re-thinking hedge fund fee structures

currently, most compensation for hedge funds works like this:

2% management fee (received regardless of performance)

20% incentive fee (hedge fund receives 20% of upside)

1 year lockup and after 1 year, quarterly redemptions

in the event of a down year (as many funds had last year), funds need to recover the money they lost for an investor before they make an incentive fee.

let me provide an example. since the 2% management fee is always charged, i'll talk numbers net of management fee. let's say an investor put in $1mm in a hedge fund at beginning of 2008. let's say the fund was down 20%, the investor now has $800k. the fund would need to be up over 25% to get the investor over $1mm before the fund took a 20% fee.

this seems to work fine but let's say 2007 was a big year for the hedge fund. for example, let's say someone put in $1mm in 2007 and the fund was up 50%. then the investor would now have $1.4mm (net of the 20% incentive fee) and the hedge fund made $100k. now let's say that same fund was down 50% in 2008. now the investor has $700k, down $300k from his initial investment but the fund has clipped $100k in performance fee. how is that fair for the investor?

the current fee structure rewards those that take big risks and provide outsized performance for the short term without penalizing the funds for losses in future periods.

another issue is redemptions. let's say i was a fund and through research i realized that a small cap stock, across the next 2 years, would become a big company. but today it is very thinly traded. a hedge fund may be unlikely to take a position today because they don't have capital that they can rely on for a long period of time. and if they get redemptions, they will have to sell an illiquid security which would depress the value and maybe spur others to redeem.

one solution that hasn't been done but i believe should be the right structure is something more like the following:

same fee structure as above, however money is locked up for 3 to 5 years. at the end of that period, all monies are returned to investors. also at the end of that period, incentive fees are taken. during the 3 to 5 year period, investors can see monthly performance but have no way to redeem their money. this would prevent fund managers from taking fees for short term aberrations and it also allows the fund managers to invest in the best ideas, without having to be worried about liquidity or managing for a month to month performance (steady month to month performance probably means you're a madoff anyway).