Curious how liquidity works against hedge fund investors.
Contrast a VC fund and hedge fund charging 2 and 20 on a $10 million investment over 5 years. Suppose they invest in identically performing assets. They buy at 100, it's valued at 110 at the end of Year 1, 200 at the end of Year 2, 190 at the end of Year 3, 180 at the end of Year 4 and 170 at the end of Year 5.
Both collect $1 million in management fees (the 2). VC collects 20% of the $7 million profit it made, i.e. $1.4 million. This happens once; VC carry is typically assessed only on distribution. So total fees of $2.4 million or roughly 1/3 of the gains.
Hedge fund managers calculate gains, and thus carry, at the end of each year. Our manager thus collects 20% of the $1 million Year 1 profit and 20% of the $9 million Year 2 profit, i.e. $2 million of Year 1 and Year 2 carry. No carry is earned for the subsequent years. Together with the management fees we have $3 million of fees for the same $7 million of gains, i.e. over 2/5ths of the profits or 25% more than the VC.
Not exactly sure what you're asking but happy to try answer any q's.
Couple points: I realize your example scenario is very hypothetical and just rough math, but a heads up about understating fees as these add up fast: For the hedge fund in year 2 when the value of the fund doubles to $20M or whatever it gets to, the 2% management fees are charged on those higher amounts. So after year 1 fees are ~$400k, ~380K, $360K etc...
With that said, a hedge fund is going to have much higher operating costs than a VC firm. The trading systems and technology costs at hedge funds can get very expensive and it comes out of the 2%. What does a VC firm need 2% every year for? Many of them seem to do their job using only a blue bottle coffee gift card and an iPad to check their schedules and answer emails, what are those management fees spent on?
Also despite having 2 and 20 in common, hedge funds and VC funds are completely different animals, comparing them is really apples to oranges. But yes in your example HF managers can earn more, one could just as easily come up with a scenario where the VC guys earn more.
Lastly, in some cases there is "clawback" on hedge fund fees. The hedge fund would give back some of the previously earned performance fees if say there's consecutive down years. It depends on the terms of fund, every fund is different and the documents of a fund's terms can be hundreds of pages long.
Pardon me, that was "curious" as in "exciting attention as strange, novel, or unexpected" [1], not short for "I am curious". That said, thank you for your comment.
> one could just as easily come up with a scenario where the VC guys earn more
When comparing carry-on-distribution versus carry-on-mark, ceteris paribus, I don't think so. High-water marks and clawbacks help, but they're ultimately a patch for a time-horizon mismatch between the LP and the GP.
Note that I wasn't comparing VC and hedge funds. I was comparing how they calculate carried interest. A hedge fund manager charging carry like a VC would assess on redemption, or at least only when a position is sold. The liquidity and transparency that benefit investors also give hedge fund managers another way to charge fees.
Haha, oh that definition of curious. My bad. (side note: I am curious why the M-W dictionary puts the archaic and obsolete definitions first)
Gotcha on the carried interest. Ya we have come a long way from sailing molasses across the ocean to calculate a carry. While scenarios and clauses can change payment to managers, c.p. or not, if we cut to the chase I think it's safe to say yes the incentive carry structures in hedge funds generally favor HF managers getting paid much more compared to VCs. When the top HF managers annual pay news articles come out, these numbers can get crazy, top 10 HF managers can make more in one year than the entire net worth of a top venture capitalist with decades in the industry. But VC guys get to do way more interesting investing, meeting with new tech companies is much cooler than public equity research I think. Thanks for posting this article btw.
This makes complete sense. The Investor is paying extra for more liquidity (they can withdraw from HF probably at least once a year, whereas VC only returns the money after 5 years).
> The Investor [sic] is paying extra for more liquidity
I'd be curious to see if hedge funds with stricter redemption terms calculate profits on distribution only. In my experience, that has not been the case.
What your describing is very unlikely to actually happen. Further, VC's don't deal in highly liquid assets making pre sale numbers basically meaningless.
> What your describing is very unlikely to actually happen
Things going up and then down?
Let's use the S&P 500 [1] from the beginning of 2007 through the end of 2015. Same 2 and 20 on $10 million investments.
9 years means $1.8 million of management fees. Gross gain is 44%. Assuming we reserved for management fees at the beginning, this means $1.8 million in profits over the $10 million (44% on $8.2 million), i.e. $0.36MM of carried interest. $2.16MM of fees with the VC carry-on-distribution model on $1.8MM of gains.
Our hedge fund manager, on the other hand, collects each year. The same 44% catches 3.5% in 2007 gains, 25.8% in 2013 gains and 11.4% in 2014. So $0.14MM of carry in 2013 and $0.24MM in 2014. $2.18MM of fees using the HF year-to-year assessment model on the same asset. That's almost a full percentage more in fees.
Note that this toy model understates the difference since when the manager moves assets to their carry pocket, they no longer compound for the investor.
VC having an accurate price. But, also those price swings in your example where odd. Useually you get steady gains then big drops followed by steady gains across years. Not big gains followed by years of losses. If nothing else inflation is pushing up prices.
+10% +90% -10% -10% -10% is odd. More likely pattern +10% -50% +10% +10% +10%
PS: You can model the s&p 500 for 10 years with each model and compare gains. But, try it every year from 1950 - 2015 not just one year.
Contrast a VC fund and hedge fund charging 2 and 20 on a $10 million investment over 5 years. Suppose they invest in identically performing assets. They buy at 100, it's valued at 110 at the end of Year 1, 200 at the end of Year 2, 190 at the end of Year 3, 180 at the end of Year 4 and 170 at the end of Year 5.
Both collect $1 million in management fees (the 2). VC collects 20% of the $7 million profit it made, i.e. $1.4 million. This happens once; VC carry is typically assessed only on distribution. So total fees of $2.4 million or roughly 1/3 of the gains.
Hedge fund managers calculate gains, and thus carry, at the end of each year. Our manager thus collects 20% of the $1 million Year 1 profit and 20% of the $9 million Year 2 profit, i.e. $2 million of Year 1 and Year 2 carry. No carry is earned for the subsequent years. Together with the management fees we have $3 million of fees for the same $7 million of gains, i.e. over 2/5ths of the profits or 25% more than the VC.