Hedge funds charge more than private equity

Fee comparison between hedge funds and private equity is riddled with complexity, but a research paper by specialist alternative consulting firm, Cliffwater – that weighs outcomes by their likelihood of occurrence – finds a fee cost for the typical hedge fund equals 32 per cent of gross profits, while for private equity it is 25 per cent of expected gross profits.

The paper, “The better deal: hedge funds or private equity”, acknowledges the difficulty in comparing fee structures, but endeavours to compare hedge fund and private equity fees, as a per cent of invested assets, over a range of return outcomes.

It finds that although hedge fund fees will vary significantly from private equity fees at different levels of return, when the outcomes are weighed according to their likelihood of occurrence, a total fee cost of 3.53 per cent is calculated for the typical hedge fund, equal to 32 per cent of expected gross profits.

Cliffwater calculates a higher total fee cost of 3.73 per cent for the typical private equity fund, but that fee represents a lower 25 per cent of expected gross profits.

“Given our return and risk assumptions, our analysis suggests that private equity has higher fees, as a per cent of invested assets, but because of its higher expected gross return, those fees represent a lower fraction of profits compared to hedge funds,” the paper says.

While detailing the differences in fees between to the two investment structures – due to management fees, application to committed capital, and performance fees – the paper goes on to compare the two.

It finds that hedge fund fees compare favourably to private equity when investment returns are negative. While hedge fund fees remain at a constant percentage of asset market value, private equity fees climb as a percentage of invested assets at lower returns because they are based on a fixed per cent of committed capital even though asset values may decline.

The paper says the fee gap also favours hedge funds at a zero per cent gross return, where hedge fund fees equal the 1.5 per cent management fee but private equity fees total 2.10 per cent.

But the presence of a preferred return for private equity but not for hedge funds creates significantly lower fees for private equity compared to hedge funds at gross returns between 5 and 10 per cent.

At a 10 per cent gross return, private equity has a fee advantage of 1.33 per cent. That advantage over hedge fund fees continues at higher levels of gross return.

The paper does not distinguish the source of return, but will address this in a supplementary paper.

“Ideally, investors are paying fees for profits generated by alpha rather than beta,” it says. “Hedge fund profits supposedly are primarily alpha while private equity profits are more likely a combination of both. We do not attempt to quantify here the source of gross return but investors’ assessment of whether return is coming from alpha as opposed to beta should weigh heavily on evaluation of fees.”