Performance-based fees align the interests of investors and managers by sharing investment outcomes, incentivizing managers to achieve better performance. These fees can be structured in three basic forms, each with unique characteristics:
1. Symmetrical Structure with Full Upside and Downside Exposures
- Formula: Fee = Base fee + Performance sharing (on both positive and negative returns).
- Characteristics:
- Full alignment between investor and manager incentives.
- Managers experience the full downside risk in poor performance periods.
- Provides strong incentives for managers to achieve higher returns.
- Advantages:
- Strongest alignment of interests.
- Encourages responsible risk-taking.
- Disadvantages:
- Increased risk for the manager due to exposure to losses.
2. Bonus with Full Upside and Limited Downside Exposures
- Formula: Fee = Greater of:
- Base fee.
- Base fee + Sharing of positive performance.
- Characteristics:
- Managers participate in gains but are insulated from losses.
- No penalties for underperformance.
- Advantages:
- Motivates managers to outperform without penalizing underperformance.
- Provides a baseline fee to ensure operational continuity.
- Disadvantages:
- Potential misalignment, as managers may not bear the cost of underperformance.
3. Bonus with Limited Upside and Downside Exposures
- Formula: Fee = Greater of:
- Base fee.
- Base fee + Sharing of positive performance (capped at a maximum fee).
- Characteristics:
- Limits both the manager’s bonus and downside.
- Suitable for investors seeking to cap costs while incentivizing managers.
- Advantages:
- Reduces investor costs by capping fees.
- Balances incentives and risk-taking by the manager.
- Disadvantages:
- May limit manager’s motivation to achieve exceptional returns.
Implications for Return Distribution
- Performance-based fees make gross active return distributions asymmetrical in their net active return distribution:
- Lower relative variance on the upside compared to the downside.
- Standard deviation, a symmetrical risk measure, may underestimate downside risk.
Advantages of Performance-Based Fees
- Investor Benefits:
- Lower fees during periods of low active returns.
- Encourages managers to strive for higher returns.
- Manager Benefits:
- Incentivizes effort and innovation.
- Aligns compensation with performance outcomes.
Disadvantages of Performance-Based Fees
- Base Fees Always Charged:
- Investors pay base fees even during underperformance.
- Potential for Misalignment:
- Managers may take excessive risks due to the asymmetric nature of bonuses (similar to having a long call option on portfolio returns).
High-Water Marks and Clawback Provisions
- High-Water Marks:
- Ensure managers only earn performance fees after recovering previous losses.
- Common in hedge funds.
- Clawback Provisions:
- Require managers to return previously earned fees if future performance deteriorates.
- Common in private equity.
Illustration: Sample Performance-Based Fee Schedule
Panel A: Fee Structure
- Base Fee: 0.25%
- Sharing: 20% of active return (above base fee).
- Breakeven Active Return: 1.50%
- Maximum Annual Fee: 0.75%
Panel B: Numerical Examples
| Active Return | Billed Fee | Net Active Return |
|---|---|---|
| ≤ 0.25% | 0.25% | ≤ 0.00% |
| 1.50% | 0.50% | 1.00% |
| ≥ 2.75% | 0.75% | ≥ 2.00% |
Key Observations
- Breakeven Active Return:
- Achieved at 1.50%, where billed fee equals the standard fee (0.50%).
- Non-Negativity Constraint:
- Performance fees are zero for active returns below 0.25%, with the billed fee equal to the base fee (0.25%).
- Maximum Fee:
- Capped at 0.75% for active returns at or above 2.75%.
Conclusion
Performance-based fees are effective in aligning manager and investor interests when structured thoughtfully. They encourage skillful management, particularly when augmented with provisions like high-water marks and clawbacks to ensure fairness and accountability.
