Performance Fee Models

Performance Fee Models

Rationale for Performance Fees Attracts the most talented managers Increase incentives for managers Intended to align the interests of the manger and investor Hurdles reward extraordinary performance Encourages risk taking

Measuring performance Defined by the fund offering memorandum Fund level performance Vs Individual Investor Performance Allocate profit to classes, series and shareholders Some profits may be excluded from performance fees Accounting $$$ profits or NAV/share profits When shareholders redeem and the fund is in a loss situation does the manager need to recover previous accounting losses? Gross Asset Value (GAV) vs Net Asset Value (NAV)

Performance Fee Period and HWM s HWM s are tested at the end of a performance period Performance fees can only be paid once they have been crystallised Crystallisation occurs upon redemption or end of the performance fee period if a HWM is reached. The dates used to measure performance can have a dramatic effect when returns are volatile. Clawbacks may help protect shareholders where a HWM has been set but the performance subsequently fall

Example : HWMs on the DOW Index With an annual performance period the last HWM was set on the 31 Dec 2008

Whole of Fund Method Fund level performance fees Does not charge performance fee based on investors individual returns Easy to calculate Easy for investors to understand Produces a fair result for all investors only if the NAV rises continuously. Governance problems may arise due to inequities that result.

Example: Whole of Fund on the DOW Index 2009 Assumption This is a new fund from 31 Dec 2008 so new HWM is established at inception. Those investors who entered the fund in the first 2 months suffered a loss and are grouped together with those who invested at the market bottom 1 March 2009. FREE RIDE - an investor who subscribes on 1 March will receive a 7.3% return to 31 March and effectively pay no performance fees as their profits are effectively netted against prior losses incurred by other investors.

Multi-Series Performance Fees Each dealing date uses a different series of shares. Performance fees are calculated at series level to reflect the profit allocated since the subscription date of each investor. Once a HWM is obtained a series consolidation or roll up of the series is made into the lead series. Accurate and relatively easy to calculate performance fees Easy for investors to understand If the fund does not reach a new HWM then there may be many open series before a series consolidation can be performed. Not suitable for daily or weekly dealing funds due to the number of open series that may result.

Equalisation Performance Fees Eliminates the need for multiple series Makes individualised adjustments to shareholder performance fees based upon each subscription entry price When a HWM is reached the performance fees are crystallised as normal. At HWM date, for subscriptions received during the performance period, the current value of the equalisation accrued is converted to shares on the shareholder accounts. Makes unit adjustments for crystallised performance fees upon shareholder redemptions.

Equalisation Deficit A deficit occurs where the GAV at subscription date is less than the high watermark GAV. Without equalisation new shareholders would receive a Free Ride if the Gross NAV increases as their profits would be mixed with other shareholder losses. Upon subscription the investor should receive notification of the maximum performance fee deficit on their contract note. The shareholder does not pay for the deficit upfront and the deficit is stored to calculate the value of the equalisation accrual. The depreciation deposit variant method charges the shareholder upfront for the deficit and is posted to a depreciation deposit account in the balance sheet (NOTE- depreciation deposit method is not widely used) The value of the shareholders investments should include the current value of their equalisation deficit to be deducted from their account

Equalisation Deficit Example HWM = $100 NAV = $80 Pf =20% If an investor subscribes 1 unit the equalisation deficit would be calculated as Units * (HWM-NAV) * 20% = $4 1 * (100-80) * 20% = $4 Therefore if the fund NAV subsequently increase to $100 and the shareholder redeemed or a HWM was reached $4 would be redeemed from their account as additional performance fees.

Equalisation Credit A credit occurs where the GAV at subscription date is greater than the high watermark GAV. Without equalisation new shareholders would receive a Free Ride if the GAV decreases as performance fees accrued would be wound back into the fund. Upon subscription the investor should receive notification of the maximum performance fee credit on their contract note. The shareholder pays for the credit upfront and the credit is allocated to the shareholders account to calculate the value of the equalisation accrual. The value of the shareholders investments should include the current value of their equalisation credit to be credited to their account

Equalisation Credit Example HWM = $100 NAV = $116 GAV = $120 Pf =20% If an investor subscribes 1 unit the equalisation credit is Units * (GAV-HWM) * 20% = $4 1 * (120-100) * 20% = $4 The shareholder pays $120 and gets 1 share at NAV $116 and $4 equalisation credit held on their account. If the fund GAV subsequently decreased to $100 they would receive the benefit of performance fees being wound back into the NAV however the value of the equalisation credit would zero and this would create an offset loss. If the fund GAV subsequently increased and a new HWM was reached the $4 equalisation credit would be converted to units on the investors account.

COMPARISON OF PERFORMANCE FEE METHODS Whole of Fund Multi Series Equalisation Single Series Yes No Yes Equitable Method No Yes Yes Accounting Easy Moderate Complex Communication Simple Moderate Complex Contract Notes Simple Series invested & Series consolidation NAV Statements Simple Show all series separately At HWM date Simple Series Consolidation Equalisation deficit/credit to be shown Show accrued value of equalisation Equalisation accrued is converted to shares RECOMMENDED NO YES YES- but only with a system

HURDLES Rewards extraordinary performance only Performance fees only for excess returns above a defined hurdle rate Hurdles can be an index or a rate of return (MSCI Index, Libor + spread) Generate performance fees with negative returns by relative outperformance of an index. The hurdle capital is critical to the calculation and the manager s target If the fund is below HWM, and the hurdle is based on the HWM, a manager may fall far below the hurdle rate of return. Compounding hurdles make it harder for the manager to catch up Equalisation with hurdles adds a level of complexity to the math.