Hedge Fund Performance Fees Not As Simple As You Think

While investment managers have been the primary advocates of performance-based fees, there is little doubt that institutional investors have given their tacit approval to them on the basis that they align the interests of manager and client.  These institutions look particularly smart when their manager hits a rough patch (see Friday’s post).

A recent study by accounting firm Grant Thornton points to lower fees as a major incentive to shift to a performance fee arrangement:

Assets under management and total fees had reduced dramatically from 2000 to 2003…Boards, in turn, saw performance fees as attractive since, depending on their structure, they could reduce total expense ratios in difficult times such as those that they had recently experienced.  (Generally, when a performance fee is introduced, the basic management fee is adjusted downwards, thereby reducing total fees in a period when a performance fee is not earned.)

The study goes on to list a variety of different possible aspects of a performance fee contract. 

• Benchmarks: “The most important aspect of setting a benchmark-based performance fee is selecting an appropriate benchmark.”
• Risk Adjusted Returns: “Risk that is arrived at mathematically is of passing interest; more relevant will be the risk parameters set by the board: use of borrowing, use of derivatives…”
• Caps: “Caps are probably ‘a good thing’.  Yet while a no-cap policy sounds irresponsible, if the benchmark is right, performance is properly understood and objectives are clear, why should there be a cap?”
• High Water Marks: “It is perhaps worth considering making the high watermark relative to the benchmark (rather than an absolute measure) otherwise, if the market crashes, the manager will be
  tempted to move to another fund.”
• Arithmetic vs. Geometric Returns: “Where a rolling measure is used to set performance fees, a geometric average will often be preferable to an arithmetic average.”
• Annual vs. Rolling Fees: “Rolling fees smooth out luck and noise, and keep a longer-term focus on performance.”

The authors use many of these dimensions to construct 6 illustrative performance fee contracts.  Structures ranged from the simple (”single year performance period, no cap or high watermark”) to the complex (”single year performance period, high watermark, total fees capped at 1.8% of net assets with carry forward of performance over cap”).

Then they saw how each structure would have played out over 5 years given three different states of the world (e.g. “modest under performance in year 3 with later recovery”). 

So if you ever thought a performance fee was a straightforward thing, read this study.  It’s got a massive appendix containing the actual performance fee arrangements for dozens of long only and hedge funds.  Here’s an example that illustrates our point about complexity:

The performance fee is equal to 15% of the out performance of the NAV total return over the benchmark. The maximum total fee payable in any one year is capped at 2% of the company’s total assets less current liabilities. In effect, this cap the potential performance fee paid in any one year to 1%. Any performance fee earned in any one year in excess of the 1% cap will be carried forward until paid in full or absorbed by any under performance in a subsequent year. The performance fee will be calculated annually on 30 September. The period of the performance fee calculation restarts when out performance of the benchmark has been achieved and a performance fee earned. This means that the performance fee is only payable when there has been positive relative performance since the last performance fee was paid.

While this particular solution may be elegant, there’s little question that it reads like the morning meal for a Bichon Frise.

Comments

[fatcat:]

Not as complex as it seems...reminds me of a tax return...in reverse..

2008 Sep 29 05:39 AM

[Augustus:]

Thanks for the article and the link to the good study. It is much more comples than first view would lead someone to believe.

2008 Sep 29 12:05 PM