HEDGE: Funds

Definition, Fees and Costs

Many physicians and other investors — even those that meet net worth guidelines — are surprised to learn that there exists a $500 – 999 billion, or more, alternative investment industry that is not generally marketed to the public. Such alternative investments have also been known as hedge funds or private investment funds.

Unlike mutual funds, these alternative investments can be structured in a wide variety of ways. Because of the very same regulations discussed above, these funds cannot be advertised, but they are far from illegal or illicit.

Definition

A hedge fund is a limited partnership of private investors whose money is managed by professional fund managers who use a wide range of strategies, including leveraging or trading of non-traditional assets, to earn above-average investment returns.

Hedge fund investment is often considered a risky alternative investment choice and usually requires a high minimum investment or net worth, often targeting wealthy clients.

CITE: https://www.r2library.com/Resource/Title/082610254

Physician History

Physicians were among the most significant early investors in one of the last century’s most successful hedge funds. Mr. Warren Buffett, Chairman of Berkshire Hathaway, Inc. and a legendary investor got his start in 1957 running the Buffett Partnership, an alternative investment fund not open to the general public. Mr. Buffett’s first public appearance as a money manager was before a group of physicians in Omaha, Nebraska. Eleven decided to put some money with him. A few of these original investors followed him into Berkshire Hathaway, now among the most highly valued companies in the world.

The alternative investment, or hedge, funds of today are similar to the original Buffett Partnership in many ways. So, we will discuss several unique terms and fees which potential investors should be aware.

Hurdle Rate

Hedge funds may feature a hurdle rate as part of the calculation of the fund manager’s performance incentive compensation. Also known as a “benchmark,” the hurdle rate is the amount, expressed in percentage points, an investor’s capital account must appreciate before the account becomes subject to a performance incentive fee. Potential medical investors should view the hurdle rate as a form of protection in context with other features of the fee arrangement.

The hurdle rate, which benchmarks a single year’s performance, may be considered mutually exclusive of any other year, or the hurdle rate may compound each year. The former case is more common. In the latter case, a portfolio manager failing to attain a hurdle rate in the first year will find the effective hurdle rate considerably higher during the second year.

Once a fund manager attains the hurdle rate for an investor, the medical investor’s capital account may be charged a performance incentive fee only on the performance above and beyond the hurdle rate. Alternatively, the account may be charged a performance fee for the entire level of performance, including the performance required to attain the hurdle rate. Other variations on the use of the hurdle rate exist, and are limited only by the contract signed between the fund manager and the investor. The hurdle rate is not generally a negotiating point, however.

Example:

A fund charges a performance fee with a 6 percent hurdle rate, calculated in mutually exclusive manner. Dr. Lanouettea, a radiologist investor places $100,000 with the fund. The first year’s performance is 5 percent. The investor therefore owes no performance fee during the first year because the portfolio manager did not attain the hurdle rate. During year two, the portfolio manager guides the fund to a 7 percent return. Because the hurdle rate is mutually exclusive of any other year, the portfolio manager has attained the 6 percent hurdle rate and is entitled to a performance fee.

High Water Mark

Some funds feature a high water mark provision, also known as a ”loss-carry forward” provision. As with the hurdle rate, potential investors should consider the high water mark a form of protection. A high water mark is an amount equal to the greatest value of an investor’s capital account, adjusted for contributions and withdrawals. The high water mark ensures that the hedge fund manager charges a performance incentive fee only on the amount of appreciation over and above the high water mark set at the time the performance fee was last charged. The current trend is for newer funds to feature this high water mark, while older, larger funds may not feature it.

Example:

A fund charges a 20 percent performance fee with a high water mark but no hurdle rate. Dr. Butalak, a dentist investor contributes $100,000 to the fund. During the first year, the hedge fund manager grows that capital account to $110,000 and charges a 20 percent performance fee, or $2,000. The ending capital account balance and high water mark is therefore $108,000. During year two, the account falls back to $100,000, but the high water mark remains $108,000. During year three, in order for the manager to charge a performance fee, the manager must grow the capital account to a level above $108,000.

Claw Back Provision

Rarely, a fund may provide investors with a claw back provision. This term, borrowed from the venture capital fund world, such provisions result in a refund to the investor of all or part of a previously charged performance fee if a certain level of performance is not attained in subsequent years. Such refunds in the face of poor or inadequate performance may not be legal in some states or under certain authorities.

How May We Serve You?

Contact: Ann Miller RN MHA for all related engagement details: email: MarcinkoAdvisors@outlook.com

***