Economic performance fee

What Is an Economic Performance Fee?

An economic performance fee is a form of compensation paid to an investment manager that is directly tied to the investment gains generated for a client or fund. Unlike traditional management fees, which are typically a fixed percentage of assets under management (AUM), performance fees are contingent on the achievement of specific financial results, placing them squarely within the broader category of investment management fees. This fee structure is designed to align the interests of the manager with those of the investor, as the manager's compensation increases only when the client's portfolio grows.

History and Origin

The concept of tying compensation to investment results has roots in early financial arrangements, but formal regulation around performance fees for public funds emerged in the mid-20th century. In the United States, the Investment Advisers Act of 1940 generally prohibited registered investment advisors from charging performance-based compensation, primarily to protect advisory clients from fee arrangements that legislators believed could encourage speculative trading practices.²⁴

Over time, exceptions were introduced, particularly for clients deemed sophisticated or "qualified," who were presumed to need less protection. The Securities and Exchange Commission (SEC) has periodically amended Rule 205-3 of the Investment Advisers Act to allow registered investment advisers, such as hedge funds and private equity funds, to charge performance fees to these qualified clients. For instance, amendments adopted in 2012, following the Dodd-Frank Act, increased the dollar thresholds for clients to be considered "qualified" and excluded the value of a primary residence from the net worth test.²³,²² The SEC further refined these rules in November 2021, adjusting the dollar amount thresholds for inflation every five years.²¹,²⁰

Key Takeaways

• An economic performance fee is compensation paid to an investment manager based on the profits generated.
• It is distinct from a fixed management fee, which is based on assets under management regardless of performance.
• Performance fees often incorporate mechanisms like a hurdle rate and a high-water mark to ensure compensation is for genuine, new gains.
• This fee structure aims to align the interests of investment managers and investors, incentivizing strong performance.
• While designed to motivate, performance fees can also be criticized for potentially encouraging excessive risk-taking or a short-term focus.

Formula and Calculation

The calculation of an economic performance fee varies but commonly involves a percentage of the profits generated above a predefined benchmark, hurdle rate, and often subject to a high-water mark.

A typical structure, especially in the hedge fund industry, is the "2 and 20" model: a 2% management fee on AUM and a 20% performance fee on profits.¹⁹

The basic formula for a performance fee can be expressed as:

$\text{Performance Fee} = \text{Performance Fee Percentage} \times (\text{Fund Profit} - \text{Hurdle Amount})$

Where:

• Performance Fee Percentage: The agreed-upon percentage of the profits paid as a fee (e.g., 20%).
• Fund Profit: The total gain in the fund's Net Asset Value (NAV) over a specific period.
• Hurdle Amount: The minimum return threshold that must be achieved before any performance fee is charged. For example, if the hurdle rate is 5% and the fund's initial value was $100 million, the hurdle amount would be $5 million ($100 million * 0.05).

Many performance fee agreements also include a high-water mark (HWM). The HWM ensures that a manager only earns a performance fee on new profits, meaning they must recover any previous losses before another performance fee can be charged. If a fund's value drops, the manager does not earn a performance fee again until the fund's NAV surpasses its previous peak value (the HWM).¹⁸

Interpreting the Economic Performance Fee

An economic performance fee is designed to incentivize active management by linking a manager's compensation directly to investment success. From an investor's perspective, this structure can appear attractive because the manager's earnings are tied to their own gains. However, understanding the specific terms is crucial.

Key elements to interpret include the chosen benchmark (if any), the hurdle rate, and the high-water mark. A manager earning a performance fee generally has a strong motivation to outperform the market or a specified return target. For example, if a portfolio achieves a 12% return and the hurdle rate is 8%, the performance fee would apply only to the 4% gain above the threshold.¹⁷ A higher performance fee percentage might indicate greater confidence by the manager in their ability to generate superior returns. Conversely, investors should assess whether the potential for increased returns justifies the higher overall fee structure, especially given that these fees are often in addition to a base management fee.

Hypothetical Example

Consider an investor, Sarah, who places $1,000,000 with a hedge fund manager. The fund charges a 1% annual management fee and a 20% economic performance fee with an 8% hurdle rate and a high-water mark.

Year 1:

• Initial Investment: $1,000,000
• Management Fee (1% of AUM): $10,000 (charged regardless of performance)
• Portfolio Return: 15% ($150,000 gain)
• Gross Portfolio Value: $1,150,000
• Hurdle Amount (8% of $1,000,000): $80,000
• Profit Above Hurdle: $150,000 - $80,000 = $70,000
• Performance Fee (20% of profit above hurdle): 0.20 * $70,000 = $14,000
• Net Gain for Investor: $150,000 (gross gain) - $10,000 (management fee) - $14,000 (performance fee) = $126,000
• Ending NAV: $1,000,000 + $126,000 = $1,126,000
• High-Water Mark is set at $1,126,000 for future calculations.

Year 2:

• Beginning NAV: $1,126,000
• Management Fee (1% of AUM): $11,260
• Portfolio Return: -5% (loss of $56,300)
• Gross Portfolio Value: $1,069,700
• Performance Fee: $0 (since there was a loss and the NAV is below the high-water mark of $1,126,000).
• Net Gain/Loss for Investor: -$56,300 (gross loss) - $11,260 (management fee) = -$67,560
• Ending NAV: $1,126,000 - $67,560 = $1,058,440
• High-Water Mark remains at $1,126,000. The manager must recover to this level before charging another performance fee.

This example illustrates how the economic performance fee model incentivizes positive returns while the high-water mark protects the investor from paying fees on recaptured losses.

Practical Applications

Economic performance fees are most prevalent in investment vehicles that cater to sophisticated investors, aiming to generate alpha (returns above a benchmark). Their primary applications include:

• Hedge Funds: These are the most common users of performance fees, often employing the "2 and 20" fee structure. The performance fee incentivizes hedge fund managers to seek outsized returns.,
• Private Equity and Venture Capital Funds: While often referred to as "carried interest," this is a specific type of performance fee that compensates the general partners for the fund's profits.¹⁶
• Separately Managed Accounts (SMAs) for Qualified Clients: Registered investment advisors may charge performance fees to individual clients who meet specific net worth and assets under management thresholds as defined by the SEC.¹⁵ This structure aligns the advisor's compensation with the client's financial growth.
• Real Estate and Alternative Investments: Some managers of illiquid alternative assets may also incorporate performance-based compensation structures due to the long-term nature of these investments and the focus on capital appreciation.

The design of these fees reflects an effort to create a "win-win" situation, where the manager directly benefits from delivering strong returns, and the investor benefits from the manager's incentivized efforts to maximize gains.

Limitations and Criticisms

While economic performance fees are designed to align interests, they also face several criticisms regarding their potential drawbacks and impact on investment manager behavior.

One significant concern is the potential for excessive risk-taking by managers. Since their compensation is directly tied to gains, there's an incentive to pursue higher-risk strategies that could lead to larger profits, but also greater losses, especially when the fund's performance is lagging.¹⁴,¹³ Research has shown that funds with performance fees may exhibit higher beta (a measure of market risk) than those without.¹²

Another criticism is the asymmetric nature of the fee structure: managers typically share in the upside (profits) but not directly in the downside (losses), beyond losing out on potential future performance fees if the high-water mark isn't cleared. This imbalance can tempt managers to increase risk after a period of poor performance to try and recover losses and reach the high-water mark faster.¹¹, Additionally, some studies suggest that funds with performance fees may not consistently outperform, and their expense ratios (inclusive of performance fees) can be higher than other funds.¹⁰ Investors should carefully evaluate the terms to ensure they align with their own risk tolerance and financial objectives.

Economic Performance Fee vs. Carried Interest

The terms "economic performance fee" and "carried interest" are often used interchangeably, but they have distinct applications within the investment management industry.

While carried interest is a specific type of performance fee, the general term "economic performance fee" is broader and applies to various investment management arrangements where compensation is directly tied to investment gains. Carried interest has also been a subject of debate due to its preferential tax treatment as capital gains for general partners.⁷,⁶

FAQs

What is the primary difference between a performance fee and a management fee?

A performance fee is calculated as a percentage of the profits an investment manager generates, while a management fee is a fixed percentage of the assets under management (AUM), charged regardless of performance.

Are performance fees allowed for all types of investment funds?

In the U.S., performance fees are generally permitted for certain types of funds like hedge funds and private equity funds, and for separately managed accounts of "qualified clients" who meet specific asset or net worth thresholds as regulated by the SEC. They are more restricted for traditional mutual funds in the U.S.⁵,

What is a "hurdle rate" in the context of performance fees?

A hurdle rate is a minimum rate of return that an investment must achieve before the manager can earn a performance fee. If the fund's returns do not exceed this hurdle, no performance fee is charged for that period, even if there are positive gains.⁴,

How does a "high-water mark" protect investors?

A high-water mark is the highest Net Asset Value (NAV) a fund has previously reached. It ensures that an investment manager only earns a performance fee on new profits. If a fund loses money, the manager must first recover those losses and surpass the previous high-water mark before they can charge another performance fee.³

Why do some critics argue against performance fees?

Critics argue that performance fees can incentivize managers to take excessive risks to chase higher returns, especially when the fund is underperforming. They also point to the asymmetry where managers share in the gains but not directly in the losses beyond foregoing a potential fee.²,¹,