Tag Archives: performance fee

SEC Proposes Change to Qualified Client Definition

Higher Threshold for Performance Fee Proposed

Under current SEC Rule 205-3, an SEC registered investment adviser can charge a performance fee (also called a performance allocation, incentive fee or incentive allocation) only to those investors who either has:

  • a $1.5M net worth or
  • at least $750,000 in assets with the manager

Many states have the same rules for state registered advisers or they explicitly make reference to the SEC regulation.

As a result of the Dodd-Frank act, the SEC is now proposing to increase the threshold for managers to be able to charge these performance fees.  The proposal declares that clients or investors of an SEC registered investment adviser can be charged a performance fee only if the client has:

  • a $2M net worth (excluding a primary residence) or
  • at least $1M in assets with the manager

What this means for SEC Registered Managers

While there will likely be a grandfathering provision for current fund managers with current investors who are “qualified clients”, when the new regulations go into effect, SEC registered managers (and potentially state registered managers) will likely need to make sure new investors meet the new threshold in order to charge these investors a performance fee.  Additionally, managers will need to update their offering documents to reflect the new definition (reprinted in full as proposed below).

The new regulation is likely to affect smaller funds disproportionally.  Many times smaller funds have investors who may just meet the qualified client threshold.  [Note: for some managers, they may allow non-qualified clients into the fund, but then just charge them a higher management fee in lieu of a performance allocation.]

Managers are urged to send comments to the SEC.  The comment period is open until July 11, 2011.

The SEC notice can be found here.

The full proposed rule can be found here: Performance Fee Rule Proposal.

Current comments on the proposal can be found here.

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Proposed Changes to Rule 205-3

Section 275.205-3 is amended by:

a.  Revising paragraph (c);

b.  Revising paragraphs (d)(1)(i) and (ii); and

c.  Adding paragraph (e).

The revisions and addition read as follows.

§ 275.205-3  Exemption from the compensation prohibition of section 205(a)(1) for investment advisers.

* * * * *

(c)  Transition rules.

(1)  Registered investment advisers.  If a registered investment adviser entered into a contract and satisfied the conditions of this section that were in effect when the contract was entered into, the adviser will be considered to satisfy the conditions of this section; Provided, however, that if a natural person or company who was not a party to the contract becomes a party (including an equity owner of a private investment company advised by the adviser), the conditions of this section in effect at that time will apply with regar

d to that person or company.

(2)  Registered investment advisers that were previously exempt from registration. If an investment adviser was exempt from registration with the Commission pursuant to section 203 of the Act (15 U.S.C. 80b-3), section 205(a)(1) of the Act will not apply to an advisory contract entered into when the adviser was exempt, or to an account of an equity owner of a private investment company advised by the adviser if the account was established when the adviser was exempt; Provided, however, that section 205(a)(1) of the Act will apply with regard to a natural person or company who was not a party to the contract and becomes a party (including an equity owner of a private investment company advised by the adviser) when the adviser is no longer exempt.

(d)  Definitions. For the purposes of this section:

(1)  The term qualified client means:

(i)  A natural person who, or a company that, immediately after entering into the contract has at least $1,000,000 under the management of the investment adviser;

(ii)  A natural person who, or a company that, the investment adviser entering into the contract (and any person acting on his behalf) reasonably believes, immediately prior to entering into the contract, either:

(A)  Has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $2,000,000, excluding the value of the primary residence of such natural person, calculated by subtracting from the estimated fair market value of the property the amount of debt secured by the property, up to the estimated fair market value of the property; or

(B)  Is a qualified purchaser as defined in section 2(a)(51)(A) of the Investment Company Act of 1940 (15 U.S.C. 80a-2(a)(51)(A)) at the time the contract is entered into; or

* * * * *

(e)  Inflation adjustments. Pursuant to section 205(e) of the Act, the dollar amounts specified in paragraphs (d)(1)(i) and (d)(1)(ii)(A) of this section shall be adjusted by order of the Commission, effective on or about May 1, 2016 and issued approximately every five years thereafter. The adjusted dollar amounts established in such orders shall be computed by:

(1)  Dividing the year-end value of the Personal Consumption

Expenditures Chain-Type Price Index (or any successor index thereto), as published by the United States Department of Commerce, for the calendar year preceding the calendar year in which the order is being issued, by the year-end value of such index (or successor) for the calendar year 1997;

(2)  For the dollar amount in paragraph (d)(1)(i) of this section, multiplying $750,000 times the quotient obtained in paragraph (e)(1) of this section and rounding the product to the nearest multiple of $100,000; and

(3)  For the dollar amount in paragraph (d)(1)(ii)(A) of this section, multiplying $1,500,000 times the quotient obtained in paragraph (e)(1) of this section and rounding the product to the nearest multiple of $100,000.

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Cole-Frieman & Mallon LLP is a hedge fund law firm focused on the investment management industry.  Bart Mallon can be reached directly at 415-868-5345.

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Revising the Hedge Fund Compensation Structure

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Syndicated Post on Hedge Fund Fees

I have recently come across a very good blog called Ten Seconds Into the Future by Bryan Goh of First Avenue Partners, a hedge fund seeder.  Bryan’s posts are very insightful and I recommend all managers take a look at his writings.  The post below discusses some possible ways which hedge fund fees may be designed in the future – this is an especially good topic as I am often asked for suggestions on alternative fee structures.

Please feel free to comment below or contact me if you have any questions or would like more information on starting a hedge fund.

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Hedge Fund Fees. Suggestions for the Future

I have argued before that hedge fund fees were poorly designed, and in that article had suggested a possible design for performance fees. Here I provide more detail into what I think is a practical solution which addresses some but not all of the problems with current fee structures.

Management fees:

This is the simpler issue to deal with. First of all, one has to question what is the purpose of management fees. In traditional long only mutual funds, management fees are the compensation for the manager for managing the fund. With the rise of absolute return funds, and their performance fees, management fees were no longer intended to be the primary compensation for managing of assets. The industry generally represents that management fees are compensation for overheads and the costs of running the asset management business.

If this is in fact the case, then the current flat percentage of assets management fee does not do as represented. The costs and overheads of running an asset management business are not linear in the size of assets under management. There are economies of scale. By charging a flat percentage of assets under management, these economies of scale accrue to the investment manager and not to the investor.

If management fees are indeed intended to cover overheads and costs, then a sliding scale is closer to the intended purpose. One can envisage management fees being charged as follows: 2% of assets as long as assets under management in the fund are under a certain amount, 1.5% when assets rise to a certain level, and 1% whenever assets are over a certain amount. This is just an example of course and there are other ways management fees can be designed to reflect the represented purpose.

A further finessing of management fees which is useful is to waive management fees for side pocketed investments. This encourages the manager to think carefully about side pocketing any assets. Certainly investors would not appreciate management fees being charged on assets that have been ‘gated’ or suspended.

Performance Fees:

Hedge funds fees typically include a profit share by the manager. This can range from 15% to 30% but for the vast majority of funds is 20% of profits. Pre-2005 there were a significant minority of funds which had a hurdle rate (strictly positive). That is, performance fees were only applied once the fund’s returns were higher than some positive return. In the later years, this practice had mostly disappeared as demand outstripped supply and hedge fund managers were able to increase their prices. Almost all hedge funds still operate a ‘High Watermark’ by which is meant that the investor pays fees only if the fund’s NAV is above the previous high. Should the fund’s value fall, performance fees are not collected until the previous high NAV is exceeded again.

This all sounds fair except that there are timing issues. Fees are accrued and at some point crystallized. This usually happens annually. A situation can arise therefore where performance fees are paid out at the end of the year or quarter, the NAV falls thereafter. Even if there is a recovery but the high watermark is not re-attained, fees paid out are not reclaimed.

A simple solution is as follows:

  • Fees are accrued semi-annually.
  • 50% of the performance fee is paid out semi-annually.
  • 50% of the performance fee is retained in Escrow (not to be invested in the fund.)
  • Each retained performance fee vests and is paid out 30 months later (for example, the delay can be made equal to the lock up for example).
  • All retained fees in Escrow are subject to negative performance fees = 20% of loss from the NAV of last performance fee calculation period.
  • When redemptions are paid in full, fees held back are released to the manager.

This design has the following features:

  • The investor pays performance fees on the net performance for their holding period, unless the performance is negative over the entire holding period. Unfortunately the manager cannot be expected to pay a negative performance fee over the entire holding period if the performance turned out to be negative over the holding period.
  • The manager is incentivized to make money over the long term instead of making money only in a given year.
  • The manager has 50% of their performance fee at risk on a rolling basis. On a cumulative basis, the manager may have a whole year’s performance fee at risk.
  • It has the same kind of incentive as a private equity clawback fee structure.
  • The above fee structure can be adjusted for the length of the holdback. The longer the holdback, the more performance fee is at risk.
  • A manager who is confident in generating returns over the length of their lock up should not object to such a fee schedule.
  • It incentivizes a manager to force redeem investors if they do not expect to be able to make money.

The Future:

Customers are the ultimate regulator of an industry, so it is investors who ultimately regulate the hedge fund industry. As long as investors are small and numerous, there may not be the aggregation of bargaining power to negotiate with fund managers. The huge concentration of assets under control in the fund of funds industry afforded funds of funds the opportunity to negotiate, not harshly but fairly with hedge fund managers. Not just on fees but on liquidity terms, transparency and controls. This was an opportunity that was missed. The battering taken by funds of funds in 2008 has greatly impaired their powers. We can only hope that investors find some way of communicating their needs to fund managers. And we can only hope that fund managers are enlightened enough to see that investors are not deliberately antagonistic, although it may seem so today.

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Other related hedge fund law blog articles:

Hedge Fund Taxation – Law School Professor Perspective

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Overview of Hedge Fund Taxation

The following is a reprint of the Joseph Bankman’s testimony before Congress.  Mr. Bankman is a professor at Stanford Law School.  While the testimony has a bias against the current hedge fund taxation structure, it provides a great overview of hedge fund tax issue, specifically the taxation of the hedge fund performance fee (also known as a “performance allocation,” “carried interest” or “carry”).  Ultimately the future of the hedge fund taxation regime will be decided in the political arena, but this article provides a good overview of the arguments for changing the current tax code.  Continue reading →

Hedge Fund Comments/ Questions and Answers

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Questions and discussions from Hedge Fund Law Blog readers

I get quite a few questions from readers and usually I am able to answer these questions via email within a couple of days.  If you have any questions, comments or simply want more information on starting a hedge fund, please feel free to contact us.  We also will take requests for blog posts on certain issues and we also will publish articles (with all appropriate recognition and links) by guest authors.  [Note: any grammatical errors in the original messages have not been corrected.] Continue reading →

Hedge Fund Performance Fee Issues for State Registered Investment Advisors

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One of the problems with the securities laws in the United States is that there are two levels of rules to be cognizant of at any single time – the federal rules and the state level rules.

For hedge fund managers that are registered as investment advisors with the SEC, there is a simple rule regarding performance fees – performance based fees can only be charged to those investors in the hedge fund who are “qualified clients” (the $1.5 million net worth requirement).  For hedge fund managers that are registered as investment advisors with the state, however, the manager may need to be aware of the performance fee rules of states other than their own state because each state has different securities laws.  (HFLB note: we will be discussing the issue of different state securities laws in an upcoming article on the Uniform Securities Act.)

Issues

There are three issues for a state-registered investment advisor to be aware of with regard to a hedge fund:

1.  Are performance fees allowed at the state level?  If so, what are the state’s investor qualification requirements?

2.  Does an investment advisor need to “look through” the hedge fund to the individual investors to determine if a performance fee can be charged?

3.  In the situation where a hedge fund investor resides in a state other than the state where the manager is registered, and with regard to the performance fee and “look through” rules, does the manager need to adopt the laws of the investor’s state or the laws of the state in which it is registered?

Discussion

First, generally all states will allow performance fees, but each state has different investor qualification requirements.  Some states track the federal rules and require that performance fees be charged only to qualified clients, some states require that the performance fees be charged only to accredited investors, and some states do not allow state-registered investment advisors to charge performance fees (whether a state can legally have such a requirement is another issue).

With regard to the second issue, most all of the states which allow performance fees will “look through” the hedge fund to the individual investor for the purpose of determining who can take the performance fees; this means that each investor in the hedge fund will need to meet the qualification requirements.  However, some states interpret their securities laws to mean that the performance fee can be taken at the fund level and that there is no “look through.”  In these cases, if the hedge fund itself meets the qualification standards (say $1.5 million dollar net worth), then presumably the performance fee can be taken on all of the hedge funds assets, even if no single investor in the hedge fund is a qualified client.  The central reason that anomalies like this exist is poor drafting on the part of the state legislatures.

Finally, we come to the third issue which is essentially a conflict of laws question.  There are a couple of situations where this would apply.

Situation 1: Manager is registered as an investment advisor in State X which allows performance fees to be charged only to “accredited investors” ($1 million net worth) and “look through” rules apply.  Investor from State Y wishes to invest in the hedge fund, but State Y has laws which prohibit performance fees except to those people who are qualified clients.

Situation 2: Same facts as above, but State X provides that there is no “look through” at the fund level and only the fund needs to be an “accredited investor” in order to charge a performance fee at the fund level (which would ultimately be paid by the investor through a diminished capital account).

While we believe that in both situations above the manager should be able to charge performance fees based on its own state laws and without regard to the laws of other states, there have been some state securities commissions that have stated informally to me over the phone that they believe the manager should charge performance fees to investors from their state pursuant to their state rules.  We have never heard of a state instituting a proceeding against a hedge fund manager in this situation, but it is one potential issue and it has not been clearly resolved.

To try to bring a little bit of resolution to this issue, we did a conflicts of law analysis and found that it would probably be ok for a hedge fund manager to charge performance fees to its investors pursuant to the manager’s state law and without regard to the state law of the investors.  However, I do not think a law firm would provide any sort of legal opinion on this issue because it is definitely still within the grey area of the law (HFLB note: this discussion should not be taken as any sort of legal advice, pursuant to our standard website disclaimer).

Generally I would recommend that state registered hedge fund managers only charge performance fees to qualified clients even if the manager’s state had lower requirements.  If the manager wanted to charge performance fees to non-qualified clients, then the manager should consider charging performance fees pursuant to the state laws of each investor in the fund.  The issue with this of course is that it would present additional work for the administrator and create additional costs for the fund.  Additionally, the subscription documents would need to be redrafted to address the state law issues.

In any event, if this situation applies to a state-registered investment advisor who manages a hedge fund, the hedge fund manager should discuss this issue with their legal counsel.

Other HFLB articles include:

Hedge Fund Performance Fees

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The hedge fund performance fee (also known as the “performance allocation,” the “incentive allocation,” the “incentive fee,” among other aliases), is a periodic fee which is calculated as a percentage of any gains of a hedge fund over a predetermined period of time.

The fee is normally taken on both realized and unrealized gains of the hedge fund.

How often do most managers take the performance fee?

The performance fee can be taken over any predetermined period of time.  For most hedge fund managers, the performance fee is taken on a yearly basis.  However, many managers will take the performance fee on a quarterly basis as well.  Some managers (mostly in the forex and futures arenas) will take a performance fee on a monthly basis.

The manager should consider the characteristics of the hedge fund strategy when determining the appropriate time period to measure performance.  If a manager is a long-term investor holding positions for 12 or more months, then it would not really be appropriate to take a performance fee on a quarterly or monthly basis.  However, for a day trader or a forex manager, who is in and out of multiple positions on a daily basis, it might make sense to have a performance fee period of shorter than one year.

What is the most common performance fee?

The most common performance fee is 20% of the gains of the fund during the performance fee period.  For managers who have shown exceptional returns over a long period of time the performance fees may be as high as 40% or 50%.

For hedge fund-of-funds the performance fee is typically 10%.  Sometimes hedge fund-of-funds will have performance fees as low as 5% and as high as 15%.

What are some of the variations of the performance fee structure?

Some managers will only take performance fees over a hurdle rate, or a minimum return required before the performance fee is taken.  Some managers will have a graduated performance fee structure where the performance fee will increase as the returns to the fund increase.

Also you should note that the hedge fund may not always have a performance fee when there are gains if the gains to not exceed the hedge fund high watermark.

Some other articles you may be interested in:

If you have any questions, please contact us.