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Saturday, March 28, 2009

Claw-back in hedge funds

The right way to set compensation is to link the pay to longer-term performance, not a single year. This should apply to both CEO pay and the fees received by hedge fund managers. The alternative compensation scheme, which is based on a five-year average investment performance, for example, is a much better solution than the current one.

Report from WSJ on big pension funds forcing hedge funds to change fee terms:

Calpers, the California public pension fund that is one of the biggest investors in hedge funds, is demanding better terms from funds, including lower prices and "clawbacks" of fees if performance weakens.

The $172 billion pension fund is a bellwether in the money-management business. A Calpers investment can help money managers like hedge funds attract other clients.

The move by the California Public Employees' Retirement System underscores the changing dynamics between hedge funds and their clients. Just two years ago, investors clamored to get into highflying funds, agreeing to pay fees that in some cases reached 3% of assets and 30% of profits. Lately, hedge funds have come under fire for failing to live up to their promise to perform in good and bad markets.

While other investors are pushing for fee cuts, Calpers, which has $5.9 billion in hedge-fund investments, holds significant clout. "Calpers is the 800-pound gorilla, pushing so much money through the system," said Eric Roper, chairman of the hedge-fund practice at New York law firm Gersten Savage LLP.

Calpers's demands were outlined in a March 11 memo sent to the 26 hedge funds and nine funds of hedge funds that do business with Calpers; it was reviewed by The Wall Street Journal.

Some of the hedge funds that manage Calpers money include Tremblant Capital, Atticus Capital and Och-Ziff Capital Management, according to Calpers records and people familiar with the investments. Spokesmen for the funds didn't comment.

Besides pressure on fees, hedge funds are likely to face closer scrutiny from regulators, threats of higher taxes and more constraints on their trading strategies, after a year of broad-based losses.

Calpers said the changes are "extremely important" and required of "managers wishing to become, or remain" in Calpers's stable of managers. The pension fund said every hedge fund won't face the same demands and that it is willing to listen to counterproposals.

One area Calpers is focusing on includes performance fees. Typically they are collected at the end of each year, but Calpers instead wants fees spread out over several years. Calpers also wants clawbacks, which allow clients to recoup fees from previous profitable years after a period of poor performance.

The pension fund also seeks greater control of its investment funds, saying it would explore opening managed accounts. In that scenario, hedge funds would place Calpers's assets in a separate bucket from other investors' assets, so if a fund faces an exodus of investors and sought to freeze redemptions, Calpers wouldn't be limited from withdrawing its funds.

Calpers also wants money managers to disclose every security held in a fund. "The only issue that keeps hedge funds from providing security transparency is their lack of cooperation," Calpers spokeswoman Pat Macht said in an interview Friday. She said that detailed fund information won't be made public.

Calpers is basically trying to wield its investment clout to shape its relationship with hedge funds. The memo says Calpers "will no longer invest in managers" that adhere to industry standards with no regard for individual situations. At the same time, Calpers bills the directives as good for hedge funds as well as for institutional investors -- a means to "improving the relationship" for the long term.

The sought-after changes would apply to new money added to existing funds and money put into new hedge funds, and will take about a year to implement, Calpers said. None of its hedge funds have formally agreed to the new terms, though discussions have started with most and cooperation appears to be widespread, Ms. Macht says.

Calpers's demands come as other institutional investors are issuing similar requests in an effort to upend industry protocols. In January, the Utah Retirement Systems circulated a four-page letter to 40 hedge fund managers, and to many like-minded investors, that called for similar changes.

"We clearly are on the same page with regards to most issues," said Larry Powell, deputy chief investment officer for the Utah fund, referring to the Calpers memo.