The increasing pressure on fund managers to perform, along
with the ability of performance fees to align the interests of
investors and fund managers, has lead to an increase in the use
of performance fees across a wide variety of managed funds.
This article looks at basic terms and methods of calculating
performance fees, whilst a subsequent article will look at
legal issues that may arise when implementing or evaluating
performance fees.
Performance fees have outgrown their traditional home of hedge
funds and private equity funds to become mainstream in listed,
infrastructure, long/short equity and other managed funds. As a
result of this growth, in-house counsel and product designers
are more likely than ever to be called upon to review or
develop performance fees for funds. ASIC have also given more
consideration to performance fees, such as the disclosure of
estimated performance fees and treatment of underlying
performance fees discussed in Regulatory Guide 97: Enhanced
Fee Disclosure Regulations: Questions and Answers
(reissued May 2007).
There are a range of practical and legal issues to be
considered when reviewing and developing performance fees. The
performance fee structure should suit the product type and
investment plan, investor requirements and provide adequate
incentives for managers.
This article provides an overview of some of the jargon used
in the area and the basic methods of calculating performance
fees in Australian funds and offshore (particularly Cayman
Islands domiciled) funds with Australian managers. A subsequent
article will look at specific legal issues that must be
addressed when evaluating and implementing performance fees
including documentation risk, disclosure risk and operational
risk.
Amount Of Performance Fee
An appropriately designed performance fee can align
investors' common goal of strong, low risk, long term
growth with a fund managers desire to maximise their fee
income.
A common performance fee rate for offshore hedge and private
equity funds is 20% of the growth in net asset value of the
fund or 20% of distributions respectively. Australian hedge
funds are also likely to set a 20% performance fee but payment
is more commonly dependent on performance matching a trigger or
a hurdle rate (see below). Other types of Australian managed
funds generally use a hurdle and charge performance fees of
between 10% to 20%.
The performance fee is often inversely related to the
management fee - generally investors prefer a lower management
fee and slightly higher performance fee to ensure they pay for
performance and not for funds under management. A management
fee / performance fee combination of "two and
twenty", a management fee of 2% per annum of net assets
and a performance fee of 20% of the growth in the value of the
fund, is common for private equity funds and offshore hedge
funds.
Timing is also important, as investors prefer performance fees
to be paid infrequently (for example, half yearly or yearly) to
reward long term performance.
Key terminology
Calculation period
The calculation period is the term over which a performance
fee is calculated and paid. Investors prefer the calculation
period to be longer (one year or more) to reward long term
performance and to discourage fund managers focussing on short
term gains.
Triggers, hurdles and high water marks
Performance fees are often payable only upon reaching
performance targets, such as triggers, hurdles and high water
marks. These targets ensure that the manager only receives fees
where it has performed, for example where performance outstrips
a low risk return such as the cash rate. The targets may be
absolute (returns must exceed 6%) or relative (returns must
exceed an index, for example, the Dow Jones Industrial
Average). The target will often be related to the investment
universe and strategy of the fund in question. For example, a
fund invested in global assets will generally choose a target
index for global equities, such as the MSCI Global Index. It is
argued that a relative target is more appropriate as managers
should only receive performance fees for outperforming a
comparable index (that is, alpha).
A trigger is the target rate of performance
that needs to be met before the performance fee is paid on the
increase in the total value of the fund. If the trigger is 8%
p.a. and the fund returns 10%, performance fee will be payable
on the full 10% performance, because the 8% p.a. trigger has
been met.
Hurdles differ from triggers because only the
increase above the hurdle will be used to determine the
performance fee. For example, if the hurdle rate is 8% p.a.,
performance of 10% p.a. will give rise to performance fees on
2% of returns, that is, the performance above the hurdle.
While a trigger is relatively common in Cayman hedge funds, in
Australia, infrastructure, equity or other managed funds are
more likely to employ a hurdle.
High water marks are a level of return that
needs to be met to ensure that managers are not paid
performance fees on gains that are simply recovering earlier
losses. The high water mark will normally be the higher of
either the initial net asset value of the fund (or class) and
the net asset value of the fund immediately after the last time
a performance fee was paid. The high water mark will generally
increase at the end of each calculation period in line with the
target rate of return. In some instances, the high water mark
may be reset after a certain period, for example, three years,
however it is argued by some investors that this is
inappropriate because the fund may still be suffering overall
losses.
Performance fee calculation methodologies
Although there are a wide variety of performance fee
calculation methodologies in the market, they can generally be
characterised into three broad types:
Whole of fund: The simplest performance fee
methodology is the whole of fund method. This involves
determining the performance of the fund (or class) as a whole
and calculating the performance fee accordingly.
The whole of fund method can be used effectively for
closed-end funds where there is only one issue of shares or
units and no (or infrequent) redemptions of shares or units.
However, where there are multiple issues or redemptions of
shares or units, the whole of fund method may produce unfair
results for investors or fund managers. Investors who subscribe
during a calculation period rather than at the
beginning obtain their interests at a different price (based on
the net asset value at that time) to existing investors.
Subsequent investors subscribing at a price based on a net
asset value below the net asset value at the start of the
calculation period obtain the benefit of a higher level of
performance than existing investors but will pay the same
performance fee (that is, they obtain a free ride').
Alternatively, investors subscribing when net asset value
exceeds the net asset value at the start of the calculation
period will pay too much performance fee because they will not
obtain the same level of performance as existing
investors.
Series: An alternative for funds with
multiple issues or redemptions of shares or units is the series
accounting method. This method uses different series of shares
or units within each class. Each series will have the same
rights attached to them but will have a different issue date
and different net asset value. Accordingly, performance fees
are calculated on a series by series basis.
Assuming a performance fee of 20% and no trigger or hurdle,
the following example illustrates the operation of series
accounting over three issues of shares:
Series |
Subscription price |
Net asset value per share at end of calculation period |
Performance |
Performance fee payable 20% |
Series 1 |
1.00 |
1.10 |
10 |
0.02 |
Series 2 |
1.05 |
1.10 |
5 |
0.01 |
Series 3 |
1.10 |
1.10 |
0 |
0 |
The series accounting method is designed to overcome the
inadequacies of the whole of fund method, however, this comes
at a cost. As discussed, series accounting involves multiple
series, all with different net asset values and performance fee
calculations, leading to more complicated fund accounting and
administration. To simplify this, at the end of a calculation
period at which a performance fee is paid in respect of a
series, that series may be 'rolled up' into the
first series. Note that rolling up may have capital gains tax
implications for investors.
Series accounting is relatively common in Australian hedge
funds and Australian fund of hedge funds, where there are
limited dealings in the fund. The series method is generally
not suitable for funds that issue and redeem shares or units
frequently (for example daily or weekly).
Equalisation: An alternative to series
accounting is the equalisation method. The equalisation method
is different from series accounting because it uses only one
series of units or shares in a class and performance fees are
adjusted in respect of each individual investor. An
equalisation credit or performance fee redemption is used to
ensure that each investor pays the correct performance fee,
that is, only in respect of performance from which they have
benefited.
If an investor invests into the fund during a calculation
period, as opposed to the beginning, when the net asset value
is above the fund's high water mark, they would
ordinarily pay too much in performance fee for the performance
they have received. In such cases an equalisation credit will
be paid by the new investor in addition to the subscription
price.
The credit is commonly equal to the accrued performance fee of
existing investors at the time of subscription by the new
investor. The new investor is required to pay the equalisation
credit to ensure that all investors have the same amount at
risk per share or unit. At the end of a calculation period at
which a performance fee is payable, the equalisation credit is
'cashed in' by applying the appropriate portion
of the equalisation credit to acquire additional interests in
the fund for the investor. This has the effect of cancelling
out the excess performance fees paid by the investor. The
remainder of any equalisation credit is carried over to the
next calculation period until the credit has been fully
applied.
If the investor invests into the fund when the net asset value
is below the fund's high water mark the equalisation
method employs a compulsory redemption of shares or units (paid
to the manager as a performance fee) to ensure that the
investor does not have a free ride' whilst maintaining
a uniform net asset value across the class.
The equalisation method allows for fair treatment of investors
while retaining a single net asset value per class of share or
unit. The main disadvantages of this method include the
complicated and non-transparent calculations that must be
conducted for each investor.
The equalisation method is common in offshore hedge funds
where there are limited dealings in the fund and limited
numbers of investors. Like series accounting, the equalisation
method is generally not suitable for funds that issue or redeem
shares or units relatively frequently.
Practical application
Given the difficulties involved with applying the series or equalisation methods, in many cases fund managers of open-ended daily dealing funds (those most commonly seen in the retail market) have opted to use the whole of fund method despite the potential inequities involved. The inequities can be partially avoided by accruing performance fees into daily unit prices. This limits the possibility of investors paying too much in performance fees, but may not prevent them enjoying a free ride. Despite this outcome, which can benefit investors at the expense of the manager, a cost versus benefit analysis undertaken by the manager often favours the whole of fund method.
Performance fees on distribution
Waterfall: In funds where exit strategy is critical to performance, the performance fee may be calculated and payable at the same time distributions are paid to investors. This is true for many private equity funds, which commonly use a payment waterfall to determine the amounts paid to both the investors and manager. A standard waterfall incorporates a return of capital and a guaranteed level of return to investors before the manager receives any performance fee. Such a waterfall may consist of:
- First, a return of capital: the investor's capital is returned to them;
- Second, a preferred return: investors receive a return disclosed in the fund documents. The preferred return is often around 8% and incorporates the time value of money by using internal rates of return;
- Next, catch up: the manager receives 100% of the distributions until it has received its performance fee of the amounts paid out to investors under return of capital and preferred return; and
- Finally, split: from then on the manager receives their portion of the distribution as performance fee with the remainder going to investors, for example, 20% to manager as performance fee and 80% to investors.
Further consideration
This article contains a high level summary of some of
the basic features of performance fees currently seen in the
market. A subsequent article dealing with this topic will look
at a number of specific legal issues that may arise when
implementing or evaluating performance fees, including
documentation, disclosure and operational issues.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.