Hedge Fund Manager Fees: 2 and 20

Unlike mutual fund managers, hedge fund managers are paid from two fees:  management and incentive/performance.  Managements fees are based on assets under management and range from 1% to 4%, with the standard being 2%.  This can be paid out quarterly, semi-annually or annually.  The average equity mutual fund management fee is 1.3% and no performance fee.

Incentive fees are based on fund returns and are paid out on an annual basis.  The standard is 20% of profits although they can range up to 50%.  The fee is calculated against a high water mark at the end of the year.  For example, the net asset value (NAV) of the fund is at $100 at the start of the year.  If the NAV is $115 at the end of the year, the fee is calculated on the $15 gain i.e.e $15 x 20% = $3.  If there is no increase in the NAV, the manager receives no performance fee.  In the event that the fund manager loses money in one year, the high water mark may carry over to the next year.  For example, the NAV starts at $100 and goes to $90 in year one.  In year two, the NAV finishes at $110.  The performance fee is calculated off the initial mark i.e. ($110 - 100) x 20% = $2.  For managers that have large losses, they would have the incentive to reset the high water mark.  The best way to do this is to launch a new fund.  Of course, this would anger the original investors and the new fund would get most of the new attention from the manager.

Some funds have hurdle rates.  Incentive fees are not paid until the fund's return have met or exceeded the rate.  It may be based on an agreed upon rate, LIBOR or the yield on US treasury bills.  There are two types of hurdles:  hard and soft.  The hard hurdle is calculated only on returns above the hurdle rate.  Soft hurdles are calculated on the whole return.  For example, the beginning NAV is $100; the ending NAV is $120 and the hurdle rate is 10% (NAV = $110).

Hard hurdle calculation is:  ($120 - 110) x 20% = $2.
Soft hurdle calculation is:  ($120 - 100) x 20% = $4.

During the latest credit crisis, there was some talk of having clawback provisions for hedge funds, just like in private equity.  A clawback allows investors to recoup prior years' incentive fees if a fund underperforms.  I have not seen much news on this front in 2010.