Performance Fee Structures: A Guide to Hedge Fund and Private Equity Fees

Performance fee structures can be complex, but understanding them is crucial for investors.

Hedge funds and private equity firms typically charge performance fees, which are a percentage of the profits generated by the fund.

A common performance fee structure for hedge funds is the 1 and 20 model, where investors pay a 1% management fee and a 20% performance fee.

This structure incentivizes fund managers to perform well, as their earnings are directly tied to the fund's returns.

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The 2 and 20 compensation structure is a common practice in the hedge fund industry. It's made up of a management fee and a performance fee.

The management fee is 2% of the total assets under management, charged regardless of the fund's performance. This fee is applied to the entire amount, not just the profits.

A 20% performance fee is charged only when the fund achieves a certain level of profit. This fee is a percentage of the profits, not the total assets.

The graphic illustrating the compensation structure makes it clear how the fees are applied.

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The 2 and 20 fee structure is a common way hedge funds finance their operations, with a 2% flat rate charged on total assets under management used to pay staff salaries and other expenses.

This fee structure rewards the hedge fund's key executives and portfolio managers with a 20% performance fee, making them some of the highest paid financial professionals.

The 2 and 20 fee structure is a key aspect of hedge fund operations, and it's essential for investors to understand how it works.

Private equity funds also have alternative fee structures, but the 2 and 20 fee structure is a widely recognized and commonly used model in the industry.

Fees can affect private equity returns, but it's been shown that net historical returns of private equity funds after fees have exceeded those of public equity benchmarks.

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The 2 and 20 fee structure is a common way for hedge funds to finance their operations. It's a flat 2% rate charged on total assets under management, used to pay staff salaries, administrative and office expenses, and other operational expenses.

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The 20% performance fee rewards the hedge fund's key executives and portfolio managers, making them some of the highest paid financial professionals. This bonus structure is what drives their performance.

Some hedge funds adopt alternative fee structures, but the 2 and 20 model remains the most widely used. This structure has been the standard for decades, and many investors have come to expect it.

Moonfare, a platform that creates feeder funds for private equity investments, charges a one-time fee based on an investor's capital allocation. This fee is a key part of their business model.

Only about 5% of available private equity funds meet Moonfare's criteria for investment, making their due diligence process crucial to their success. This shows just how selective they are when it comes to choosing which funds to invest in.

The yearly management fee charged by Moonfare depends on the share class, adding another layer of complexity to their fee structure. Investors need to carefully review these fees before investing.

The 2 and 20 fee structure may be the most well-known, but alternative structures like Moonfare's are becoming more common. As the hedge fund industry evolves, we can expect to see more innovative fee structures emerge.

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Founders Shares offer investors a lower fee structure, such as "1.5 and 10", instead of the standard "2 and 20".

This incentive is designed to attract early investors and can be a significant cost savings for those who invest in the fund's early stages.

Founders Shares can also come with a promise to reduce the fee when the fund reaches a specific milestone, such as charging "2 and 20" on profits up to 20%, but only charging "2 and 15" on profits beyond that level.

Private equity performance fees are a key component of hedge fund structure, providing the General Partner (GP) with an incentive to maximize investment value by participating in asset appreciation.

The GP receives a percentage of carried interest, typically around 20%, which is distributed after investors have received their capital back and a return on capital, typically around 8%.

Investors always receive their capital back, plus some element of return on capital, before the fund manager can start to share in the profits.

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A "waterfall" schedule determines how the proceeds of asset sales will be distributed between the GP and Limited Partners (LPs) in advance, ensuring investors receive their fair share first.

The GP then receives distributions until they've caught up with their prescribed share of carried interest, after which all future distributions continue with the same split.

A "clawback" provision requires the GP to return part of their performance fees to the investors if they receive more than their share of sales proceeds according to the investment agreement.

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In the hedge fund industry, it's standard practice for funds to charge a management fee and a performance fee. The average management fee for hedge funds is 1.38% for arbitrage funds and 0.85% for long-biased funds.

The performance fee is where things get more interesting, with an average of 19.57% for arbitrage funds and 10.49% for long-biased funds. These fees can eat into your returns, but they're a common part of the hedge fund landscape.

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Some hedge funds offer alternative fee structures, but the traditional fee structure is still widely used.

In private equity, the gross returns to investors are reduced by fees to the General Partner (GP), but the net historical returns after fees have exceeded those of public equity benchmarks.

Investors can confidently compare public and private equity returns using measures like Multiple on invested capital (MOIC) and Internal rate of return (IRR), both of which are reported on a net after-fee basis.

Private equity performance fees are designed to incentivize the GP to maximize investment value by participating in asset appreciation.

The performance fee is taken from the proceeds of asset sales according to a "waterfall" schedule in the investment agreement.

Investors receive their capital back, plus some element of return on capital, typically around 8%, before the fund manager can share in the profits.

The fund manager then receives distributions until they have caught up their percentage of carried interest, which is usually around 20%.

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The 20% performance fee is a significant source of income for hedge funds, charged only when the fund's profits exceed an agreed-upon level, typically 8%.

This fee is calculated on the incremental profit above the threshold, as seen in the example of a fund generating a 15% return, where the 20% performance fee is charged on the 7% profit above the 8% threshold.

The 2% management fee is paid to hedge fund managers regardless of the fund's performance, as illustrated by a hedge fund manager with $1 billion AUM earning $20 million in management fees annually.

A high watermark policy ensures that the fund manager will only be paid a percentage of the profits if the fund's net value exceeds its previous highest value, preventing large sums for poor performance.

The 2 and 20 fee structure has been widely adopted across the private equity industry, with the GP's management fee being 2% of the investment and the incentive fee being 20% of the profits, as seen in the example of a private equity fund's fee arrangement.

Some investors consider the 2 and 20 fee structure excessively high, but the industry has maintained it due to hedge funds' consistent ability to generate high returns for investors.

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Capital Lockup Discounts can be a significant incentive for investors who are willing to commit to a longer-term investment.

A substantial discount can be offered to investors who lock up their investments with a hedge fund for a specified time period, such as five, seven, or 10 years.

This practice is most common with hedge funds whose investments typically require longer time frames to generate a significant ROI.

In exchange for the longer lockup period, clients benefit from a reduced fee structure.

For example, a hedge fund may offer a substantial discount to investors who are willing to lock up their investments for 10 years.

The High Watermark Clause is a crucial aspect of hedge fund fees. It ensures that fund managers are only paid performance fees after the fund has generated new profits. If the fund incurs losses, it must recover the losses before charging performance fees.

A high watermark clause specifies that the fund manager will only be paid a percentage of the profits if the fund's net value exceeds its previous highest value. This means that if the fund's value drops below its previous high, the manager won't be paid performance fees until the fund's value exceeds that previous high.

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For example, Peak-to-Trough Investments (PTI) had a high watermark of $1.15 billion. The fund's AUM fell to $920 million, but then rebounded to $1.25 billion. Only then was the performance fee paid on the incremental growth above the high watermark.

Here's a breakdown of how the high watermark clause affects performance fees:

As you can see, the high watermark clause prevented the fund manager from being paid performance fees in Year 2, even though the fund generated profits. This clause ensures that fund managers are incentivized to generate consistent returns and that investors are protected from excessive fees.

Calculating 20% can be a bit tricky, but let's break it down. The 20% performance fee is only charged when the fund's profits exceed a prior agreed-upon level, commonly known as the hurdle rate. This rate is often set at 8%.

For example, assume a fund with an 8% threshold level generates a return of 15% for the year. Then the 20% performance fee will be charged on the incremental 7% profit above the 8% threshold.

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The hurdle rate can be a preset percentage or based on a benchmark such as the return on an equity or bond index. Some hedge funds also have a high watermark policy, which specifies that the fund manager will only be paid a percentage of the profits if the fund's net value exceeds its previous highest value.

To illustrate this, let's look at an example from a hypothetical hedge fund, Peak-to-Trough Investments (PTI). In Year 1, the fund's AUM grows from $1 billion to $1.15 billion, resulting in a management fee of $23 million and a performance fee of $30 million. However, in Year 2, the fund's AUM falls to $920 million, and the performance fee is not payable as the high watermark of $1.15 billion has not been exceeded.

Here's a breakdown of the fees for PTI in each year:

As you can see, the 20% performance fee is only charged when the fund's profits exceed the hurdle rate, and the high watermark policy ensures that the fund manager is only paid a percentage of the profits if the fund's net value exceeds its previous highest value.

The 2 and 20 fee structure has been under scrutiny in recent years. Both investors and politicians have put hedge funds under pressure for this compensation structure.

The 2008 financial crisis had a significant impact on hedge fund performance, leading to a decline in their ability to perform at optimally high levels. As a result, many investors have sought out hedge funds with lower fees.

Politicians have also sought to tax hedge fund profits as ordinary income rather than at the lower capital gains rate. This has been a point of contention between the hedge fund industry and politicians.

The hedge fund industry has managed to maintain the lower tax rate as of 2018, arguing that their income is not a fixed salary and is based on performance.

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Moonfare and other hedge funds have adopted alternative fee structures. Some of these structures include performance fees, which are a percentage of the fund's profits.

These alternative fee structures are designed to align the interests of the hedge fund manager with those of the investors. By charging a percentage of the profits, the manager's compensation is directly tied to the fund's performance.

For example, some hedge funds charge a performance fee of 20% of the profits. This means that if the fund makes a profit of $100,000, the manager would receive $20,000 as their performance fee.

This approach can be beneficial for investors, as it incentivizes the manager to take calculated risks and make smart investment decisions.