BULLS & BEARS: Hedge fund fees should link pay to performance

A performance, or incentive, fee is an arrangement where the investment manager is compensated by collecting a percentage of the annual profit earned by an investment fund. Performance fees, when properly structured, can be a fair deal for both the investor and the investment manager.

However, pay for performance is a bit of a misnomer when it comes to the fee structure of many hedge funds today. Often, hedge fund managers can receive substantial compensation even if their fund produces unremarkable returns.

Consider the most common performance fee structure used by hedge funds: a 1-percent annual management fee and 20 percent of profits. If the hedge fund achieves a gross return of 5 percent for the year, the manager earns a 2-percent fee (1 percent plus 0.2 times 5 percent) and the fund’s investors keep 3 percent. Using the same math, if the fund earns a 10-percent gross return for the year, investors net a 7-percent return and the manager collects 3 percent.

In both cases, the hedge fund manager receives a lucrative payday, while failing to achieve to the long-term average return of the stock market. Also, note that the fund’s investors in these examples earn “bondlike” returns while assuming considerably more risk than a fixed-income investment.

This inequity can be corrected by structuring a performance fee to do what it is meant to do: Reward the investment manager who produces above-average investment results with higher compensation. One way of accomplishing this is the use of a “hurdle rate.”

For example, the investors in the fund must earn, say, a 10-percent return (the hurdle rate) before the manager shares in any percentage of profits. Thus, if a manager is able to achieve, say, a 25-percent return, he will earn a 4-percent fee (1 percent plus 0.2 times the 15-percent return in excess of the hurdle rate) and the fund’s investors share in the spoils with a net 21-percent return. However, if the fund earns 10 percent or less, the manager is merely paid his management fee.

Another way to structure a performance fee that is equitable to both investor and manager employs a maintenance, or “keep the lights on,” fee. The maintenance fee is a greatly reduced annual management fee of, say, 0.3 percent.

The manager then charges an additional, but reasonable, performance fee. Under this type of arrangement, even more of an onus is placed on the manager’s investment performance. Here, low investment returns result in low compensation levels that only increase in scale as investment results ratchet higher.

Investors need to weigh the pros and cons when entering into investment vehicles such as hedge funds, private equity funds and venture capital funds, all of which typically use performance fees.

One criticism of performance fees is that they apply too much focus on short-term results and encourage investment managers to adopt a gun-slinging investment behavior. This is partly why regulators restrict the use of performance-fee investment contracts to wealthy investors and institutions.

In the end, when selecting among investment vehicles, adopting a discerning and rational approach applies just as it should any investment opportunity. Investors should seek investment managers who have a prudent investment strategy and a compensation arrangement that is fair for both parties.