Cerulli Associates’ latest report, European Alternative Investments 2020: Matching Different Demands, shows that the crowded marketplace and decreasing risk-adjusted returns are putting pressure on alternative asset managers, with investors questioning why they should pay the same fees for returns that have declined. Nearly 30% of the hedge fund managers Cerulli surveyed have reduced their management and performance fees over the past 12 months.

Whereas hedge fund managers are experiencing relatively poor performance and fee compression, private equity managers are benefiting from more positive market sentiment. However, intensifying competition between general partners and greater scrutiny of market practices will limit the number of private equity managers that can secure more favorable fund terms to only top-tier funds with strong results.

Fees and alignment of interests are improving in the hedge fund industry, but fee structures in the private equity sector have not shifted to favor the interests of limited partners (LPs). Although negotiating carry fees is rare, LPs should pay increasing attention to contract terms outlining the use of subscription lines. Requiring managers to recalculate performance adjusting for the use of subscription lines can help overcome issues regarding performance manipulation and carry fee calculations.

“To survive fee pressure, asset managers must adapt,” says Justina Deveikyte, associate director of Cerulli’s institutional research and lead author of the report. “They should use innovative fee structures to better align interests and demonstrate value. However, it is important that new, creative pricing models offer fresh choices without overwhelming clients. Managers should consider introducing longevity fees or charging lower management but higher performance fees.”

Around 14% of the managers Cerulli surveyed said that they plan to introduce longevity fees and innovative fee structures in the next 12 months. Hedge fund managers are willing to offer lower fees for large and strategically important clients, although they typically offer meaningful discounts only on large mandates and for clients that offer cross-selling opportunities.

Cerulli expects to see more innovative fee structures for Cayman funds than for UCITS hedge funds. Although an increasing number of institutional investors—mostly larger, more sophisticated institutional clients—are asking managers about innovative fee structures, their actual adoption of innovative fees remains low. Most of the time, investors stick to traditional fee structures in the hedge fund industry.

Almost half of the large institutional investors—those with assets of more than €15 billion (US$16.8 billion)—Cerulli surveyed for the report said that they always receive discounts for onshore hedge funds. In addition, 52% of institutional investors said that the discounts they achieve for onshore hedge funds range from 1% to 10%, and 26% said that, on average, they achieve a discount of up to 20%. Strategies that offer higher alpha tend to be discounted less: only around one-third of respondents said that they always get discounts for offshore hedge funds.

Private investment strategies are more resistant to pricing pressure than hedge funds. Only 22% of the institutional investors Cerulli surveyed said that they always get discounts from private equity managers and around one-third said that they never achieve discounts for real estate investments. Ultimately, investors do not mind paying a performance fee if their manager delivers real alpha.

“Downward pressure on returns is likely to continue for private investments, keeping increasingly sophisticated investors focused on fees, incentive alignment, and manager selection,” says Deveikyte. “Private investment firms and hedge funds should consider launching new products and targeting new distribution channels in order to balance competitive and cost pressures with investor demands.”