Performance Fees – Good or Bad? Part I

Guest Contributor: Carl Bacon, Chairman, StatPro

After a brief lull during the credit crisis, performance (or incentive) fees are again becoming increasingly high profile. An excellent time therefore to pose two questions: Are they a good thing? And if used, how should they be structured?

Supporters of performance fees would suggest that they are desirable because they align the interests of the asset manager with the investor. If the manager performs well, the investor’s assets rise in value. For the most part investors appear happy to pay performance fees for good performance. If the manager performs poorly only a smaller base fee and no incentive fee is paid.

Those not in favor claim that rather than aligning interests, performance fees create a conflict of interest, and for the most part are biased in favour of the asset manager. Certainly during my 25 year plus career in asset management performance fees have had a beneficial impact on revenues. In the first 10 years the pressure on fees trended down. For the last 15 years average fees have increased significantly across the entire industry. Hedge funds demonstrated to the entire industry that clients, including institutions (and the hedge fund industry has become more institutionalised during this period), are prepared to accept high management fees if they are dressed up in the form of a performance fee. Hedge fund clients first accepted 2 % annual fees plus a 20% incentive fee, and just before the credit crisis 3% annual fees and 30% incentive fees(or even higher) were not uncommon. Recently fees may have dropped back to 1.5% and 15% but are already showing signs of reverting back to 2% and 20%.

Of course the answer really depends on how the performance fees are structured. There are many flavors, but essentially there are two main types; asymmetric and symmetric. Asymmetric fees shown in the diagram below are by far the most common and are very seductive to investors.

Typically asset managers will present these types of fees to clients at a base fee rate considerably lower than their normal management fee with an incentive fee only for performance greater than a hurdle rate. Clearly there is considerable variation in the hurdle rate, angle of the participation rate, time period, excess or absolute return, caps and collars and perhaps a high water mark but the basic structure is the same. This is attractive to investors; they are paying a lower fee and will only pay higher fees if the manager performs well.

A rare alternative would be a symmetric structure. In this type of structure the base fee would probably not be lower and may even be higher than the normal management fee. Incentive fees are paid for outperformance, but crucially fees are rebated for underperformance to the extent that the asset manger may ultimately make a net payment to the client if performance is sufficiently bad. Though unpopular with asset managers, these types of fees genuinely align the interest of both parties.

To read Part II please click here.

About Maureen Lowe

President and Founder of Financial Technologies Forum, LLC. Editor-In-Chief of FTF News. Entrepreneur, Jersey Girl that recently returned to Jersey, Loves to Bake, Married to a Kiwi, First Time Mom
This entry was posted in Back-Office, Guest Blog, Performance Measurement and tagged , , . Bookmark the permalink.

One Response to Performance Fees – Good or Bad? Part I

  1. Pingback: Performance Fees – Good or Bad?… Part II | The Bull Run

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