Performance Fee

What is a Performance Fee?

A performance fee is a payment made to an investment manager for generating positive returns. This is rather than a management fee, which is charged regardless of returns. A performance fee can be calculated numerous ways. Most common is as a percentage of investment profits, frequently both realized and unrealized. It is to a great extent a feature of the hedge fund industry, where performance fees have made many hedge fund managers among the most well off individuals in the world.

Understanding Performance Fees

The essential reasoning for performance fees is that they adjust the interests of fund managers and their investors, and are an incentive for fund managers to create positive returns. A "2 and 20" annual fee structure — a management fee of 2% of the fund's net asset value and a performance fee of 20% of [the fund's profits](/ace feeder-fund) — is a standard practice among hedge funds.

Illustration of a Performance Fee

Envision an investor takes a $10 million position with a hedge fund and following a year the net asset value (NAV) has increased by 10% (or $1 million) making that position worth $11 million. The manager will have earned 20% of that $1 million change, or $200,000. That fee diminishes the NAV to $10.8 million which equals a 8% return independent of some other fees.

The highest value of a fund over a given period is known as a high-water mark. On the off chance that the fund falls from that high, generally a performance fee isn't incurred. Managers will quite often charge a fee just when they outperform the high-water mark.

Hurdles and Performance Fees

A hurdle would be a foreordained level of return a fund must meet to earn a performance fee. Hurdles can appear as an index or a set, foreordained percentage. For instance, if NAV growth of 10% is subject to a 3% hurdle, a performance fee would be charged exclusively on the 7% difference. Hedge funds have been famous enough in recent years that less of them use hurdles currently compared to the years after the Great Recession.

Pundits of performance fees, including Warren Buffett, think that the slanted structure of performance fees — where managers share in the funds' profits however not in their losses — just entices fund managers to face greater challenges to create higher returns.

Performance Fee Regulation

Performance fees charged by U.S. registered investment advisors fall under the Investment Advisers Act of 1940 and fees charged to pension funds represented by the Employee Retirement Income Security Act (ERISA) must fulfill special requirements. Hedge funds are, of course, outside of this group.