Performance Fees - Part 2
Part 2 - Mechanics
Risk and Reward. Traditional thinking states that the more risk you take, the higher the potential reward that should be possible. Generally this rule holds well, throughout life, not just investing.
But who is taking on the risk?
Is it the investor, who is locking up their cash in a particular investment for a period of time, essentially taking on an opportunity cost and capital at risk? Or is it the investment manager who is responsible for allocating this cash to specific investment opportunities; making use of their contacts, reputation, skills and knowledge force, taking on full liability if something goes wrong?
Immediately, the two sides don’t appear to be aligned.
We left Part 1 of this Series by touching on the critical point that a Performance Fee structure cannot only reward the two sides when things go well; it also needs to share the negative impacts fairly amongst the two sides when things go badly.
"You Shall Not Pass" - Gandalf the Grey
A manager that can earn a performance fee on any level of performance is not actually adding any real value.
Year 1 | Year 2 | Year 3 | |
Investment Start Value | 1’000’000 | 1’080’000 | 1’000’000 |
Investment End Value | 1’100’000 | 1’000’000 | 1’100’000 |
Profit / (Loss) | 100’000 | (80’000) | 100’000 |
Performance Fee (%) | 20% | 20% | 20% |
Performance Fee (Value) | 20’000 | 0 | 20’000 |
Investment Net Value | 1’080’000 | 1’000’000 | 1’080’000 |
Consider that this investment gained a gross return of 10% in Year 1, experienced a negative return in Year 2 bringing it back to original value level, and in Year 3 experienced a 10% gross return.
Did the manager actually generate a 20% gross return overall?
Of course not, but they have been compensated as if they have.
In fact, what Time Weighted Return (TWR) did the manager actually generate?
Year | Return |
Year 1 | 10.0% |
Year 2 | (7.4%) |
Year 3 | 10.0% |
Net Return | 12.6% |
So the manager has been compensated as if they generated a 20% return, while in reality they only generated 12.6%.
But should the manager even have earned a performance fee in Year 3? What value was created by bringing the investment back up to the same value It ended Year 1 on? The answer is simple - nothing.
This is known as the Free-Ride effect, and it can be dealt with by putting in mechanisms that redefine the base-performance level at set intervals, to ensure that managers cannot be compensated for free-riding.
High Water Mark (HWM)
An HWM resets the base-performance level of the investment, according to a defined crystallization period (something we will cover later on in this discussion). In other words with this mechanism the starting value of your investment, in a particular period, may not be the value that needs to be exceeded before the manager is eligible for a performance fee.
The best way to explain this is visually.
Year 1 | Year 2 | Year 3 | |
Investment Start Value | 1’000’000 | 1’080’000 | 1’000’000 |
HWM to Beat | 1’000’000 | 1’100’000 | 1’100’000 |
Investment End Value | 1’100’000 | 1’000’000 | 1’100’000 |
New HWM to Beat | 1’100’000 | 1’100’000 | 1’100’000 |
So what are we looking at?
We are looking at the same investment as the one at the beginning of this chapter.
Year 1 sets the base-performance level at 1’000’000, in other words, this is the amount that needs to be exceeded before the manager is eligible for a performance fee. Year 1 ends at 1’100’000, however, now the HWM changes, setting the new base-performance to beat to 1’100’000.
Why is this so significant?
Well remember how in our first example, Year 2 saw an erosion of all the gains made, essentially putting investors back into the position they were in at the beginning of Year 1. Year 3 then saw the investment generate a gross return of 10%, exactly the same as Year 1.
Where no HWM exists, the manager was allowed to charge a performance fee in Year 1 on 10% gross performance and again in Year on 10% gross performance, even though there was no real value created.
But, with an HWM, the Year 1 Investment End Value becomes the new value to beat. This value was not beaten in Year 2, but more significantly it also wasn’t beaten in Year 3. With an HWM the manger would only be allowed to charge a performance fee once (in this time series, only in Year 1).
One key point to discuss, and maybe you’ve already picked this up: the HWM is set to the Investment End Value before the performance fee charge. Why? Performance is based on trading activity. If the manager was able to generate 10%, then they are compensated on that 10%; they need to beat this 10% once again. If we had to set the HWM to an after performance fee charge value, then the manager needs only beat 8%. In simple words, we would be paying the manager a performance fee based on 10% performance, and then telling them they only need to beat 8% performance to get the next performance fee.
Hurdle Rates
A Hurdle Rate is a defined rate of return that must be met before the manager can be considered eligible to earn a performance fee. For example, let’s assume on this same investment the manager has a defined hurdle rate of 6%; until the performance of this investment exceeds 6% the manager is not eligible to claim a performance fee.
Catch-Up
To solve the problem of when a manager becomes eligible to earn a Performance Fee, we used the Hurdle Rate. But this now creates a new problem: “What level of performance may a manager charge a performance fee on?”.
A Catch-Up mechanism solves for this. The two most common Catch-Up mechanism’s are No Catch-Up and Full Catch-Up, but Catch-Up’s can be structured in more complex ways.
In a No Catch-Up environment, the manager is only entitled to charge a Performance Fee on the performance exceeding the Hurdle Rate; so in the example we’ve been working through, if the Performance Fee is subject to a Hurdle Rate of 6%, No Catch-Up, then the manager is only entitled to a Performance Fee on the difference between the 10% overall performance and the 6% Hurdle Rate (being 4%).
In a Full Catch-Up environment the manager is entitled to charge a Performance Fee on the full performance realized; again, carrying through the example we’ve been working on, that would mean the manager is entitled to charge a Performance Fee on the full 10%.
Tiered Fee
This is not a widely used mechanism but the idea with a Tiered Fee is that the Performance Fee is not a fixed rate, but rather variable, and changes depending on whether there is positive outperformance and the level of this outperformance.
For example: instead of having a flat 20% Performance Fee, rather you would have something like the following:
Performance Threshold | Performance Fee |
1% - 5% above Hurdle Rate | 5% |
5% - 10% above Hurdle Rate | 10% |
10% - 20% above Hurdle Rate | 20% |
Fulcrum Fees
This is a very different mechanism in nature, and is not widely used (if at all).
For all other cases, we have never mentioned the managers Asset Manager (AM) fee that they may charge, as this is a completely different fee, one that would be earned regardless of performance.
With a Fulcrum Fee, the AM Fee actually forms part of the Performance Fee and is no longer guaranteed.
A Fulcrum Fee is made up of two parts, the AM Fee (being the base fee) and the performance kicker, being any addition over and above the base.
To earn the performance fee, the manager must still achieve a performance above a Benchmark Rate, but the Performance Fee is tiered; the more the Benchmark Rate is exceeded, the higher the Performance Fee. The tiers are set levels.
The catch here is that there is also a downside tiering, which is symmetrical to the upside tiering.
If the manager wants to design aggressive upside tiering, then the downside tiering must be equally as aggressive.
The biggest catch though is that in bad years, the manager doesn’t just not earn a Performance Fee, but because of the downside tiering can also reduce, or totally lose their AM Fee as well; earning absolutely zero in a given year.
For this reason Fulcrum Fees are seen as uncommercial and are generally not used.
Post Script
Before we move on it’s important to talk about the fact that Free-Riding is not an issue specific to managers, but can also be an investor issue that needs to be addressed.
Investment structures that do not record individual investors, or that do not keep a capital account of each investor, are most prone to Free-Riding.
Certificated Products with no Registered Investor Book (RIB) are prone to this issue.
For example, in an AMC with no RIB, all investors are treated equally regardless of when they enter the product. To explain the Free-Riding effect, it’s easier to show it rather than explain it.
Below is the time series for our example:
NAV Date | AMC NAV | HWM |
Jan 2026 | 1’350 | 1’350 |
Feb 2026 | 1’202 | 1’350 |
Mar 2026 | 1’475 | 1’350 |
Apr 2026 | 1’523 | 1’475 |
Assume that an investor subscribes to an AMC well after the AMC was originally issued.
At this time the prevailing HWM is 1’350.
In our example, assume that a Performance Fee is calculated and paid to the manager once per calendar quarter (in this case in March 2026).
Our investor subscribes to the AMC in February 2026, and pays 1’202 per Certificate.
In March 2026, the AMC performs well and exceeds the HWM.
On what amount is the performance fee calculated? On 1’475 - 1’350 = 125
But our investor actually realized a performance of: 1’475 - 1’202 = 273
So our investor gets 148 of Performance basically free.
“Rejoice With Those Who Rejoice; Mourn With Those Who Mourn” - Romans 12:15
Mechanisms defining when a manager may be eligible for a Performance Fee, and controls put in place to define the base of calculation for these fees is an important variable when setting up an investment opportunity, but it does not address what happens when investors start losing money.
Who fits the bill? And, to what extent?
Investing is risky business, regardless if you are the manager or the investor. Going into any investment an investor should be honest with themselves that they can lose money (even if they don’t want to).
Just like an entrepreneurial venture, the success rates of investment funds, even those run by skilled managers, frequently fail to beat a simple passive benchmark (Morningstar’s data puts successful funds at anywhere between 15% - 40% depending on category and year).
The mechanisms we’ve covered thus far are all focused on limiting managers from just charging whatever they want, whenever they want.
Investors would prefer to hedge all their risk, and demanding that managers foot the bill for any and all losses would be their modus operandi. There are cases where investors have a legitimate reason for making managers carry some of the losses, but the argument now needs to be switched: the manager does take on risk, but the investor knows what they are getting into (hopefully); they know that capital is always at risk. Invest at your own risk.
Therefore we now need to limit investors from claiming as much as they want from managers.
First-Loss Capital Arrangement
Managers investing a portion of their own capital into the same fund they are managing is not unheard of, and can be fairly common in private funds. By investing their own capital the manager signals to investors that they believe in their strategy and they are willing to align themselves with their investors.
In some cases, and this is not very common, the manager may subordinate their own invested capital in relation to the investors capital, to absorb losses first until their capital runs out and then investors start taking the losses.
Keep in mind that in this arrangement the manager may already have unlimited liability for being the General Partner (or similar role) in the structure; they are now increasing their risk position with this type of mechanism, so be prepared to pay higher fees.
Clawbacks
What happens in a case where the manager is able to secure strong performance on the investment portfolio in the first years, but significantly underperform in the later years?
Assume the following very simple scenario:
Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
Investment Start Value | 1’000’000 | 1’080’000 | 1’176’000 | 1’315’200 | 1’000’000 |
Investment End Value | 1’100’000 | 1’200’000 | 1’350’000 | 1’000’000 | 500’000 |
Performance (%) | 10% | 11.1% | 14.8% | (24.0%) | (50%) |
Performance Fee (%) | 20% | 20% | 20% | 0% | 0% |
Performance Fee (Value) | 20’000 | 24’000 | 34’800 | 0 | 0 |
Cumulative Gross Performance | 10% | 22.21% | 40.3% | 6.63% | (46.7%) |
In the first three years of this investment, the manager was able to generate 40.3% gross return. However in the last two years 61.9% of the performance was eroded. Overall investors have been hit with a compounded 46.7% loss over this 5 year period, but in real money terms lost 50% of their invested capital.
Notice though that the manager collected Performance Fees for Years 1, 2 and 3. They were eligible to do so.
But, is it fair that they get to keep this fee, if overall investors 50% of their invested capital? Many would argue not, and to keep incentives aligned, many argue that in order for managers to keep the Performance Fees they have been eligible to charge, they need to keep performance of the investments strong throughout its lifetime, and not just in certain years.
This is where Clawbacks come in; their use is aimed to incentivize managers to continue performing throughout the lifetime of the investment, rather than cash in early and walk away before the job is done.
Deferred Compensation
Depending on the investment strategy, investors may demand that where a Performance Fee is earned by a manager, not all of it is paid out immediately. Instead, a portion is paid out immediately, with the remainder paid out in tranches over time, and contingent on maintain an average performance over this period of time. Should the average performance drop then certain tranches will be revoked away from the manager.
“Nothing Is More Useful Than A Well-Timed Delay” - Jean de La Fontaine
The mechanisms to control calculation methods, entitlements and loss protection form the bulk of Performance Fee crafting, but there is an equally important element very few people consider, and this is the timing relating to when Performance Fee’s are calculated, as well as when they are paid out of the investment.
For the very keen eyed reader, you may have noticed that in all of our examples we have never defined a specific time period in which the Performance Fee is calculated and paid out. We have always been assuming that the Performance Fee is calculated and paid out at the end of each calendar year. In reality however, this is not always a given. This timing period is known as Crystallization.
Crystallization
The Crystallization period dictates when a Performance Fee is calculated and contractually owed to the manager.
When a Performance Fee is crystallized, it can no longer be adjusted.
Crystallization periods can be anything from daily, calendar weekly, calendar monthly, calendar quarterly, calendar semi-annual and calendar annual.
You are most likely to find Performance Fees crystallizing on a calendar annual basis for most funds, but just know that this is not always the case.
For Certificated Products, including Structured Products, its generally market practice that a Performance Fee is crystallized daily (unless otherwise defined).
Crystallization matters for both managers and investors.
For managers, the Crystallization frequency is a balance between maximizing the investments compounding return vs the timing of cash in bank.
The longer the Crystallization period, the more time the investment has to compound its returns, leading to a potentially higher Performance Fee payout. However, this also means the manager has to go for a longer amount of time without having that cash in its bank account. A short Crystallization period means more frequent cash payments to the manager, and this is better when considering the Time Value of Money (TVM).
For investors a longer Crystallization period also means more time for investments to compound their returns, which may mean a higher potential payout to the manager.
Shorter Crystallization periods means that cash exits the investment more frequently and therefore there is less cash invested and generating returns.
Cash Payout Frequency
Not to be confused with the Crystallization period.
Even once a Performance Fee has been Crystallised, when the funds actually get paid out to the manager may be different.
This is an important consideration for the manger as it means that the cash earmarked for Performance Fee payout is actually still invested and generating a return for investors.
When things are going well this doesn’t really matter (as it means potentially stronger investment performance in the next period), but when things start going bad, there is the chance that a negative return may wipe out that cash earmarked but not yet paid out; leaving the manager empty handed.
The Sum Of Its Parts
Everything discussed is a toolbox of mechanics and considerations that you can use when building a Performance Fee.
This article won’t teach you how to actually build the Performance Fee, that’s not really the point. Instead, I try to give you the details not really discussed or considered in general financial literature.
To actually go out and build a Performance Fee, that work needs to be undertaken by you; but I hope that you will consider these different mechanisms and pick and choose a blend that best suits your needs and the needs of your investors.
Whether you are a first time manager, an experienced manager, or even an experienced investor, my hope is that the details in this article help you see things a little bit differently and perhaps even approach your structuring or decision making differently.
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