What is a Performance Fee?
A performance fee is a payment made to an investment manager for generating positive returns. This is as opposed to a management fee, which is charged without regard to returns. A performance fee can be calculated many ways. Most common is as a percentage of investment profits, often both realized and unrealized. It is largely a feature of the hedge fund industry, where performance fees have made many hedge fund managers among the wealthiest people in the world.
Understanding Performance Fees
The basic rationale for performance fees is that they align the interests of fund managers and their investors, and are an incentive for fund managers to generate positive returns. A "2 and 20" annual fee structure—a management fee of 2% of the fund's net asset value and a performance fee of 20% of the fund's profits—is a standard practice among hedge funds.
Example of a Performance Fee
Imagine an investor takes a $10 million position with a hedge fund and after a year the net asset value (NAV) has increased by 10% (or $1 million) making that position worth $11 million. The manager will have earned 20% of that $1 million change, or $200,000. That fee reduces the NAV to $10.8 million which equals an 8% return independent of any other fees.
The highest value of a fund over a given period is known as a high-water mark. If the fund falls from that high, generally a performance fee isn't incurred. Managers tend to charge a fee only when they surpass the high-water mark.
Hurdles and Performance Fees
A hurdle would be a predetermined level of return a fund must meet to earn a performance fee. Hurdles can take the form of an index or a set, predetermined percentage. For example, if NAV growth of 10% is subject to a 3% hurdle, a performance fee would be charged only on the 7% difference. Hedge funds have been popular enough in recent years that fewer of them utilize hurdles now compared to the years after the Great Recession.
Critics of performance fees, including Warren Buffett, opine that the skewed structure of performance fees — where managers share in the funds' profits but not in their losses — only tempts fund managers to take greater risks to generate higher returns.
Performance Fee Regulation
Performance fees charged by U.S. registered investment advisors fall under the Investment Advisers Act of 1940 and fees charged to pension funds governed by the Employee Retirement Income Security Act (ERISA) must satisfy special requirements. Hedge funds are, of course, outside of this group.
FAQs
Performance fees are typically calculated as a percentage of the profits generated by an investment. For example, if an investment generates a profit of $1 million and the performance fee is 20%, then the manager would receive $200,000 as compensation.
What is an example of a hedge fund performance fee? ›
Example of a Performance Fee
Imagine an investor takes a $10 million position with a hedge fund and after a year the net asset value (NAV) has increased by 10% (or $1 million) making that position worth $11 million. The manager will have earned 20% of that $1 million change, or $200,000.
What is the difference between performance fee and incentive fee? ›
An incentive fee, also known as a performance fee, is usually tied to a manager's compensation and their level of performance, more specifically, their level of financial return. Such fees can be calculated in a variety of ways.
What is a performance fee hurdle rate for hedge funds? ›
Hedge Fund Fee Structure
A hard hurdle rate means that incentive fees are only collected on returns in excess of the benchmark. For example, if a hedge fund returned 25% with a 10% hurdle rate, incentive fees would be collected on the excess return of 15%.
What is the difference between carried interest and performance fee? ›
Carried interest is due to general partners based on their role rather than an initial investment in the fund. As a performance fee, carried interest aligns the general partner's compensation with the fund's returns. 1 Carried interest is often only paid if the fund achieves a minimum return known as the hurdle rate.
How do you determine the performance of a hedge fund? ›
Measuring Hedge Fund Performance
Cumulative performance is calculated as the aggregate percentage change in a fund's net asset value (NAV) over a given timeframe. The cumulative performance is typically measured over trailing periods such as the past three months, one year, three years, or five years.
What is a 20% performance fee? ›
The 2 and 20 is a hedge fund compensation structure consisting of a management fee and a performance fee. 2% represents a management fee which is applied to the total assets under management. A 20% performance fee is charged on the profits that the hedge fund generates, beyond a specified minimum threshold.
What is the average performance fee? ›
The performance fee is generally set at 20% of the fund's profit.
What is the performance fee for equity? ›
The performance fee in a private equity fund provides the GP with an incentive to maximise the investment value of the fund by participating in the asset appreciation. These fees are taken from the proceeds of asset sales in accordance with a “waterfall” schedule described in the investment agreement.
What is a performance fee on a fund? ›
A performance fee is a fee that a client account or an investment fund may be charged by the investment manager that manages its assets in addition to its management fee. A performance fee may be calculated many ways.
For example, consider a deal where a LP has a 10% preferred return, and a GP has a 15% performance fee and a catch-up provision. The property's income and profits would first be allocated 100% to the LP until the 10% hurdle has been reached.
What is the incentive fee for hedge funds? ›
While hedge fund managers earn a management fee, which is a constant percentage applied to the amount of assets managed in the hedge fund, they receive an incentive fee, which is a form of profit sharing when a profitable return is earned for their investors.
How to calculate hedge fund performance fee? ›
Performance Fee (PF) or Incentive Fee equals the Performance Fee rate multiplied by the difference between the Gross Asset Value (GAV) and the High-Water-Mark (HWM). HWM is a specified Net Asset Value (NAV) level that a fund must exceed before Performance Fees are paid to the hedge fund manager.
How are hedge fund performance fees taxed? ›
Depending on how much a person invests in the fund will determine the amount of management they pay. For example, if an investor invests $10 million into the fund then would have a $200,000 management fee. This is usually taxed to the Hedge Fund as Ordinary Income.
What is a crystalized performance fee? ›
Crystallization, in the context of hedge funds and investment, typically refers to the process of locking in or realizing gains or losses on an investment. This term is often used when discussing performance fees, which are fees charged by hedge fund managers based on the fund's performance.
What is the performance fee for fund of funds? ›
A typical FoF fee would be “1 and 5”, which means a 1% management fee on your investment plus a 5% performance fee on the gains from the investment. Similar to individual funds, most FoFs also have to meet a certain hurdle rate in order to receive their share of the performance fee, also known as 'carried interest'.
What is an example of a fund management fee? ›
Typical management fees are taken as a percentage of the total assets under management (AUM). The amount is quoted annually and usually applied on a monthly or quarterly basis. For example, if you've invested $10,000 with an annual management fee of 2.00%, you would expect to pay a fee of $200 per year.
What is a hedge fund performance fee high water mark? ›
A high-water mark ensures that investors do not have to pay performance fees for poor performance, but, more importantly, guarantees that investors do not pay performance-based fees twice for the same amount of performance.
