No two hedge funds or hedge fund managers are the same – the same is also true for hedge fund performance fees which can take any structure that the hedge fund manager fancies.  I have seen many different styles of performance fees and many different hedge fund hurdle rates.

Some managers will institute “graduated” performance fees.  The graduated performance fee is characterized by fees which change based on the returns to the partnership.  The fee is typically calculated on gross returns.  Many times you will see a hurdle rate with a graduated performance fee. An example of a graduated performance fee follows:

• Returns up to 20% will be charged a 20% performance fee
• Returns of 20% to 40% will be charged a 25% performance fee
• Returns of 40% to 50% will be charged a 35% performance fee
• Returns greater than 50% will be charged a 40% performance fee

There are two different ways the fee can be applied.  The fee can be on the overall returns or it can be on the returns from the plateau only.  Using the numbers from above, here is how it would work:

If straight 20% performance fee applies:

Total
Return    % to Manager        % to Investors
20%        4%                        16%
40%        8%                        32%
50%        10%                      40%
60%        12%                      48%

If fee applies to overall returns:

Total
Return    % to Manager        % to Investors
20%        4%                        16%
40%        10%                      30%
50%        17.5%                   32.5%
60%        24%                      36%

If fee applies to return on each plateau only:

Total
Return    % to Manager        % to Investors
20%        4%                        16%
40%        9%                        31%
50%        12.5%                   38.5%
60%        16.5%                   43.5%

The purpose of the graduated performance fee is to provide greater marginal compensation to the hedge fund manager when the fund’s performance is particularly good.  One downfall of the graduated performance fee is the potential for the manager to take excessive risks once a certain return level has been reached in order to get to a higher performance plateau.  Generally, it seems that in my experience, both investors and managers can benefit from the graduated performance fee structure.  As I noted above, though, each hedge fund fee structure is different and a graduated performance fee may not be appropriate in all situations.

Other related articles:

• Hedge Fund Hurdle Rate
• Hedge Fund Performance Fees
• Hedge Fund Offering Documents
• Hedge Fund Attorney

Please contact us if you would like to discuss performance fees or other issues.