After a hedge fund has been set up, there is often a lockup period within which the investors in the fund cannot withdraw their money. The purpose of this lockup period is to allow the hedge fund manager to set up their initial investment strategy without the risk of investors withdrawing funds if performance is initially poor. This allows time for the fund to demonstrate the strength of its strategy. Lockup periods were longer. Historically, however, since the 2008 financial crisis, many institutional investors have placed restrictions on the maximum allowable lockup period, forcing hedge funds to reduce the length of lockup periods.
A further restriction on LPs are gate provisions, which allow hedge fund managers to restrict redemptions from the fund to help prevent a run on that fund. When a hedge fund is holding complex investment products, unwinding positions can take time. The gate provision is built into the fund offering to prevent a situation where redemption requests add to the market value losses A fund is experiencing and cost the fund further by forcing liquidation in an adverse market situation or at a discounted price, which would adversely harm the other investors in the fund. Hard gates prevent any liquidations when they are triggered. While soft gates allow investors to withdraw their funds from the fund if they agreed to pay a redemption fee, which could range from 2 to 5% of the funds being withdrawn.
Turning to management fees, hedge funds have traditionally operated a 2 and 20 structure. This means that an annual management fee of 2% of the assets under management or AUM is paid to the GP, the general partner, and a further 20% performance fee is paid, which equates to 20% of the gains made by the fund.
Typically, the performance fee is only payable if the gains made by the fund are above a hurdle rate of return. For example, 5% to incentivize the GP to generate excellent returns for the LP, since if they do, they get to retain one fifth of the return above that hurdle rate. Both of these rates have come under pressure from investors and due to competition within the industry since the 2008 financial crisis, meaning that many hedge funds now have management fee rates below 2% and performance fee rates below 20%. However, the overall Management fee and performance fee structure remains.
It is also worth noting that most hedge funds use high watermark provisions when calculating performance fees. A high watermark is the highest value a fund has reached in the past. The high watermark is used as the baseline in determining performance fees that an investor must pay. The purpose of this is to protect investors from paying a performance fee for the fund manager, merely recovering past losses if a fund falls in value and then recovers that value. Subsequently, a fund manager might have a tough time convincing their investors that they deserve a performance fee. Since they've only got the investors back to the point that they had been in previously. With the high watermark, the investor ultimately pays a performance fee on the amount the fund has earned between the entry point of the fund and its highest level.
