Mar

31

The Effect of Contract Marketing Fees on Hedge Funds

March 31, 2004 | Leave a Comment

Below is an illustrated example of the effect of contract marketer fees:    I mentioned that I would put together a mockup of a hedge fund using a contract marketer in previous articles and I have finally gotten around to doing it. I can assure you that you will not find this type of article anywhere else in the world. Below I will show the effects that contract marketing agreements have on the fund and what it does in terms of diluting returns. I will also examine how investors who have not been introduced to the hedge fund manager via a contract marketer are getting harmed due to these agreements.   

Let’s pretend that we start a hedge fund on 1/1/05. Prior to the launch, the hedge fund manager was able to raise $50,000,000 on his own and a contract marketer raised the remaining $150,000,000, giving us a 1/1/05 launch of $200,000,000. For simplicity’s sake, there were no other contributions or withdrawals after the launch and yes, the hedge fund manager was that good at his prior employer that he could launch with $200 million..   

Total Assets of the Fund:  $200,000,000   

Amount Raised By Contract Marketer: $150,000,000    

Simple enough.   

Let’s assume the following:   

Fund Returns     2005 Return was 15%:   $30,000,000     

So, at the end of the year, the fund was up 15% resulting a $30 million profit for the fund. The following fees would be clipped in the fund.   

Fees    

1.5% Management Fee: $3,000,000    

20% Incentive Fee:    $6,000,000    

 The fees taken by the hedge fund manager are noted above. His contract marketing agreement states that he will give 20% of the incentive fee and 20% of the management fee to the contract marketer on the money raised. We come to that calculation as follows:    $150,000,000 / $200,000,000 = 75%   

First we have to determine the portion of the management fee and the portion of the incentive fee that the marketer can clip his own fees from:     

75% of Management Fee on money raised: $2,250,000  

75% of Incentive Fee on money raised: $4,500,000    

Now that we have determined what fees were charged on the money he explicitly bought in, we can determine his own fees. The typical fee structure is 20% of the management and incentive fees. You can negotiate ANY agreement you want with these firms but they will usually start out by asking for the 20/20 deal. So let’s use 20/20.   

20% of Management Fee on Money raised: $450,000  

20% of Incentive Fee on Money raised: $900,000  

TOTAL DUE TO MARKETER $1,350,000      

So, how do we pay these out? These contract marketers are setup as broker dealers and you direct commissions so that you can satisfy your obligation to them. In other words, you have to execute trades with their broker dealer. Let’s use a standard street rate of 3 cents per share to come to some analysis: If I were paying 3 cents in a contract marketer’s broker dealer to execute trades, I would have to do 45,000,000 shares through that account in business.   

45,000,000 shares x .03 = $1,350,000   

That is alot of shares and it is also why your strategy determines who will work with you. Everyone on the street loves active momentum driven traders who turnover portfolios on a monthly or even daily basis. That type of activity benefits everyone and allows items to wiggle into commission rates.    

Some more assumptions:   

Assume the following    

# of trades the fund does per day 15    

Average share size per trade 100,000  

Number of shares per day traded on average 1,500,000        

Number of days required to fulfill marketer’s commitment  (45,000,000 shares divided by 1,500,000 shares per day)   30.    

I added in the 30 day calculation to put it in perspective. Obviously the manager is not going to conduct 30 straight days of trading in that one account, but will spread it out for the year. It also means that 23% of all the trades that this fund does over the course of a year will be with the contract marketer’s broker dealer. Fund managers need to have relationships all over the street and this fee agreement is not allowing the manager to “spread the wealth” to investment banks who can offer tremendously more than the contract marketer can in terms of ideas and more importantly, information.    To take it a step further, I put together this little chart:    

Other Variables     

1 Cent over Street Rates (45,000,000 X .01) $450,000   

2 Cents Over Street Rates (45,000,000 X .02) $900,000   

3 Cents over Street Rates (45,000,000 X .03) $1,350,000.00  

4 Cents over Street Rates (45,000,000 X .04) $1,800,000    

The chart details what happens when the contract marketer’s broker dealer is charging the fund more than the average street commission rate, in our case it is 3 cents. Why would they charge more? For a variety of reasons. They may be clearing through another broker and that broker is charging them a fee as well and they are merely passing on that cost to the fund manager instead of absorbing it.   

There may also be a “catch-up” going on if the manager is behind in his scheduled payments. The fund manager can pay a cent,. 2 cents or more than the street rate to bring down the balance owed. There may even have been new money that came in through the contract marketer in the fourth quarter and the marketer wants their year end fee.   

Why is this bad? It harms investors who did not invest in the fund via a contract marketer. The extra cent or more is passed on right to them and they share in the increased fee. In other words, let’s say that the fund is paying 4 cents per share when fulfilling the contract marketer’s obligation, there is an increase of commission costs of $450,000 that is being absorbed by the entire fund on money raised by the contract marketer AND money raised by the manager.   

I am not against contract marketers at all. They offer a valuable service to hedge fund managers who are too consumed with money management and investment decisions to actively get involved in marketing the funds.   

Investors and hedge fund managers really need to weigh the costs. Is it more cost efficient to hire in-house marketers?   

By Bin Bulsara


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