1. Performance fees vest over 5 years — Attrition in the hedge fund industry is high for a reason—funds have an incentive to “go big or go home”. The standard 20% of annual profits approach rewards high risk-taking. If funds (and their investment staff) are given a vesting schedule on performance fees and bonuses this will align manager behavior with longer-term oriented investors. So instead of paying the full 20% at the end of year one, pay 1/5th of those profits each year over a 5 year period, subject to withholding if subsequent year performance is down.
2. Tie Performance Fees to Fund Objectives — This sounds almost sarcastically obvious but this is actually not the standard in the industry. If a long/short fund runs a net long book and the S&P is up 30%, the fund is in a position to reap a substantial reward no matter whether they generated alpha. Not every hedge fund is designed to be an absolute return vehicle. Many are meant to provide better risk adjusted returns relative to the market, or some are meant to outperform benchmarks on an absolute basis. A fund should be clear with their objectives and tie their performance directly to those objectives.
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