Performance fees

What Is Performance Fees?

Performance fees are a form of compensation paid to investment managers based on the returns generated by the assets they manage, typically exceeding a predefined benchmark or hurdle. These fees fall under the broader category of Investment Management Fees and are designed to align the interests of the manager with those of their clients, incentivizing superior performance. Unlike a fixed management fees, which are usually a percentage of assets under management, performance fees are directly tied to the profitability of the investments. They are a common feature in alternative investments such as hedge funds and private equity funds.

History and Origin

The concept of performance-based compensation in investment management dates back to the mid-20th century. Alfred Winslow Jones is widely credited with establishing the first hedge fund in 1949. By 1952, Jones had refined his fund's structure to include an incentive fee, converting it into a pooled investment vehicles that combined a hedged strategy with leverage and a 20% performance fee. This marked the genesis of what would become a standard fee model in the alternative investment industry. The popularity of hedge funds and their fee structures grew significantly after a 1966 Fortune magazine article highlighted Jones's fund's outperformance, even after accounting for fees.¹⁷

The regulatory landscape concerning performance fees has also evolved. In the United States, Section 205(a)(1) of the Investment Advisers Act of 1940 generally prohibited registered investment advisers from charging fees based on capital gains or appreciation.¹⁶ However, the Securities and Exchange Commission (SEC) has provided exemptions, notably Rule 205-3, which permits performance fees for "qualified clients" who meet specific asset under management or net worth thresholds. These thresholds have been periodically adjusted for inflation, with the SEC adopting amendments in 2012 and later increasing thresholds in 2021 to ensure such fees are charged to financially sophisticated investors who do not require the same level of protection.¹⁴, ¹⁵

Key Takeaways

• Performance fees are compensation for fund managers based on investment returns.
• They are prevalent in alternative investment strategies, aiming to align manager and investor interests.
• A common structure for performance fees includes a "hurdle rate" that must be surpassed before fees are charged.
• A "high-water mark" often ensures fees are only paid on new profits, preventing charges for recovering past losses.
• Regulations, such as those by the SEC, stipulate conditions under which registered investment advisers can charge performance fees.

Formula and Calculation

The calculation of performance fees can vary, but typically involves a percentage of profits above a specific benchmark or hurdle rate. A common structure, particularly in private equity and hedge funds, is the "2 and 20" model, referring to a 2% management fees and a 20% performance fee (also known as "carried interest").¹³

The general formula can be expressed as:

Where:

• (\text{Performance Fee Rate}) is the agreed-upon percentage of profits taken as a fee.
• (\text{Fund Return}) is the percentage gain on the fund's investments.
• (\text{Hurdle Return}) is the minimum return the fund must achieve before performance fees are applied.
• (\text{Assets Under Management}) is the value of the capital managed by the fund.

Many agreements also include a high-water mark provision. This ensures that a manager only earns performance fees on new profits. If a fund experiences losses, it must first recover those losses and surpass its previous peak value before new performance fees can be charged. This protects investors from paying performance fees multiple times on the same gains.

Interpreting the Performance Fees

Interpreting performance fees involves understanding not just the percentage charged, but also the underlying conditions and benchmarks. A higher performance fee rate might be justified if the investment strategy consistently generates exceptional risk-adjusted returns. Conversely, a high performance fee coupled with a low or no hurdle rate, or without a high-water mark, could disproportionately benefit the manager even during periods of modest returns or after significant drawdowns.

Investors typically evaluate performance fees in the context of the overall fee structure and the historical net-of-fee returns. While performance fees are intended to align manager and investor interests, critics argue that they can incentivize excessive risk-taking, especially if managers aim for short-term outperformance to maximize their compensation. Therefore, understanding the specific terms, such as the hurdle rate and high-water mark, is crucial for assessing the fairness and impact of performance fees on potential returns.

Hypothetical Example

Consider an alternative investment fund with $100 million in assets under management. The fund charges a 2% management fee and a 20% performance fee, with an 8% hurdle rate and a high-water mark.

At the beginning of the year, the fund's net asset value (NAV) is $100 million.
During the year, the fund generates a 15% gross return.

1. Calculate the Management Fee:

   • Management Fee = 2% of $100,000,000 = $2,000,000

2. Calculate the Gross Profit:

   • Gross Profit = 15% of $100,000,000 = $15,000,000

3. Determine if the Hurdle Rate is Met:

   • Hurdle Return = 8% of $100,000,000 = $8,000,000
   • The fund's gross profit ($15,000,000) exceeds the hurdle return ($8,000,000).

4. Calculate the Profit Subject to Performance Fee:

   • Profit above Hurdle = Gross Profit - Hurdle Return = $15,000,000 - $8,000,000 = $7,000,000

5. Calculate the Performance Fee:

   • Performance Fee = 20% of $7,000,000 = $1,400,000

6. Calculate Total Fees Paid by Investors:

   • Total Fees = Management Fee + Performance Fee = $2,000,000 + $1,400,000 = $3,400,000

In this scenario, the fund manager earns a total of $3.4 million in fees due to the strong performance, which exceeded the defined hurdle.

Practical Applications

Performance fees are most commonly found in investment advisory contracts for actively managed funds, particularly within the alternative investment space.

• Hedge Funds: These funds frequently employ the "2 and 20" model, where general partners receive a percentage of the profits above a certain threshold.¹² This aligns with the aggressive, absolute-return-seeking strategies often pursued by hedge funds.
• Private Equity and Venture Capital: In these sectors, performance fees are typically referred to as "carried interest." It represents the general partners' share of the profits from the fund's investments, often after the limited partners have received their initial capital back plus a preferred return. The median management fee for private equity funds during the investment period has been consistently around 1.75%-2.00%, with carried interest often set at 20%.¹¹ Some specialized strategies like venture capital and secondaries may even charge higher carried interest.⁹, ¹⁰
• Mutual Funds (Limited): While less common due to stricter financial regulations, some mutual funds are permitted to charge performance fees, often structured to be symmetrical, meaning fees can also decrease or be rebated if performance is poor.

The widespread adoption of performance fees in alternative investments reflects a desire to link compensation directly to investment success, incentivizing managers to maximize capital gains and overall returns for investors.

Limitations and Criticisms

Despite their intended benefit of aligning interests, performance fees face several criticisms and limitations. One major concern is the potential for fund managers to engage in excessive risk-taking.⁸ If a manager's compensation is heavily dependent on outperformance, there can be an incentive to pursue more speculative strategies to hit return targets, even if it means exposing investor capital to undue risk. This "option-like" nature of asymmetric performance fees, where managers benefit significantly from upside but do not directly share in losses beyond losing their fee, can distort incentives.⁷

Research suggests that the effective incentive fee rate in hedge funds can be significantly higher than the contractual rate. A study on hedge fund compensation structures found that over a 22-year period (1995-2016), the aggregate effective incentive fee rate was about 2.5 times the average contractual rate (approximately 50% instead of 20%).⁴, ⁵, ⁶ This disconnect largely stems from the asymmetry of the performance contract, investor behavior of chasing returns, and the closure of "underwater" funds where prior losses are not fully recouped.³ Investors, on average, collected only about 36 cents for every dollar of gross excess return generated by hedge funds, with the remaining 64 cents going to management and performance fees.²

Furthermore, the complexity of fee structures, particularly in private equity funds, can make it challenging for limited partners to fully understand and compare total costs across different funds. Some contractual prohibitions might even prevent investors from obtaining detailed fee breakdowns.¹

Performance Fees vs. Management Fees

The primary distinction between performance fees and management fees lies in their basis and purpose:

While management fees provide a stable revenue stream for the fund managers to cover overheads like salaries and administration, performance fees act as an additional, variable compensation directly tied to the value created for investors. The combination, famously known as "2 and 20," aims to balance operational coverage with strong incentives for generating high returns.

FAQs

Are performance fees legal?

Yes, performance fees are legal in many jurisdictions, but they are often subject to specific financial regulations. In the United States, for example, the SEC permits registered investment managers to charge performance fees only to "qualified clients" who meet certain financial thresholds, as outlined in Rule 205-3 of the Investment Company Act of 1940. This regulation aims to protect less sophisticated investors.

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

A hurdle rate is a minimum rate of return that an investment fund must achieve before its manager can begin to collect performance fees. For instance, if a fund has an 8% hurdle rate, the manager only earns performance fees on profits generated above that 8% return. This ensures that investors receive a basic level of return before the manager shares in the profits.

What is a "high-water mark"?

A high-water mark is a critical provision in performance fee agreements. It ensures that a fund manager only earns a performance fee on new profits. If the fund experiences losses, it must first recover those losses and surpass its previous highest value (the high-water mark) before any new performance fees can be charged. This prevents investors from paying performance fees repeatedly on the same gains or on gains that merely recover past losses.

How do performance fees impact overall investment returns?

Performance fees can significantly impact overall investment returns, especially in high-performing funds. While they incentivize managers to generate higher returns, they also reduce the net profit received by investors. Understanding the fee structure, including the performance fee rate, hurdle rate, and high-water mark, is crucial for investors to assess the true cost of management and the potential net returns on their investments.