Performance Fees - Part 3
Part 3 - Operations
Before modern day maritime insurance existed, merchants who funded ship voyages were each individually at risk that if the ship their cargo was on was at risk of sinking, the crew of the ship could choose to throw any cargo overboard to save the entire vessel.
A merchant who had their cargo thrown overboard lost everything; alone. The merchants whose cargo was never thrown overboard, because the ship was already saved by that point, got their treasure and bore no loss.
The risk of loss, and the loss itself, was never shared fairly between all merchants.
It wasn’t until the introduction of the General Average principle, that merchants all shared the risk of loss, or the losses themselves, proportionally.
The principle was an agreement between all merchants in a sea venture to share any losses in a voluntary sacrifice proportionally amongst all merchants.
Key to this mechanism was the agreement in advance by all merchants on how the proportional sharing would be calculated, in other words, all parties had to agree upon a specific number in order to achieve alignment.
Once that number, or formula, existed, no merchant had to fear being the one whose cargo was sacrificed to save everyone else; the cost was already spoken for and agreed upon, shared in advance, before anyone knew whose cargo it would be.
This need to agree upon a number is just as important when constructing Performance Fee’s, because as we will cover in this Part of the Series, determining how the final Performance Fee figure is calculated needs to be clearly agreed upon upfront in order to truly achieve alignment between investors and the manager.
The River Moves, Whether You Like It Or Not
Whether we like it or not a Performance Fee is not a static, single calculation, done once in a period and then forgotten about.
Once your investment begins, it never sits still. Changes in values, cash flows, allocations, redemptions, fees, etc. all have an ongoing effect to the performance of your investment.
These constant changes to the performance of the investment means that the Performance Fee attributable to the manager is in constant change.
This constant change creates a unique challenge: how do you calculate and publish a Net Asset Value (NAV) with an ever changing Performance Fee? Or actually the real question is at what point do we all agree upon a number that becomes the agreed Performance Fee?
We have touched on Crystallization before, but this is really where it comes into play. Crystallization happens when a Performance Fee calculation is final and can no longer be adjusted.
When this event occurs is important to define, running the Performance Fee calculation before or after this point can lead to a completely different figure being produced.
As a quick example, say you have an investment that is highly liquid, it allows investors to subscribe to or redeem out of the investment daily. In such a case it would make sense to crystallize a Performance Fee daily, so that the NAV of the investment that is being published is a true NAV (ie: it accounts for all fees).
By contrast, an illiquid investment would only crystallise a Performance Fee at select intervals, this could be calendar monthly, quarterly, semi-annually, annually, or even longer.
A Performance Fee that is Crystallised daily is also accrued daily, until it is eventually paid out to the manager.
This may or may not hold true for a Performance Fee crystallising at specific periods.
However life is never black-and-white, and a Performance Fee is not always calculated on the Crystallization date. Consider a case where the investment may be illiquid, with a Performance Fee crystallising at set intervals, but still allowing investors to subscribe to or redeem out in-between these intervals (lets just say daily).
A NAV still needs to be published daily, as this will be the price used for all subscriptions and redemptions.
It is here that we introduce the concept of a simulated Performance Fee (shadow performance fee as some like to call it). The basis of this Performance Fee calculation comes from the question “if today was the crystallization date, what would the Performance Fee be?”.
Everyday a Performance Fee is calculated and used to calculate a NAV, which is then published to market.
However this Performance Fee is not crystallized. What it is, is just an accounting entry for the day; a way for the NAV to be calculated.
And as it is not Crystallised, this means it also does not accrue.
This is a very important point to keep in mind as it trips up a lot of people: a simulated calculation is a calculation run on the day; and because it is a simulation it is not an accruing number; and because it is not an accruing number this means that by the end of the day the calculation is totally erased. An entirely new calculation is run the next day, and so on.
Calculating a simulated performance fee also has two further effects: (1) it smooths out the NAV of your product, so that on the Crystallization date when a Performance Fee is calculated and Crystallised, there is no large drop in NAV; (2) it also helps with equalizing positions between investors already in the investment and those coming in at a later stage.
The second point we will go into greater detail in the next section, but for point 1 lets consider a scenario where no simulated Performance Fee is calculated, to illustrate the issue at hand:
Where a simulated Performance Fee is not used
In the table above we are not concerned about movements due to the trading performance of the investment (ie: change in asset values), instead I want you to focus on the change in NAV on the Crystallization date.
Notice how the sudden calculation and Crystallization of the Performance Fee causes a drop in NAV value by 0.62%.
This is the key point: it’s a change in NAV value not due to a change in the value of the assets.
Now consider when a simulated Performance Fee is used:
Where a simulated Performance Fee is used
Again, ignore changes in NAV due to trading performance, and focus only on the change in NAV value on Crystallization date.
Note how the change is non-existent.
This is because we have been “smoothing out” the effect of the Performance Fee since the start of the period.
So which is the correct method? The truth is there is no “correct” method; either method can be used, but it really depends on the level of transparency you want to give to investors. Some managers stand firmly that if a NAV is being published, it must reflect the full economic effect of the investment.
Other managers believe that a simulated Performance Fee is not a true economic indication of the investments performance, and that a NAV should be published without it, while having full disclosures made to investors about this fact.
In the end, the choice is yours. But make sure that whatever you choose is clearly explained to your investors!
Reality is Just Perception
Performance is not realized equally by each investor.
This is not because of the size of the investment each investor has made, but rather due to two very important factors: (1) the time when the investor subscribed to the investment (or redeemed from the investment), and (2) the price the investor paid to subscribe to the investment (or the price sold at, to redeem from the investment).
This creates the challenge of needing to measure each investors relative performance so that as the manager you can charge a fair Performance Fee.
What do I mean?
Consider the below:
In the table above we are tracking the overall performance of an investment.
The NAV starts at 100 and ends at 106.6 at the point that the Performance Fee crystallizes, equating to a total performance of 6.6.
However, is this really the performance that each investor realizes?
Keep this investment in mind, and now lets consider two investors subscribed; each having subscribed at different times:
Investor 1 subscribed to the investment at the beginning.
However, Investor 2 subscribed to the same investment, but in Period 3.
This difference in time subscribed and price paid has created dramatically different performance results.
If a manager had to charge a Performance Fee on the total performance of the investment then, every investor would need to pay 10% of 6.6.
For Investor 1 this is fair, they also realized a performance of 6.6.
But for Investor 2 this hardly seems fair, especially when their performance was only 0.5.
Keeping track of investor performance is clearly important, but the ability to do so relies heavily on the investment structure setup.
Where the investment structure has a recorded list of investors (a Registered Investor Book (RIB)) managers will keep an individual account for each investor.
This account records the date the particular investor subscribed to the investment, the price paid, and all income and expenses related to their proportion of the investment.
This is called Capital Accounting, and if you have invested in funds, especially private market funds, you’ve likely received a capital account statement before.
But not all structures keep an RIB. If you have been following my articles, you will know that an Actively Managed Certificate (AMC) is usually setup without an RIB.
This means it is physically impossible to record every investor’s relative performance; everyone is lumped together and charged an overall Performance Fee based on the overall performance of the investment.
This is known as Pooled NAV accounting. The benefit is that it keeps things simple; there are fewer accounts to maintain and far less overhead to incur when running your investment, but the drawback is clear: it does not fairly charge a Performance Fee to each investor.
To solve for this, managers setup no-RIB structures as either Series Structures, or Note Programs.
What this means is that one main investment is built, usually called the Main Program; investors are grouped together based on the time they subscribe to the investment, usually as defined intervals. Each group is assigned their own ISIN code (usually called a Series), and each series is individually tracked to calculate a Performance Fee that is specific and relative to that series.
This helps avoid having to convert a no-RIB investment structure into one with an RIB, and solves the issue of calculating a Performance Fee that is relative and correct for each set of investors.
You Owe Me
A specific asset type needs to be touched on here before we move on, because the nature of this asset has a unique effect on NAV calculations.
Assets like private credit, leased real estate, and in some cases listed fixed income, not only have fluctuating values, but uniquely they are income generating assets. (Yes, dividend stocks are also an income generating asset, but in most cases the dividend paid is not a contractually defined number, and for this reason I am leaving dividend stocks out of this example).
For an investment made up of a portfolio of income generating assets, the price an investor must pay to subscribe (or sell to redeem out) to the investment is incredibly important.
Consider an investment portfolio made up of listed equities and listed fixed income. Generally for these assets there are prices published daily, so you know on any given day what the going market rate is to buy or sell these assets.
But a private credit investment is a completely different animal. There are no daily prices being published (known in the finance world as “Mark to Market”). Quite often an investment in private credit is valued at cost, and changed only upon a realization event, such as: the receipt of interest, or the confirmation of an accrued interest position, or the event of default.
So if Investor 1 subscribed on day-1 and paid 100, what does Investor 2 pay when they subscribe several months or years later?
Let’s look at this in numbers. We’ll consider a very simple private credit investment.
A loan of 100 is made, where interest of 10 is calculated each month (on a straight line basis), but is accruing on a calendar quarter basis.
When the interest accrues it does not get capitalized (ie: added to the outstanding loan amount), we are keeping things simple. The interest that has accrued all gets paid out in cash after the end of each calendar year.
Notice how on each accrual period the NAV changes, now reflecting the amount of interest accrued and owed to the Lender.
At the end of Quarter 1 a total of 30 interest has accrued and is now a booked asset, alongside the outstanding loan amount, so the NAV goes from 100 to 130. This process continues each quarter, until all accrued interest is then paid in cash to the Lender; which is why you see a -120 in period 12, and the NAV drop back down to 100 (to its original cost value).
Assume Investor 1 subscribes at the beginning and pays 100. At the end of the year, Investor 1 will receive 120 worth of interest.
Later on Investor 2 wants to subscribe to the investment as well, how much should Investor 2 pay to subscribe if they subscribe in Period 2, or perhaps Period 6?
In Period 2 the NAV of the investment is still 100. But is 100 a fair price to pay? Assume Investors 2 subscribes to the investment on Period 2 by paying 100. At the end of the quarter interest accrued and both Investor 1 and Investor 2 now have a claim to receive an additional 30. But Investor 1 had to wait 3 months to have this accrual, which Investor 2 only waited 2 months to receive the same gain.
When we look at this in yield terms, Investor 1 is earning a yield of 10%, whereas Investor 2 is earning a yield of 15% but essentially doing nothing special.
This is a major problem.
Let’s assume that Investor 2 decided to rather subscribe in Period 6. What should Investor 2 pay?
Should Investor 2 pay 130, or pay 160?
By the end of the year, the investment will have a NAV of 220: 100 of capital plus 120 of accrued interest, before any interest is paid out in cash. By Period 6, 60 of that interest has already accrued, which leaves 60 still to accrue.
If Investor 2 pays 130, then they should end off the year with a NAV of 190, and not 220. But we already know that the investment will end the year off with a NAV of 220; so Investor 2 lands up scoring 30 interest for free simply by paying an incorrect price.
Another major problem.
So how do we solve this? If Investor 2 subscribed to the investment at any point after the start of the Period but before the end of Period, meaning before accrued interest is paid out in cash, then the buy price that Investor 2 pays must be the NAV adjusted for accrued interest until that time. This is called equalization and it ensures that some investors don’t get a free ride.
So for the sake of clarity, if Investor 2 subscribes in Period 2, then they should pay 110, being NAV of 100 plus 10 accrued interest.
If Investor 2 subscribes in Period 6, they should pay 160, ensuring that they end up accruing the same amount go interest like all other investors, pro-rata to their time in the investment.
Mind the Gap!
Mind the Gap!
Crystallization settles the debate of when a Performance Fee calculation is finalized.
However, it does not cover when the manager actually gets paid.
In many cases there is a time gap between a Performance Fee crystallizing and when it finally gets paid to the manager.
This timing gap creates a unique risk for the manager, because until it is paid, the manager’s money is still in the investment, essentially giving a form of free funding to investors: any return generated during this time goes almost 100% to the investors, but not to the manager.
The longer this timing gap exists for, then the longer the manager is providing this free financing, and the longer the manager depends on the vehicle’s ability to pay. If assets turn illiquid, or the vehicle fails before the cash leaves, the manager has become an unsecured creditor of the very investment they manage, something they may never have agreed to.
The most obvious solution to this problem is to simply have the manager paid as quickly as possible, but this not always possible. Depending on the investment structure and the underlying assets, the calculation and finalization of the NAV of the investment can take longer than expected.
In these cases there exists several solutions:
Managers will segregated cash to cover their fee into a separate account, only being paid out once the NAV of the investment has been finalized and approved by the administrator or calculation agent.
Some investment structures will have the managers crystallized fees rank as high priority in the Priority of Fee Payments, to ensure that as soon as payments are being made, the manager’s fee is one of the first to be paid out.
For the use of the manager’s funds as a free source of financing, some managers will actually charge interest for every day their fee has not been paid.
For more illiquid assets, such as Private Equity, managers will have a Performance Fee calculated, crystallized and paid out only upon a realization event, such as buyout, an IPO, a successful sale, etc.
This is Where I Leave You
Accurate NAV calculations and clearly defined Performance Fee crystallization periods are not only important for investors who want to subscribe to your investment, but equally as important for investors seeking to redeem out of the investment.
I want you to go back to the first example investment we used, where the investment was inherently liquid, but a Performance Fee was being calculated on a periodic basis.
We solved the issue of daily NAV pricing by calculated a simulated Performance Fee daily.
This simulated Performance Fee allowed us to price the investment daily, so that on any particular day, an investor wishing to subscribe to the investment would have an accurate price to pay.
Assume however, that this same investment has an existing investor that wants to redeem out of the investment mid-period (ie: when the Performance Fee has not yet been crystallized).
Pricing this redemption is already solved for thanks to the use of a simulated Performance Fee.
By using a simulated Performance Fee we are charging the investor a Performance Fee when they leave the investment. The calculation is accurate as of that day, and so the deduction will be fair.
However, for investors leaving the investment mid-period, their Performance Fee is crystallized on the day their redemption is settled (ie: they are physically exited from the investment).
This is the scenario where a simulated Performance Fee is actually used as the true Performance Fee, making the simulated calculation not just a nice-to-have for NAV calculations but an actual necessity.
Without using a simulated Performance Fee, an investor leaving could theoretically leave the investment without paying their share of a Performance Fee. So who pays for this?
The manager carries the loss themselves.
However, keep in mind that just because the Performance Fee has crystallized already, this does not mean that the cash relating to this fee is already paid to the manager. Quite often there will exist a timing gap that needs to be understood by the manager.
This wraps up the three-part series on Performance Fees.
While it may not be the most exciting series for every reader, Performance Fees remain one of the most misunderstood, but also one of the most powerful, alignment fees in a managers toolbox. When built incorrectly it can lead to disaster. But when crafted with thought and respect, it can act as an effective conduit in the pursuit of success.
My hope is that you will use this series as an ongoing reference guide for your own investment journey.
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