Calculating Performance Fees for Your Own Hedge Fund

I’ve been speaking to a few potential investors about opportunities for them to invest in my little fund. During the process of discussing the best way forward, one of the many topics we had to ensure was crystal clear is the payment of Performance fees.  To help with the explanation I produced a diagram similar to the one below, and talked them through the various numbers.  It was a few days later when I recognized that this may be useful to others looking to manage their own hedge funds, who wish to charge a performance fee for doing so.  So I produced the following diagram for you!

First some context and definitions:

The Hedge Fund presented here is a theoretical fund that charges a Performance Fee only (no Management Fee – although including a simple percentage based management fee would not add too much complexity).  The Fee has a hurdle rate of 5%, charges a performance fee equal to 15% of any excess return above the hurdle rate, and uses a high water mark.

hurdle rate: the rate of return that the fund manager must exceed before charging performance fees.

performance fee: a payment made to a fund manager for generating returns in excess of the hurdle rate.

Investopedia explains ‘Performance Fee’

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 – has become standard practice among hedge funds.   Read more: http://www.investopedia.com/terms/p/performance-fee.asp#ixzz22NQyorht

high water mark: the minimum value a fund must achieve before a performance fee can be charged.  In your first year of operation, the high water mark is the minimum value (generally measured as Unit Price) that the fund must reach by year end (assuming annual Performance Fees) before a fee can be charged, which is therefore the  starting value plus the hurdle rate.  High water marks motivate the fund manager to avoid taking large risks to achieve large performance fees, and come in to their own in a year following a negative or low return year.  For example, if an investor buys Units in your fund at $1.00, and after the first year the Units are only worth $0.80, not only will the manager get no Performance Fee (for failing to exceed the hurdle rate), but they will need to get your Unit price back above it’s previous high water mark of $1.00  before a performance fee could be considered.  In the example below, the high water mark is incremented each year by the hurdle rate.

So let’s use the table below to walk through an example.

The four rows within the table represent four different investments in the fund, made at different times and at different prices (Unit Value).  The highlighted numbers in the example correspond with the numbered list below.

  1. The first external Investor in the fund makes an Investment of $1,500 on 30/11/2010, at a Unit Price of $1.1085 per unit.
  2. To generate a Performance Fee payable to the Fund manager, the Unit Price one year after the date of investment (30/11/2011) must be greater than 1.1085 plus the 5% hurdle rate [1.1085 x 1.05], or greater than 1.1639.  Otherwise no Fee is payable.A Year Later….
  3. The Actual Unit Price on the first anniversary of the investment (30/11/2011) was 1.3380 per unit, representing a 20.70% return over the year.  Before fees, the Investors $1,500 has grown to $1,810.55.
  4. This 20.70% return was 15.70% more than the Minimum Return (Hurdle Rate) required to trigger a Performance Fee, and as such generated a performance fee of 15% times the excess return [15% x 15.70%], or 2.36%.  This fee is applied to the Investment Value at the start of the relevant year, so 2.36% times $1,500 equals a $35.33 Performance Fee.
    The Investor can be invoiced directly for this fee, or can transfer Units to the Fund Manager to the value of the Fee.
  5. At the end of this first year, the High Water Mark (HWM) is reset to be 5% higher than the greater of either:
    • the HWM at time t (see point 2 above)  or,
    • the Price a time t (see point 3 above).

Let’s consider another investor.  Investor 3 invested $1,000 on 31/03/11 after the Unit price had climbed to $1.2854.  With the 5% hurdle rate, the fund price (unit value) must grow to $1.3497 before a Performance Fee is payable

 A Year later….

6.   The fund has grown by 4.29%, but only to $1.3406.  Where the Return is less than the Minimum return (5%), no Performance fee is payable.

7.  The final row represents a fourth investor who held their investment for a year in which the fund underperformed (returning -1.25%).  Where the Return is less than the Minimum return (5%), the HWM (High Water Mark) set for the subsequent Year is 5% greater than the HWM for the initial Year (so the HWM goes from $1.4191 as the minimum after 1 year to generate a fee, up to $1.4900 by the end of the second year).

Comments

10 Comments on Calculating Performance Fees for Your Own Hedge Fund

  1. Craig Harper on Thu, 15th Nov 2012 2:26 am
  2. Hi, like the example. But say some one invested 100$ at the start of the year and then added money after say 3 and 7 months, another 100$ each time . Assuming the fund at the end of the period is say 500$ . How would you calculate the performance fee ?

  3. Andrew on Fri, 16th Nov 2012 6:52 am
  4. Hi Craig,
    If you are using a High Water Mark, then each investment amount has to be considered individually, and the performance fee will be subject to the fund value (unit price) at the time each investment is made. For example, if the original $100 in your example was invested at a time when the unit price was $1.0000, the next $100 at a unit price of $2.0000, and the third $100 at a time when the unit price was $4.0000, then the investor will own 175 units in the fund (100 + 50 + 25). If the fund is valued at $500 at the end of the period, then the unit price will be $2.8571 ($500/175), and the performance fees for each investment will be based on the relevant change in value. Therefore the original investment has grown by 185.71%, the second by 42.85%, but the third has declined in value and therefore would not be subject to a performance fee. Don’t forget, you need to translate each of these return amounts into annualized performance. Although not clearly specified in my examples, I charge performance fee for each investment on the anniversary of the investment, or pro-rata the charge if an investor redeems their investment.
    Hope this answers your question. If not, let me know.
    Andrew

  5. sreyash on Wed, 5th Dec 2012 7:16 pm
  6. Hi Andrew,

    Could you please elaborate on how equalization is used in this scenario.

    Thanks for sharing this example.

    Sreyash

  7. Andrew on Mon, 31st Dec 2012 2:52 pm
  8. Hi Sreyash,

    Equalization is easy to implement (but harder to administrate). Because each investment is recorded and tracked individually, each can have different high water marks. Therefore, an investment that has suffered a recent loss would have a high water mark based on prior peak performance, whereas an investor making a new investment would be subject to a high water mark equal to the current price plus minimum performance.

    Using the data from the example I provided: The last investment was made on 30/06/11 at a Unit Price of 1.3515 which generated a High Water Mark of 1.4191. One year later (30/06/12) the Unit Price had fallen to 1.3346, yet the original investments High Water Mark for the subsequent year had increased to 1.4900. Whereas a new investor would buy in to the fund at 1.3346, and their investment would only be subject to a High Water Mark of 1.4013 (which is 5% growth on 1.3346). Therefore, if the Unit Price at 30/06/13 had increased above 1.4013 but remained below 1.4900, then the original investor would not be subject to a Performance Fee, but the new investor WOULD be subject to such a fee.
    Hope this helps,
    Andrew

  9. michail on Mon, 14th Jan 2013 10:52 pm
  10. does this mean that every investor has its own NAV (if we use the equilization)?

  11. michail on Mon, 14th Jan 2013 10:56 pm
  12. also my fund accrue performance every month and pay the cumulative amount at the end of the year, my question is do we do netting for cumulative accrued performance fees if we had negative excess perofmance

  13. Lou on Wed, 16th Jan 2013 4:56 pm
  14. Hi Andrew, this is a great write-up, thanks for posting.

    Had a question regarding the first investor that saw a 20.7% gain in period 1. Assuming their investment grows 4% in period 2, how would you calculate the performance fee at the end of period 2? The HWM at t+1 that you show (1.4049) seems to imply that the manager should not get a performance fee in period 2 because the return in period 2 did not exceed 5%. However the annualized return over the 2-year period is 12.04%, which exceeds the 5% hurdle rate.

    Also, regarding the last investor that lost 1.25% in period 1. How would you calculate the performance fee in period 2 if the manager earned 13.78% in period 2, netting a 2-year CAGR of 6%? Thanks!

  15. david on Sun, 25th Aug 2013 11:51 pm
  16. Question for you: Suppose you start your fund with $100 on 1/1 and at 6/30 it is valued at $200 representing a 100% gain. Now you receive another $100 in new committments on 7/1 so the total value of your fund is $300 ($200+$100). If your fund is valued at $400 on 12/31, how do you calculate the next 6 month performance? By taking on the new capital ($100) you have diluted your performance. Thanks.

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