Performance Fee

A performance fee is a payment made to an investment manager that depends on the investment results achieved, expressed as a percentage of the gains of a fund or account over a period. It is charged on top of the management fee, which is a fixed percentage of assets and is payable whatever the outcome. The purpose is to align the manager's reward with the investor's return: the manager earns more only when the investor has made money, or has done better than a stated benchmark.

Performance fees are standard in hedge funds, where they are also called incentive fees, and they appear in some retail funds and segregated mandates. The equivalent in private equity and venture capital is carried interest, which follows the same principle but is calculated on realised profits over the life of a fund rather than on periodic valuations.

The traditional hedge fund arrangement, often summarised as two and twenty, combined a management fee of 2 per cent of assets with a performance fee of 20 per cent of gains. Rates have since come under pressure, and many funds charge less on one or both. The fee is accrued in each calculation of the fund's net asset value, so that the published price is net of the fee earned to date, and it is paid to the manager, or crystallised, at the end of each performance period, usually a year.

For example, a fund starts the year at 100 per unit and ends it at 115 before the performance fee. With a 20 per cent fee and no hurdle, the fee is 20 per cent of the gain of 15, or 3 per unit, and the investor's net value is 112.

A performance fee on raw gains would pay the manager repeatedly for recovering earlier losses, or for returns that required no skill. Fund terms therefore usually include one or more of the following:

• High-water mark. The fee is charged only on gains above the highest value on which a fee was previously paid. If the fund falls from 112 to 100 and then recovers to 110, no fee is due until it passes 112 again. See high-water mark.
• Hurdle rate. The fee applies only to returns above a minimum, which may be a fixed percentage or a reference interest rate. A hurdle rate prevents the manager from being paid for a return available on cash.
• Benchmark-relative fee. In long-only funds the fee is commonly a share of the outperformance over a benchmark index, so that the manager is not rewarded merely for a rising market.
• Clawback and deferral. Part of the fee may be held back and released only if performance persists, or be recoverable under a clawback provision.

In an open-ended fund, investors enter at different times and prices, yet the fund has a single unit price. Without adjustment, an investor who subscribes when the fund is below its high-water mark would enjoy a recovery free of performance fee, while one who joins mid-period might pay for gains made before arriving. Administrators deal with this through equalisation, which adjusts each investor's position so that each bears the fee attributable to their own gain, or by issuing a separate series of shares for each subscription date. The calculations form part of fund accounting and are a known source of pricing errors.

Rules vary by investor type. In the United States, the Investment Advisers Act generally prohibits advisers from charging fees based on a share of capital gains, with an exemption for clients who meet wealth or investment thresholds and are known as qualified clients. Registered mutual funds may use a performance fee only in the symmetrical form called a fulcrum fee, which rises and falls by the same amount around a base fee according to performance against an index.

In the European Union, guidelines issued by the European Securities and Markets Authority in 2020 apply to retail funds and to some alternative funds sold to retail investors. They require the calculation method to be verifiable, the benchmark to be consistent with the fund's objectives, fees to crystallise no more than once a year, and past underperformance to be recovered before a fee is paid, over a reference period of at least five years where the model is not a permanent high-water mark. Disclosure rules require the fee to be shown in the fund's cost information.

The principal objection is asymmetry. The manager shares in gains but not in losses, which resembles holding an option on the fund's performance and may encourage greater risk-taking, particularly when a fund is well below its high-water mark and the manager has little prospect of earning a fee without a large gain. A manager in that position may also close the fund and start another, leaving investors with the loss.

Other criticisms concern benchmarks that are too easy to beat, fees taken on unrealised gains that later reverse, and the total cost when a fund-of-funds adds its own layer. Studies of hedge fund returns have found that a large share of gross gains over long periods has gone to managers in fees. Institutional investors have responded by negotiating lower rates, longer crystallisation periods and hurdles, often set out in side letters.