Taking Their Pound of Flesh: How Much Should You Pay an Alternatives Manager?

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My friend and colleague Ari Rastegar was mentioned by the Wall Street Journal this week.  You can read the full article here, but I’ve covered some of the highlights below.

If you think paying a 20% cut in profits is steep, try paying 25% or 30%, or how about 50%?

Ari Rastegar, who worked for Chelsea Hotels Chief Executive Ed Scheetz and real-estate investor Nate Paul, is striking out on his own to raise $250 million to $500 million for a fund that invests in income-producing real-estate assets like self-storage facilities and discount retail locations in secondary and tertiary markets, a person familiar with the situation said.

He is proposing a 1.2% management fee, and would take half of the profits above an investment return hurdle of 8%, the person said. The fund also deviates from standard private-equity practice in not charging commissions and fees on acquisitions and add-on purchases, or for monitoring investments, in the hope of ditching the complexities in fee structure and better aligning with investor interests, the person said.

Although it is an extreme example, Mr. Rastegar’s fee structure is a reminder that the two-and-20 compensation model that many private-fund managers typically employ is primarily a behavioral norm, albeit one that is deeply entrenched in investor mind-sets.

 

Charles here. As I recently wrote in In Defense of Hedge Funds, you shouldn’t automatically discard a hedge fund or other private investment because of high fees. If the fund is doing something truly unique, adding real diversification to your portfolio by being uncorrelated to your existing investments, and posting good returns, high fees might be completely reasonable.

Should you pay the standard 2% of assets and 20% of profits to a long-only large-cap growth fund? Absolutely not. In highly-liquid and efficient market like large-cap equities, you’re probably better off going with a Vanguard ETF or mutual fund because it’s highly unlikely the manager will outperform enough to justify the fees. But if your alternative manager is adding real value and giving you something you’re not getting elsewhere, you shouldn’t begrudge them their pay. They earned it.

In fact, a high incentive fee — if structured well — will incentivize the manager to work harder at creating value. Just make sure you understand the fee structure and that you’re not incentivizing the manager to take excessive risk at the same time.

As the WSJ continues,

Now that the investor conversation has focused on fees, it is hard to steer it back to performance. Rastegar’s fund is an attempt to do just that. So far, some high net worth investors and one public pension fund, the District Attorneys’ Retirement System of Louisiana, have signed up for the fund.

 

Charles here again. While I applaud Vanguard and other low-cost pioneers for saving their clients money, I do find it discouraging that cost is the only factor a lot of investors bother to consider these days. Fees matter — a lot — but performance and diversification can matter more. Most patients don’t choose their doctor or dentist based on the lowest cost. Cost is definitely a consideration, but they focus on quality and reputation first. I’d recommend you take the same approach with your investments. It’s perfectly reasonable to pay up, so long as you’re getting value for your money.

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