Performance Fees - Part 1

Oh boy.

This is going to be a big topic.

You’re either going to love this topic or hate it.

Whichever camp you sit in, Performance Fees are a factor of investing life, and while there are plenty of articles that discuss what Performance Fees are, I rather want to discuss the ins-and-outs of performance fee setups and calculations, because when it comes to setting up an investment opportunity this is usually one of the main areas that managers find the most complex.

This is also not a discussion on whether Performance Fees are good or bad; that’s a debate for another time to be had by other people.

And if you’re an investor reading this, my hope is that you too will find this discussion to be of value.

Performance Fees are a big topic, so I will be covering this topic in three different parts, rather than one extremely long essay.

- Part 1 will discuss the architecture of a Performance Fee.

- Part 2 will then go into mechanics of a Performance Fee.

- Part 3 will go through cash & NAV implications from Performance Fees.

While I highly recommend reading all three parts to get the maximum benefit each part has been written to act as its own standalone piece - so feel free to do as you please.

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Part 1 - Architecture

Before we start there are two elements we need to clear up. (1) A Performance Fee is not unique to private market transactions, it is also very commonly found in public market investment funds or other such mandates. (2) Performance Fees have several legal forms, and to some extent they refer to different unique elements, but achieve the same end goal for the party receiving them.

• Performance Fee: the term generally used in traditional asset management. It links the managers compensation to the performance of the portfolio.

• Success Fee: paid when a transaction or investment reaches a certain goal (performance based) or completion (transaction based).

• Carried Interest: generally used in the world of private equity (including venture capital) and represents the share of the fund’s profits that the manager has a claim on.

• Incentive Fee: generally used in the world of hedge funds. It is a fee rewarding the investment manager for achieving returns above a threshold or benchmark (ie: performance based).

• Profit Participation: this is a direct participation on the profits generated by a venture. Generally used in Real Estate transactions or other private ventures.

In this discussion I’ll be using the term “Performance Fee” only, but feel free to use the concepts I talk about for your own fee type.

For Better, For Worse, For Richer, For Poorer

A Performance Fee needs to, by design, align the interests between the manager and investors. Investors, who provide the majority, or all the investment capital, want to maximize the economic gain they receive from risking their capital.

While managers need to be incentivised for taking risks in sourcing, executing and managing investments. Generally, a manager is going to make use of their networks, leverage business relationships and stake their reputation in the process. No one is willing to do this for free, and if they do it properly managers know they can unlock real value.

So the question isn’t whether a manager should charge a performance fee.

The real questions are: how much should they charge and what would be a structure that aligns incentives between managers and investors?

While there are industry standards on the level of Performance Fee that is charged (around 10% - 20%), theoretically, a manager can charge whatever they want and investors must decide if they are willing to pay.

However, an efficient Performance Fee should be designed taking into consideration how it relates to the total cost of the investment.

Is a Management Fee being charged? If so, how much and more crucially how often does cash physically get paid to the manager?

Is an Access Fee being charged? Generally, for high-profile private market transactions, an Access Fee is almost always charged. Again, consider factors such as how much and when cash move hands.

With this in mind, is a 20% Performance Fee warranted? Is a 40% Performance Fee warranted?

I have seen some managers consider charging upward of 55%.

In general, charging an ongoing Management Fee, and perhaps an Access Fee, then an outsized performance fee, or a high claim on any profits, would likely receive pushback from investors.

However many managers forego charging a Management Fee, and instead charge a higher Performance Fee, which gets collected at shorter intervals.

A fully aligned incentive scheme will determine how easily you will be able to attract more investment capital in light of the Performance Fee you plan to charge.

Remember: Demand (for your fund/investment) is your own opinion, but raising capital is the ultimate Fact.

To best understand the relationship a performance fee has to the overall economics of your investment, let's work through an example.

Assume you invest 1'000'000. The manager charges a 1.00% management fee per annum and a 20% performance fee. For simplicity, ignore all other factors — we'll tackle those in Part 2.

The investment returns 10% for the year.

Gross Return	100’000 / 10%
(Less) Management Fee (1% on 1’000’000)	(10’000)
(Less) Performance Fee (20% on 100’000)	(20’000)
Net Return	70’000 / 7%

The investor should treat that 10'000 management fee as a cost they're wearing regardless of performance, it's due whether the year is good, flat, or bad. Out of the 10% generated, the investor keeps 7% and the manager earns 3% for a full year's work.

Now compare that to a manager who charges no management fee at all, and instead takes a 30% performance fee. Same 1'000'000, same 10% return:

Gross Return	100’000 / 10%
(Less) Management Fee (0% on 1’000’000)	(0)
(Less) Performance Fee (30% on 100’000)	(30’000)
Net Return	70’000 / 7%

Interestingly the investor nets exactly the same 7% in both scenarios. Same outcome, structured two completely different ways.

It's tempting to compare fee structures by simply asking "which percentage is bigger?" But percentages in isolation are meaningless, what matters is what they translate to in real terms, at the return level you actually expect. In this example, 10% happens to be the exact breakeven point between "1% + 20%" and "0% + 30%." Change the return, and the comparison flips entirely.

Take the same two structures at a 5% return instead:

	1% Man + 20% PF	0% Man + 30% PF
Gross Return	50’000 / 5%	50’000 / 5%
(Less) Management Fee (on 1’000’000)	(10’000)	(0)
(Less) Performance Fee (on 100’000)	(10’000)	(15’000)
Net Return	30’000 / 3%	35’000 / 3.5%

And if we run the same calculation again, assuming 0%, then the structure with zero management fee lands up being the most efficient for investors. Interestingly this structure also says something about the manager’s view on the expected performance of the investment - by foregoing a fixed income distribution in the form of a management fee, they have conviction that the investment will clear the breakeven point.

Are we really aligned in this relationship?

All this time Ive been talking about how a Performance Fee needs to be structured so as to align the incentives between the manager and investors. However, let’s ignore economics for a moment and focus on the payout model in each scenario.

You’ve probably already noticed that as returns drop down to zero the manager’s earnings reduce down to zero.

But what happens when returns turn negative?

The manager’s earnings remain at zero.

This ultimately means that a Performance Fee structure is never neutral by its nature. It not only shapes economic incentives but also shapes risk appetite.

If returns can turn negative, but this negative impact is not equally shared between investor and manager, then there is a fundamental misalignment in risk appetite between the parties.

Which gives you a genuinely useful question to sit with, whichever side of the table you're on.

As a manager: does the structure you're proposing reward you for delivering steady, appropriate returns to your investors — or does it only really pay off if you swing big?

As an investor: before you sign, ask not just "what's the fee," but "what does this fee structure make it rational for my manager to do with my money?"

Every marriage looks aligned at the altar. What matters is how it holds up once things get hard; a down year, a delayed exit, a manager under pressure to perform. That's not an architecture question anymore. That's mechanics, and it's where Part 2 picks up.