The ABCs of Performance Fees
Here's an introduction to performance (incentive) fees.
The investment manager is responsible for making investment decisions on behalf of a fund. An investment management agreement, between the fund and the investment manager, outlines the roles and responsibilities of the investment manager. In addition, it will state the rate of management fee to be paid. The investment manager is paid a management fee for managing the fund. Investment funds pay a management fee. It is usually based on the size of the fund as a percentage of net assets. Hedge fund managers often earn a management fee at a rate of about 2%. If a fund has assets of $100 million, the manager earns a $2 million per annum management fee.
Note that the manager earns this fee regardless of whether the fund has a positive or negative return.
Performance (Incentive) Fee
There is another fee that hedge fund managers can earn if the fund generates a positive return. It’s called a performance fee or an incentive fee. If the investment manager generates a positive return over a performance fee period, she gets paid a performance fee. The amount of the fee depends on the fund but it is often 20% of the profits made by the fund. This is where the term ‘2 and 20’ comes from. It refers to a fund with a 2% management fee and a 20% performance fee.
Performance fees have been used in the hedge fund industry as a means of aligning the interests of the manager with those of the investors.
Here is simple performance fee illustration. The Absolutely Fabulous Fund is launched on 1st January. Initial capital is $100 million. The performance fee period could be 3 months, 6 months, 12 months or longer; it depends on the fund. This particular fund has a performance fee period of 3 months and charges performance fee at 20%. During the first quarter the fund makes a profit of $50 million. This is before performance fees have been charged but after all other expenses have been charged. The investment manager earns a performance fee of 20%. So the investment manager earns $10 million.
The GAV is the total fund value before performance fees payable have been taken into account
Gross Asset Value (GAV)
Let’s look at this a slightly different way. At the end of the first quarter, the total fund value before performance fees is $150 million. We’ll call this the gross asset value, the GAV. The GAV is the total fund value before performance fees payable have been taken into account.
The initial capital, in this case, is called the high water mark. So the formula for calculating the performance fee?
The performance fee equals 20% of the difference between the GAV and the high water mark.
Let’s calculate the NAV at the end of that quarter.
GAV was $150 million. The performance fee payable at quarter-end was $10 million. So the total NAV is $140 million.
So the NAV = GAV less Performance Fee.
Note the terminology used here. The term GAV, while common, is not the only term used in the industry. Some funds use the term ‘G-NAV’ and you might come across other terms. For any particular fund, consult the fund documentation to understand the exact meaning of the terms used.
The Credit That Fund has a quarterly performance fee period and has a performance fee rate of 20%. The fund launches on 1st January with initial capital of $100 million. At the end of the first quarter, the total fund value, before performance fees have been charged but after all other expenses have been charged, is $120 million.
What is the PF payable at 31st March? The performance fee equals 20% of the difference between the GAV and the high water mark. 20% of $20 million is $4 million. The performance fee payable at 31st March is $4 million.
What is the NAV? If the GAV is $120 million and the performance fee payable is $4 million, then the NAV is $116 million.
The Not So Fab Fund also launched on 1st January, also with $100 million seed capital. But at 31st March, the GAV was $80 million. Does the investment manager earn a performance fee in the first quarter? No. GAV is below the high water mark so no performance fee is accrued as at 31st March.
But let’s look at quarter 2. At 30th June, the total fund value, before performance fees have been charged but after all other expenses have been charged, the GAV, is $130 million. So in quarter 2, the GAV went from 80 to 130. Should the investment manager earn a performance fee based on the increase in GAV during the quarter? Based on $50 million? No. The investment manager should not earn a fee for recouping the losses incurred in the first quarter. The performance fee calculation will compare the GAV at 30th June to the high water mark, in this case, the initial capital of $100 million. So the investment manager earns $6 million in the second quarter.
So the NAV at 30th June is, GAV less performance fee payable, $124 million.
- Some funds involve a performance fee. Also known as an incentive fee, this involves a % of the gains made by the fund being paid to the investment manager.
- The GAV, or sometimes called the G-NAV, is the fund value before performance fees have been charged but after all other expenses have been charged.
- The NAV equals the GAV less the performance fee.
- In the examples in above, the high water mark was the initial capital invested. In the Performance Fees online course here, the idea of the high water mark is developed further.