Management Fees

These fees are determined by portfolio returns and are intended to reward managers who create value. Performance-based fees are structured in one of three basic ways:

Symmetrical structure in which the manager is fully exposed to both the downside and upside:

$$
\textbf{(Computed fee} = \textbf{Base} + \textbf{Sharing of performance).} $$

Symmetrical fees tend to be unpopular with managers as they increase their risk of bankruptcy. According to a utility maximization model, this style of fee tends to yield better alignment between investors and managers.

Bonus Structure in Which the Manager is Not Fully Exposed to the Downside but is Fully Exposed to the Upside

[Computed fee = Higher of either (1) Base or (2) Base plus sharing of positive performance]

Bonus-style fees are akin to a manager's call option on active return, with the base fee as the strike price. The option's payoff is adjusted by a maximum fee cap. This concept involves three fee components: a base fee, a long call option on active return (strike price equals the base fee), and a less valuable call option (strike price equals the maximum fee).

Managers may increase portfolio risk as the value of their call option benefits from higher portfolio volatility. It's important for senior managers to establish penalties for excessive risk-taking and rewards for strong performance in compensation structures.

A Bonus Structure in Which the Manager is Not Fully Exposed to Either the Downside or the Upside:

[Computed fee = Higher of (1) Base or (2) Base plus sharing of performance, to a limit].

These fees may include maximum and high-water mark (or clawback) features that protect investors from situations such as paying for current positive performance before the negative effects of prior underperformance have been offset. Highwater marks prevent investors from paying performance fees on portfolio appreciation below an already achieved level. These clauses are common in hedge funds.

In private equity, a common provision is a requirement that the limited partners (investors) receive their principal and share of profits before performance fees are distributed to the general partner (the manager).

Issues with Performance-based Fees

Other problems exist with performance-based fees. Managers may favor clients with performance-based fee arrangements over other clients. This could result in, for example, allocating more profitable trades to those clients or giving them access to a limited IPO, which could benefit the manager at the other client's expense.

When managers can control the timing of profit realization, as is often the case with private equity partnerships, they may have an incentive to hold on to assets until a profit can be realized. Managers may do so even when clients would benefit from selling assets at a loss and investing the proceeds outside of the partnership.

In contrast, hedge fund managers have an incentive to return assets in poor-performing partnerships when the high-water mark is substantially above the current value. This may be done with the intention of looking for other opportunities to earn money elsewhere and thereby closing shop when the current situation is not in the manager's favor. This action results in the investor missing the opportunity to recoup previously paid fees based on future strong performance.

Funds of funds (FoFs) commonly charge fees in addition to the fees charged by the underlying funds. These fees pay for the investor's access to the underlying funds' expertise. In addition to these two sets of fees (from the FoF and the portfolio hedge funds), investors are required to share the profits from viable underlying funds but incur the full loss from those who underperform.

Performance Measurement: Learning Module 2: Investment Manager Selection; Los 2(h) Describe the three basic forms of performance-based fees