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: