By Mark Barnicutt on February 18, 2015
Investor clients and investment fiduciaries need to carefully think through the performance fees used in many investment products.
I believe performance fees are a structural issue, as they tend to:
- Incentivize risk seeking instead of risk mitigation investment behaviours by money managers due to the outperformance fee structure.
- Skew return sharing (both positive and negative) in favour of the money managers at the expense of the investor client due to the high water mark structure.
A classic recent example of performance incentive fees gone wild was the hedge fund boom years from 2000 – 2007.
Let’s examine each of these issues in depth.
1. The Outperformance Fee Structure
During 2000 – 2007, the standard investment fee structure was 2 & 20, which meant that the hedge fund manager was compensated with a 2% annual fee (also known as a “Base Fee”, which is based upon the market value of the underlying assets), plus an incentive fee of 20% of the performance beyond a certain hurdle rate, which is typically tied to some form of index.
For simplicity, let’s assume that a hurdle rate on a given investment fund portfolio strategy was 4% and an investment manager thought that they could swing for the fences and get a return (net of fund operating expenses) in a given year of 14%. This would amount to an outperformance return of 10%.
If the manager was successful in getting this return, the investors would undoubtedly be happy (at least for that given year), the incentive performance fee for the investment manager would be 20% of the 10% outperformance, or 2%. As a result, the investment manager effectively doubled their overall investment management fees to 4% instead of the base fee of 2%.
To put this in dollar terms, let’s assume that this manager was operating a $100MM portfolio. Their gross annual investment fees would double from the Base Fee of $2 Million to $4 Million (including the Performance Incentive Fee). Given that the business expenses of the investment management firm probably didn’t increase in order to get that outperformance, the extra $2 Million is pure gravy to the investment management firm. In the hedge fund glory years between 2000 and 2007, these types of investment management fees were very common place.
Now, many investor clients would look at this scenario and say to themselves, “That’s pretty fair. The manager made me 10% more than they’d targeted, so if I have to give-up 20% of the outperformance return to get 80% of the outperformance return that I never would have gotten without that manager, that’s a fair deal!“
Like many things in life, this looks good on paper but falls apart in reality. This is the central issue that I believe investment fiduciaries should be aware of with these incentive fee structures.
Until the global capital markets crisis of 2008/9, the question was never really asked: “How much EXTRA risk has my investment manager assumed in my portfolio in order to achieve that EXTRA performance for me?”
In other words, there is no free lunch!
That extra return comes at a cost, which typically is extra assumed risk. Although the risk side of the investment equation is not always known at the time of the extra return, it’s embedded within the portfolio. Unfortunately, investors don’t usually know that it’s there unless they do their homework.
In fact, these embedded risks can go undetected for many years when investors are so dazzled by successive years of attractive total returns, but when that extra risk is finally recognized by investors, the damage to wealth can be extremely dramatic.
As an example: During the 2000 – 2007 time period, the total returns on many hedge funds were unprecedented as it was a time of easy money and a very strong global bull market. But when the party ended in 2008/9, the embedded risks that many hedge funds had been sitting on were financial leverage and illiquidity. As a result, many hedge funds gave back most — and in some cases — all of their recent year gains within a matter of months. In the worst case scenarios, many hedge funds — unable to meet redemption requests of their investors, due to this illiquidity, were forced to close their doors.
2. The High Water Mark Structure
The other issue related to Performance Incentive Fees is that of the High Water Mark concept.
This fee structure was designed to prevent an investment manager from collecting twice on a performance fee when the value of the underlying portfolio sinks below a previous high water mark value.
For example, the highest value to date of a given fund is known as the high water mark. If the value of the fund declines during a given year, no performance fee will be payable to the investment manager. If the fund value subsequently increases over the following year back to the high water mark (but no higher), no performance incentive fees would be eligible because the investor had not yet made any return on their investment. As a result, the fund would only be able to collect a performance incentive fee on increases in fund value beyond the high water mark.
Sounds fair right? Well not exactly. Earning it back is not the same as paying it back.
Although the investment manager doesn’t collect a performance fee in periods where portfolio values are below the high water mark, this is not the same thing as an investment manager being required to pay back a portion (or all) of previously earned performance fees in periods of extended under-performance.
When combined with the fact that the investment manager is still entitled to collect their Base Fee – albeit at a lower portfolio valuation – the issue with this typical high water mark structure is that it doesn’t go sufficiently far enough in creating a fee sharing policy between investment manager and client that is fair and two-sided (both on the upside and on the downside).
It’s interesting to note that one of the compensation consequences for investment banks from the 2008/9 global financial crisis is that the boards of many of these organizations have altered their short-term compensation structures for investment bankers so that annual bonuses — which are comparable to performance incentive fees on investment funds — are held back by the banks for a period of time with clawback provisions if the investment bankers’ deals come back in future years (within a certain time period) to cost/cause damage to the bank (i.e. a high water mark type concept).
Perhaps a similar set of performance fee clawback provisions could become mainstream for investment management firms who use such fee structures.
The recent experience around the high water mark concept came in the aftermath of the 2008/9 financial crisis. Many hedge fund managers closed their funds and gave all the money (what was left of it) back to investors because the managers knew it would take them years to get back to the high water mark; but, they then turned around and opened up new funds running the exact same investment strategies!
Investors Need to Know the Drawbacks of Performance Fee Structures
The examples of performance incentive fees given above have been simplified for illustration purposes. Although there are a wide variety of types and structures of such performance fee arrangements, my intent in writing this article was to highlight to investors the importance of doing your homework before investing with any investment manager that has a performance incentive fee structure.
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