are not giving advice for a fee. They are taking investor capital to use their wisdom and advice to generate returns for which they will take a piece of the profits and a fee that will increase with the wealth they create based on AUM. Managers may trade the capital for which they provide the advice as a convenience and added service.
There is a cost with renting this capital which is an expected return that should be received by investors. The manager and investor should agree on the rental cost of capital based on the manager’s use of the capital and the desires of the investor. A manager who is an EM specialist will want to rent capital form investor to profit from their expertise. The manager will provide a minimum return for rental in exchange for a percentage of the excess over this cost of funds.
Managers should share the excess after paying the cost of renting the capital. If a manager cannot generate returns beyond the cost of rental capital, he is not entitled to excess returns. The negotiation should be centered on the cost of rent. A management fee could be charged as a fee to maintain or service the capital rental, but this fee should not be viewed as a profit by the managers but as a cost agreed upon with the investor to ensure that the invested capital is monitored effectively and not mishandled.
This construct of giving your capital over to a manger, not as a trustee or custodian, seems somewhat unusual. Investors, the owners of the capital, should not give-up their capital for others to use so easily. Nevertheless, the core problem of this rental argument is determining what happens if the manager does not generate the rental rate and underperforms. The simple solution is having a high water mark for any incentive fee, but making up for any rental shortfall, as an opportunity cost, seems reasonable. More strongly, the question is whether managers should forfeit their management fees if they cannot return minimum rates after some period of time.
Thinking through a capital rental model may make discussion of incentive fees, hurdle rates, fees or incentive choices, and liquidity easier. However, there needs to be further discussions on the principal-agent and incentive problems like excessive risk-taking and the impact of large loses. This is better controlled through heightened transparency. Additionally, there are industry structure effects with this rental model. Small firms and start-ups which need more certain capital to cover costs will be negatively effected; nevertheless, these are consideration that already exist.
Of course, the current market structure developed because there was a shortage of knowledge and managerial talent on what to do with capital. If an investor did not know how to manage or how to employ their capital, the rent on the capital should be low. There were no hurdle rates. With passive investments now available and better understanding of benchmarks, the rental rate on capital should be better defined and higher than zero. An investor will give a manager their capital if they can more efficiently use the capital relative to a low cost index alternative. Simply put, active managers can rent and receive profits if they meet the rental cost. If there are no skills, they will not be able to meet the rental rate and should lose money.