Performance Fee

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Performance Fee Definition

The performance fee is an amount that the investor pays to the investment manager for making profits or positive returns on the investment. It is very common in the case of hedge funds investment that comprises mainly two fee structures, i.e., the management fee and the performance fee.

It is a win-win situation for the investor and investment managers as the former gets positive returns on the amount invested, and the latter makes money in the form of a performance fee in return for assisting in profit generation or the positive returns.

Performance Fee Definition

The performance fee is the payment made to the investment manager by the investor for producing positive returns.
Traditionally hedge funds employ a "2 and 20" annual fee structure, which consists of a management fee of 2% of the fund's net asset value and a performance fee of 20% of the fund's profits.
The investor and the fund managers benefit from the situation because the former see favorable returns on their investments, and the latter earn money through rewards for favorable returns.
It explains a performance-based fee structure since it pays managers according to their relative performance: if they outperform their benchmark, they will earn larger fees; if they underperform, they will receive smaller or no fees.

Performance Fee Explained

The performance fee is also referred to as the incentive fee. It is paid as a reward for the profits made on the investment. Hence the incentive fee is positively correlated with positive returns. Furthermore, it indicates that such a fee does not account for a consistent income for investment managers. It occurs only in the presence of positive returns.

How To Calculate?

The performance fee is generally set at 20% of the fund's profit. The conventional "2 and 20" structure is a hedge fund compensation structure consisting of management and performance fees. The management fee is 2% of the total asset under the management, and 20% is the performance fee charged on the profits made on the hedge funds. The management fee is charged irrespective of the profits made on the funds, whereas the performance fee is only charged when the funds ensure considerable returns in terms of profits.

In industry, two methods are widely used to calculate the performance of the funds, one is the measurement period, and the other is the high-water mark. The calculation is done on the quarter or annual performance depending on the investor entity.

According to a global study of hedge fund managers released in 2019, hedge funds are abandoning the conventional "two and twenty" (2 and 20) fee structure that has damaged the industry's reputation and drawn criticism for providing poor value for money. In addition, some hedge fund customers felt they were paying too much upside to managers when bets went well, which has led them to become less and less fond of the fee arrangement. According to a survey by the Alternative Investment Management Association, the average fee disclosed by the sector is 1.3% of assets under management (AUM) and 1.4% for funds created.

Examples

Let us look at the performance fee examples to understand the concept better:

Example #1

Mr. Justin invests a total amount of $2,000,000 in the hedge funds. The total value of the funds keeps fluctuating, but after a year, the total amount of the fund is $2,100,000. The investment manager charges an incentive fee from Justin on the total profits and not in the case of losses.

The positive return is $100,000. Hence the fee will be 20% of the positive return of $100,000. So the 20% of $100,000 is $20,000, and $20,000 will outflow as an incentive fee towards the fund manager, and the NAV after the fee reduction will be $2,080,000.

Example #2

The total value of the fund at the start was $30,000. The value of $30,000 is the high water mark; after the end of the year, the fund's total value is =$37,000. Therefore, the profit made on the fund's total value will equal $7000 ($37000-30,000= $7000).

The performance fee, in this case, would be equal to $7000*20%= 1400

Carried Interest vs Performance Fee

Carried interest is a type of incentive fee or financial incentive associated with private equity funds, whereas a performance fee is more common with hedge funds. An economic gain accruing to the general partner unrelated to the general partner's investment contribution is represented by a carried interest in a private equity fund. Distributions to the carried interest holder are only made when the private equity fund earns an annualized return greater than the preferred return.

Performance Fee	Carried Interest
More common with hedge funds.	Commonly associated with private equity funds.
It can go up to 50% of the fund returns.	It varies between 10% to 40% of the private equity fund's distributions.

Performance Fee Equalization

The increasing pressure on investment managers has a direct alignment with performance fees. The equalization method is an accounting method that considers categories of shares also to calculate the incentive fees. Applying the technique contributes to ensuring appropriate payment from the investors concerning the return or expected profits they make from the investment.

Frequently Asked Questions (FAQs)

What is a 20% performance fee?

If the fund performs at a level over a certain base threshold, known as the hurdle rate, a 20% performance fee is assessed. The hurdle rate may be based on a benchmark like the return on investment or a fixed percentage.

Can mutual funds charge performance fees?

No, the mutual funds do not charge the performance fee. However, mutual funds charge the expense ratio for managing the funds. The expense ratio covers all expenses, including management fees and operating expenses. It is the fee paid to the fund managers to make an expected return on investment.

How often are performance fees charged?

The fee is calculated annually, quarterly, or monthly depending on the investment criteria. It is calculated via two methods: the measurement period and the other is the high-water mark. The incentive fee is only charged on the profits or the expected returns made on the funds.