Pass-Through Expenses

The previous decade of fund-raising has seen consistent downward pressure from investors leading to reduced management fees across the private capital industry. However, recent data from Preqin1; has suggested that we are potentially seeing a return to the time-honoured maxim of "2 and 20" applied to private funds, on the closed-ended side of the industry.

We are seeing a similar uplift in fees for the hedge market as well. According to a recent BNP Paribas survey, hedge fund management fees have increased for the first time since 2014 to an average of 1.54%2. This increase in management fees may be explained in part by the larger allocations by investors to large multi-manager hedge funds, such as Citadel and Millennium, who run costly strategies of utilising numerous portfolio managers with varying strategies out of a single fund structure to deliver consistently high returns to investors (for a price). Some of these managers have done away with management fees entirely, introducing what is known in the industry as a pass-through expense model.

Pass-through expenses charge the expenses of a manager to the funds it manages. Managers have discretion as to the extent to which it chooses to charge investors for its outgoings. Some managers have opted for what is known as a partial pass-through, cherry-picking specific expenses such as infrastructure and research costs whilst others have opted for full pass-throughs with items such as performance-based compensation of employees being covered for by investors. These pass-through expenses have had the effect of significantly increasing the fees due to managers as high as 10% p.a. in some instances3. The adoption of pass-through fees has been driven somewhat by the continual talent war between managers seeking to attract and retain top portfolio management talent4.

The SEC has set its sights on pass-through expenses previously, proposing to prohibit funds from being able to pass-through costs in relation to investigations by governmental or regulatory authorities and compliance with the same5. The AIMA has since produced survey data showing that 21% of investors surveyed by EY in relation to their views on management fee models responded that they preferred pass-through expenses in lieu of management fees6. The SEC eventually stepped down from this position, instead opting to require managers to disclose charges for regulatory, compliance and examination fees and expenses within 45 days after the end of the relevant fiscal quarter as well as stricter disclosure requirements for pass-through fees7.

Though the vast majority of the research and literature produced on pass-through expenses has focused on the open-ended funds space, anecdotally, we have seen instances of closed-ended fund managers introducing both partial and full pass-through expenses disclosures into their most recent vintages, noting that in a few instances these have been included for flexibility rather than being utilised in the first instance.

In light of the difficult capital raise environment, the widespread adoption of pass-through expenses throughout the funds industry will remain a fund term to watch. As the private capital industry continues to push forward with retailisation, we do expect regulators to shift their focus once again to increased disclosure surrounding opaque fee structures, as they have with many firms that already serve retail clients8. Given the positive news regarding management fees across the private capital industry, it may be that pass-through expenses remain in the toolbox for the moment, to reappear in periods where management fees begin to decrease.