Fulcrum AM: Some degree of ‘adverse selection’ is acceptable
Fulcrum Asset Management has weighed up the benefits of competitive fee structures in the private markets, having assessed their use in hedge funds.
The asset manager, which invests in alternative credit, highlighted in a recent blog that institutional investors are facing intense cost competition, causing them to innovate their approaches when allocating to alternative assets.
This can introduce an “adverse selection bias”, where the pricing is at risk of inaccurately reflecting the sustainability of the investments and any fee savings can be lost when managers are unable to deliver the required service at that price.
However, Fulcrum summarised that: “We think that some degree of ‘adverse selection’ is acceptable (or even appropriate) for well-designed, flat fee portfolios where the savings are meaningful and there has been sufficient depth of due diligence supporting the investment thesis.
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“We find it harder to get comfortable taking on these kinds of risks where the design/transparency of the fee structure has been materially compromised, doesn’t reflect long term system sustainability or indeed the value/cost of the services provided.”
The firm referred to its own 2018 investment in flat fee-only UCITS hedge funds, when the model was relatively rare. While they found the flat fee portfolio to have been slightly more volatile and incurred a slightly larger drawdown during Covid, over time the returns were similar to those of the unconstrained portfolio.
“The analysis gives us some confidence around flat fee-only portfolios from an adverse selection perspective, but also some confidence that the performance fees negotiated are reasonable,” the firm said.
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Having conducted the comparison, Fulcrum said it could “see the argument that performance fees or carried interest can provide important incentives for fund managers as they are building their business or looking to exit deals.”
However, it warned: “we think that achieving genuinely aligned interests can be very challenging – e.g., because poorly aligned fee structures can incentivise counter-productive risk-taking behaviour.”
Ultimately, the firm said poor outcomes are sometimes experienced by manager selection teams whether in fee constrained portfolios and unconstrained portfolios, but “finding an appropriate balance in risk sharing should benefit all stakeholders.”
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