What
is a Performance Fee?
A performance fee
is a periodic charge to investors based upon any gains in the fund, calculated in reference to any increase in
the fund’s net asset value (“NAV”). In
other words, it is the charge levied to investors when the fund performs.
Performance
Fee Issues
• Fee Amount
- The performance fee will be a set percentage of any increase in the NAV (net asset value) of a
fund, but there is still the issue of what that percentage will be. The fee will normally be set at 20% of any increase, but
there is the possibility for higher fees for very large funds or managers with
a proven history of outstanding returns, or lower fees for smaller or nascent
funds or managers.
Note that for a fund of funds,
however, there may be the additional consideration of performance fees at each
level; (i) performance fees charged by the fund of fund manager, and (ii) those charged
by the underlying fund(s). To offset,
performance fees of the manager of a fund of funds are typically considerably lower than the traditional
20%, but when added to the applicable fee for the portion of the fund of funds invested in an underlying fund will nevetheless generally result in a
higher cumulative performance fee for each such portion. In many cases, a manager of a fund of funds will just charge a flat administration fee based on NAV (e.g. 2% per year of NAV) which is unrelated to performance.
•
Hurdle Rate - The hurdle rate
is essentially a set percentage return, which the manager must exceed in order
to receive any performance fee. That
hurdle may be set at a flat percentage return, or in reference to an index such
as LIBOR or the S&P 500. A slight
variation of this model is a graduated fee structure whereby the performance fee
percentage increases in line with increased returns for the fund, so that
extraordinary performance is rewarded.
•
High Water Mark - The high
water mark, akin to the hurdle rate, is a set minimum a hedge fund must
outperform in order to levy any performance fee. The distinguishing future of the high water
mark is that it is fluid, and based on previous returns/losses of the fund
dating back to the beginning of the performance fee period – set at zero
percentage points. The purpose is to
avoid any undeserved payoffs for underperforming funds, denying a performance
fee for any increases that are simply an erasure of previous losses.
A separate issue from the calculation of the hedge fund
performance fee (i.e. hurdle rate, high water mark), is the frequency of the
withdrawal. The chosen period of
withdrawal will depend upon the investment strategy of the fund, but will
normally be set to an annual or quarterly basis. An extensive article discussing the impact of frequency of permitted withdrawal on fund performance appeared in an earlier article in this blog appearing May 20, 2008.
*
A
hedge fund will also charge a administration fee, along with the performance fee
discussed in this article. The administration fee is a fixed periodic charge to investors for the maintenance of
the fund. Other important issues in
hedge fund formation and structure include:
Side
Letters
Redemption
Requests
Gate
Provision
Soft
Dollars
Side
Pocket
3(c)(1)
Status
3(c)(7)
Status
Watch
future issues of the blog for discussions of these items.
* * *
Robert
Kiggins, Esq. of McCarthy
Fingar LLP, is author of the blog, and may be reached at (914) 385-1024 or rkiggins@mccarthyfingar.com.
