Offering Legal, Tax, Business & Banking Services to Hedge Funds & Fund Managers Worldwide
Performance & Management Fees Hedge fund manager (and managed account) adviser compensation typically consists of the management fee and the performance allocation (also referred to as a performance fee, incentive allocation, and/or carried interest). Unlicensed fund managers and managed account advisers can generally charge any fee they, assuming their clients are willing to pay it. Licensed fund managers and managed account advisers may be subject to restrictions, depending on where there are licensed. Some U.S. states impose restrictions on client fee arrangements similar to the SEC’s. Some U.S. states prohibit any use of performance fees, place different limits on who can be charged performance fees, and/or impose restrictions on how performance fees are calculated. Fund mangers should make full and fair disclosure of the fees they charge investors. Fund managers and managed account advisors should research the rules and regulations concerning advisory fees and charges in the state(s) in which the advisors do business. We handle SEC Investment Adviser Registration and State Investment Adviser Registration We also assist with investment adviser licensing in the British Virgin Islands, the Cayman Island and St. Lucia. Contact Us For Help
Contingent Management & Other Fees Investment advisers may accidentally charge a performance fee when it waives or refunds management fees if a fund's (or a client’s account) does not meet a specified level of performance. A contingent fee arrangement provides for a fee that is based upon a share of capital gains or capital appreciation because the client's obligation to pay the fee is dependent on the client's account achieving a specified level of capital gains or appreciation. When management and other fees are contingent (or in effect based on a share of capital gains or appreciation) they are in fact performance fees. See Contingent Advisory Compensation Arrangements SEC Rel. No. IA-721 (May 16, 1980). SEC registered investment advisers can charge performance fees only to qualified clients. Many states now allow performance fees to be charged only to qualified clients as well and some states do not allow performance fees at all.
State Law Impact on Performance Fees Many state RIAs are confused when they read their home state securities statutes. Most states, with a few twists, allow for performance fees. Learn More About Investment Adviser Registration Some states use the older federal law definition of "qualified client" with the result that in some states, a registered RIA can charge the performance fee to what is in today's currency, an "accredited investor." Do not assume that your home state allows for "plain vanilla" performance fees or that you can charge them to everyone. Learn More About Accredited Investors
Management Fees can be assessed monthly, quarterly, semi-annually and annually. The Management Fee, if charged, is charged against aggregate assets under management of a fund, regardless of the fund’s performance. The Management Fee is deducted from each investor’s account periodically (either in arrears or in advance) as set forth in the offering documents. The Management Fee is subject to ordinary taxable income rates and is considered self-employment income and subject to FICA taxes (in addition to the Unincorporated Business Tax for fund managers located in New York).
Performance Allocations are a percentage of the increase in the value of the fund assets allocated to the fund’s general partner as an incentive for positive performance. The Performance Allocation aligns the interests of fund management with those of the investors. When properly structured, a performance allocation is not considered a “fee,” but a reallocation of partnership profits from an investor’s capital account to the general partner’s capital account. Learn More About Hedge Fund Taxes and Contact Us For Help
Is Running a Hedge Fund Profitable? Yes. Hedge fund managers typically demand management fees of 1% to 2% of assets under management (AUM) as well as performance fees of 20% to 50% of net trading gains. This income can be substantial! If you had $2 million AUM and a 1% management fee and a 20% performance fee, you would have combined fee income of fee income of $140,000 from a $20,000 management fee ($2 million x 1%) and (assuming fund performance of 30%) performance fee income of $120,000 ($2 million AUM x 30% performance=$600,000 x 20%). If you had $5 million under management, you would have combined fee income of $350,000. If you had $1 billion under management, you wuld have $50million in combined fees, assuming fund perforance of 20%.
Best Practices for Hedge Fund Performance & Management Fees The fund's offering documents must clearly spell out the manager's approach to charging fees. Learn About Hedge Fund Offering Documents The offering documents should include a description of the fee schedule; the exact formula used to calculate fees owed, including where appropriate, example calculations; the time period for fee calculations; and the source of information to be used to calculate the fee payments. Hedge fund fees should be calculated based on audited portfolio valuations. Where the period of audited financial valuations does not coincide with the fee calculation period, investors should familiarize themselves with the hedge fund manager's portfolio valuation methodologies and the processes used to prepare the fee calculation. Once audited financials become available, the fee calculations should be reviewed and adjusted for any valuation differences. Performance Fees should be based on dollars of value added and not as percentage returns or average capital invested for the calculation period. Performance fees computed as carried interest should be calculated based on net value added as opposed to gross value added. Offering documents should define "net value added" upon which performance fees are calculated (gross value added less any other expenses charged to the hedge fund). Offering documents should discuss all types of possible expenses and other charges that potentially could be deducted from fund assets. These expenses may include, but are not limited to: legal expenses, accounting expenses, trustee fees, administrative fees, marketing and sales fees, custodial fees, and general investment management charges. Performance fees should be calculated over a period of time that is appropriate given the volatility of the hedge fund strategy's returns and any lock-up period required by the hedge fund manager. Generally, the more volatile the investment strategy, the longer the period included for calculating the performance fee.
Drafting Your Performance Allocation The performance allocation of profits in a U.S. hedge fund is not a fee, but rather an allocation of profits (separated into all of its components) from a tentative allocation to an investor's capital account to the manager's capital account. From the standpoint of partnership tax law, it is as though the investor never saw the re-allocated amount. Learn More About Hedge Fund Taxes In an offshore hedge fund, the incentive share is in fact a performance fee. To convert the performance fee to a performance allocation, a mini-master fund may be used. Learn More About the Mini-Master Fund
Example 1 Hedge Fund, LP, has a General Partner LLC. On January 1, 2013, new limited partner RL makes his only capital contribution of the year of $1 million. His ending book capital account prior to reallocation is $2 million. He is subject to a 20% performance re-allocation. As of December 31, 2013, $200,000 of capital account value is re-allocated from RL's account to LLC's. RL's ending book capital account is $1.8 million.
High-Water Mark High water marks are widely used and are considered a market standard best practice. The high-water mark's function is to make sure that a manager who has made money for an investor and then loses part of that capital cannot take a performance allocation (or incentive fee) until the loss has been made up. To accomplish this, a high water mark is established immediately following the allocation of the performance allocation. As a result, a performance fee can be taken only on the profits above the high-water mark. A performance allocation is always calculated with respect to the fund's economic performance. Further, since investors may join a hedge fund at different times, it is necessary to track high water marks for specific for each investor.
Example 3 Same as Example 2, except that in 2014, the fund makes 100% (economic) return and RL's (tentative) book capital account is $2.7 million. LLC is entitled to a re-allocation of $180,000 ($2.7 million less the high-water mark of $1.8 million x 0.20). If there is no high-water mark, LLC's re-allocation is $270,000 ($1.35 million x 0.20) and RL would have been subject to a re-allocation twice on the same amount. If the investor is a fiduciary account (trust account, pension plan, endowment, etc.) the prudential concerns of the fiduciary may well require that the fiduciary invest in a fund that has a high-water mark. In any event, the absence of a high-water mark provision may be viewed as indicative of a fund manager not overly concerned with issues of fairness to investors.
Hurdle Rate Many hedge funds also have a "hurdle rate" provision. Hurdle rates are used to guarantee that the hedge fund achieves a minimum investment performance before the fund's manager can receive a performance allocation. Hurdle rates establish a floor that the investment adviser must exceed to obtain performance fees. Some funds require a certain level of return, either as a fixed percentage or a benchmark rate (i.e., such as LIBOR or the S&P 500) before the payment of performance fees. Hurdle rates can be either "hard" or "soft". A hard hurdle rate means that the manager only receives performance compensation that exceeds the hurdle rate (i.e., the incentive allocation is charged only on economic profits made above the hurdle rate). A soft hurdle rate means that no performance compensation is received if performance falls short of the soft hurdle rate, but once the soft hurdle rate is exceeded, the manager is entitled to the entire performance compensation (i.e., once the hurdle rate is achieved, the performance is based on the entire economic profit.
Combing a Hurdle Rate and a High Water Mark A high-water mark and a hurdle rate can be combined.
Example 4 Same as Example 1, except that the incentive allocation is chargeable only after RL's book capital account earns a rate exceeding the federal funds rate plus 200 basis points, determined each year based on the rate in effect on the first business day of that year, and that the performance is chargeable only to profits exceeding that hurdle rate. With a hurdle rate of 4.5% for 2013, the incentive reallocation of profit is $155,000 ($1 million x [0.2 - 0.045]).
Example 5 Same as Example 4, except that the incentive allocation is chargeable in full to the profits, provided that the hurdle rate is met for that year. The incentive allocation is $200,000 (same as Example 1). The hurdle rate is optional; it provides an additional layer of computational complexity to whichever of the two alternatives is chosen, although the first alternative is clearly more complex. In some funds, the hurdle rate is quarterly, or even monthly, which is certainly an additional complexity and administrative expense as these calculations must be checked by the fund's accountants. Further, in some funds, the hurdle rate is cumulative; thus in Example 3 above, RL's hurdle rate would have to be calculated separately to determine what the performance allocation is when profitable years kick in.
Withdrawals Many issues go into the performance's calculation. For example, how is performance calculated when an investor withdraws, in whole or in part, prior to the end of the tax year; if there is a hurdle rate, should it be annualized or applied in full?
Example 6 Same as Example 4, except that RL withdraws June 30, 2013. Should the hurdle rate be 4.5% or 2.25%? Proration is the standard practice.
What about the high-water mark when an investor withdraws only part of their capital?
Example 7 Same as Example 2, except that RL withdraws half his (much depleted) capital account of $900,000 on December 31. Should his high-water mark be $1.8 million or prorated to $900,000? If $1.8 million, the manager is unlikely to realize a penny of performance from RL for a very long time, if ever. If prorated to $900,000, LLC at least has a fighting chance of making good and earning performance. Again, proration is the standard practice.
Written By Hannah Terhune, Esquire (Copyright 2008 - All Rights Reserved) Reprinted in part with Permission. Portions of this article were originally published in part "Derivatives: Financial Products Report" an RIA publication, September 2005, as 'Hedge Funds - Do's and Don'ts for Crafting Hedge Fund Performance Allocations' by Hannah Terhune, Esq. and Roger Lorence, Esq.
Keep Fund Accounting Simple The fund manager who has a highly complex performance allocation and expects the financials and tax returns by March 1 is tempting fate. The manager must recall that once the investor is promised something, less cannot be given. At the very least, no fund manager wants to go back to investors and ask them to sign amended fund documents about how the manager's own cut of the profits is determined. The preceding examples discuss critical points to be considered in drafting the performance/incentive provisions, both from the manager's and the investor's standpoint. The foregoing examples do not discuss the rules for commodity pool operators (CPOs) under the jurisdiction of the CFTC. The CFTC (and the industry self-regulatory organization, National Futures Association) have no comparable restrictions on a CPO's entitlement to performance, provided that the investor receives appropriate disclosure and consents in writing to a performance-based compensation (or allocation of profits). Because many funds trade both securities and commodities, the SEC rules on performance typically govern the outcome.
Call Us First We are experts in international hedge funds and tax. Click on any reference below to our leading articles: