# Performance fee

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Folks, i have been looking at what some of the performance fee that hedge fund charges, one thing confuses me.

Here is what pabrai fund charges:

Performance fee of 25% of the returns over 6% annualized (subject to high-water mark)

I am a little confused by how the 6% annualized work with high-water mark.

For example:

Lets say your fund start at \$100,000 with 10,000 units (\$10 per unit)

After year 1, its now \$150,000 still 10,000 units (\$15 per unit) so this is obviously above 6% and its at all time high - fee is charge at 25% of whatever is above 6%

But lets say after year 2, its now \$140,000 still 10,000 units (\$14 per unit) no fee for that year because of high water mark, need to be above \$15

After year 3 its now \$157500 still 10,000 units (\$15.75 per unit) this is above all time high of \$15, but do you charge a fee for year 3?

I would assume the 6% annualize mean if your fund is above \$11.91 per unit you get to charge a fee (\$11.91 = \$10 * 1.06 * 1.06 * 1.06)

Or does the annualize mean it has to be higher than \$15 * 1.06 = \$15.9 (which the fund is not) so no fee

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Folks, i have been looking at what some of the performance fee that hedge fund charges, one thing confuses me.

Here is what pabrai fund charges:

Performance fee of 25% of the returns over 6% annualized (subject to high-water mark)

I am a little confused by how the 6% annualized work with high-water mark.

For example:

Lets say your fund start at \$100,000 with 10,000 units (\$10 per unit)

After year 1, its now \$150,000 still 10,000 units (\$15 per unit) so this is obviously above 6% and its at all time high - fee is charge at 25% of whatever is above 6%

But lets say after year 2, its now \$140,000 still 10,000 units (\$14 per unit) no fee for that year because of high water mark, need to be above \$15

After year 3 its now \$157500 still 10,000 units (\$15.75 per unit) this is above all time high of \$15, but do you charge a fee for year 3?

I would assume the 6% annualize mean if your fund is above \$11.91 per unit you get to charge a fee (\$11.91 = \$10 * 1.06 * 1.06 * 1.06)

Or does the annualize mean it has to be higher than \$15 * 1.06 = \$15.9 (which the fund is not) so no fee

How a performance fee is charged is specific to the terms of the agreement.  Unfortunately, each party to a contract tends to assume that the terms should be interpreted in a way that is most favorable to him. Therefore, any possible ambiguity should be clearly illustrated with example(s).  You might write an example of how you think the terms should work and ask the other party to confirm your understanding in writing.

If your understanding is confirmed in writing as being correct, ask that that example be incorporated into the contract or add that example as a separate, handwritten, circled clause in the margin, pointing with an arrow to the appropriate spot in the contract.  Then, initial that revised point of the contract before signing the complete doccument at its end.  Do this with two signed hard copies.  Return both copies to the other party, asking that one hard copy be returned to you with a hard copy signature.  Notarization of the signatures on the copies is optional.  :)

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twacowfca

thanks for you reply. i was wondering how does most hedge fund handle this? I would think this is very typical? how is it typically interpreted.

i am looking at  starting a fund that is why i am asking.

hy

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In your example the answer is \$15.90.  \$15 was the new high water mark.

To quote from US Regulation of Hedge Funds by the ABA (Shartsis Friese): "Traditionally, an investment adviser's performance fee or allocation is charged only on profits above the previous highest value of each account"  pg. 329.

Tim

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In your example the answer is \$15.90.  \$15 was the new high water mark.

To quote from US Regulation of Hedge Funds by the ABA (Shartsis Friese): "Traditionally, an investment adviser's performance fee or allocation is charged only on profits above the previous highest value of each account"  pg. 329.

Tim

Yes, this is how it generally works, but make sure this is what the agreement says.

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twacowfca

thanks for you reply. i was wondering how does most hedge fund handle this? I would think this is very typical? how is it typically interpreted.

i am looking at  starting a fund that is why i am asking.

hy

The Pabrai funds that you cite are unusual in that these, in the fashion of BG and WEB's funds, have not, I think, charged the usual about 1% or 2% annual management fee.  Very few investment managers have been able to survive long term by waiving all but the performance fee.  Tilson did this for a few years, and then changed  terms to add the management fee.

The S&P500 P/E 10 is currently 23+, above the long term mean of about 16.  It will be difficult for any hedge fund to survive long term without an annual fee as the current PE 10 almost certainly will regress from the current record profit levels to a lower mean at reduced profit levels.  :)

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twacowfca/tim

thanks

another stupid question. what about new money that comes in? if your fund its at \$14 per unit (via the example) and new money come in at \$14. what is the high water mark for new money? is it \$14 or \$15?

hy

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Regarding new money.  Obviously it depends on the fund documents, but most funds are set up so that each investor has their own high water mark.  If an existing investor adds money after the NAV falls the new money is usually subject to the new high water mark (\$14 in your example) as well.  I am sure there are some exceptions to that though.

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I would assume the 6% annualize mean if your fund is above \$11.91 per unit you get to charge a fee (\$11.91 = \$10 * 1.06 * 1.06 * 1.06)

Or does the annualize mean it has to be higher than \$15 * 1.06 = \$15.9 (which the fund is not) so no fee

Make sure in the agreement.  The LP Agreement is the end all of the fee structure and is the equivalent of a legal contract.  Different funds have different rules.  Our fund operates the same as Mohnish's.  Every time the fund is valued (in our case monthly, but some are quarterly, etc), if the fund reaches a new high then that becomes the new high watermark, and the fund has to achieve the equivalent of 6% annualized before any incentive fee is paid.

another stupid question. what about new money that comes in? if your fund its at \$14 per unit (via the example) and new money come in at \$14. what is the high water mark for new money? is it \$14 or \$15?

Our fund operates only on an incentive fee.  There is no set management fee like many other funds.  Again, you need to clarify how the incentive allocation is calculated with the fund manager, and you should probably get it in writing if it isn't clear from the LP Agreement.  With our fund, if the fund is below the high watermark, no incentive fee is paid at all until all the partners, old and new included, are made whole and then their 6% annualized return is also achieved.  The general partner doesn't receive any partnership income at the expense of the limited partners.

This is something you really need to pay attention to.  Alot of funds back in 2008 did not take incentive fees on old money because their fund was below their high watermark, but they did take incentive fees from all the new money they took in.  In our opinion, this isn't fair as the markets rebounded significantly in 2009/2010, and these managers took healthy incentive fees while many of their older partners still had not been made whole.

The Pabrai funds that you cite are unusual in that these, in the fashion of BG and WEB's funds, have not, I think, charged the usual about 1% or 2% annual management fee.  Very few investment managers have been able to survive long term by waiving all but the performance fee.  Tilson did this for a few years, and then changed  terms to add the management fee.

The S&P500 P/E 10 is currently 23+, above the long term mean of about 16.  It will be difficult for any hedge fund to survive long term without an annual fee as the current PE 10 almost certainly will regress from the current record profit levels to a lower mean at reduced profit levels.

This is true, but let's examine the reason why.  I would bet that the majority of fund managers who don't last long-term, usually do so for two reasons:

1)  Exorbitant operating expenses...they want the fund image to be like a typical Wall Street bank and a salary to boot!

2)  Excessive risks...they decide they want to operate like a typical Wall Street hedge fund!

You cannot survive long-term without running your fund as lean as possible, and you have to always do everything to avoid risks that could lead to permanent loss.  We've managed five years on a shoe string budget, beaten the S&P500 handily, and mitigated investment risk.  The way we've managed the fund, means that long-term isn't an issue for us at all...and we are tiny!  If you don't survive long-term, it comes down to the two points above.  Cheers!

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I would assume the 6% annualize mean if your fund is above \$11.91 per unit you get to charge a fee (\$11.91 = \$10 * 1.06 * 1.06 * 1.06)

Or does the annualize mean it has to be higher than \$15 * 1.06 = \$15.9 (which the fund is not) so no fee

Make sure in the agreement.  The LP Agreement is the end all of the fee structure and is the equivalent of a legal contract.  Different funds have different rules.  Our fund operates the same as Mohnish's.  Every time the fund is valued (in our case monthly, but some are quarterly, etc), if the fund reaches a new high then that becomes the new high watermark, and the fund has to achieve the equivalent of 6% annualized before any incentive fee is paid.

another stupid question. what about new money that comes in? if your fund its at \$14 per unit (via the example) and new money come in at \$14. what is the high water mark for new money? is it \$14 or \$15?

Our fund operates only on an incentive fee.  There is no set management fee like many other funds.  Again, you need to clarify how the incentive allocation is calculated with the fund manager, and you should probably get it in writing if it isn't clear from the LP Agreement.  With our fund, if the fund is below the high watermark, no incentive fee is paid at all until all the partners, old and new included, are made whole and then their 6% annualized return is also achieved.  The general partner doesn't receive any partnership income at the expense of the limited partners.

This is something you really need to pay attention to.  Alot of funds back in 2008 did not take incentive fees on old money because their fund was below their high watermark, but they did take incentive fees from all the new money they took in.  In our opinion, this isn't fair as the markets rebounded significantly in 2009/2010, and these managers took healthy incentive fees while many of their older partners still had not been made whole.

The Pabrai funds that you cite are unusual in that these, in the fashion of BG and WEB's funds, have not, I think, charged the usual about 1% or 2% annual management fee.  Very few investment managers have been able to survive long term by waiving all but the performance fee.  Tilson did this for a few years, and then changed  terms to add the management fee.

The S&P500 P/E 10 is currently 23+, above the long term mean of about 16.  It will be difficult for any hedge fund to survive long term without an annual fee as the current PE 10 almost certainly will regress from the current record profit levels to a lower mean at reduced profit levels.

This is true, but let's examine the reason why.  I would bet that the majority of fund managers who don't last long-term, usually do so for two reasons:

1)  Exorbitant operating expenses...they want the fund image to be like a typical Wall Street bank and a salary to boot!

2)  Excessive risks...they decide they want to operate like a typical Wall Street hedge fund!

You cannot survive long-term without running your fund as lean as possible, and you have to always do everything to avoid risks that could lead to permanent loss.  We've managed five years on a shoe string budget, beaten the S&P500 handily, and mitigated investment risk.  The way we've managed the fund, means that long-term isn't an issue for us at all...and we are tiny!  If you don't survive long-term, it comes down to the two points above.  Cheers!

Lean and not mean is the better way, the road less traveled, the straight and narrow, not the broad and greedy way of  Wall Street.  Blessings on you Sanjeev for taking the road less traveled.  :)

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thanks for your reply, base on what you said your fund will treat new money coming in at \$14 with the same high water mark of \$15 as the old money then. I think that is how mohnish does it.

also this statement "and the fund has to achieve the equivalent of 6% annualized before any incentive fee is paid." always confused me a little. In mohnish and your case its not really 6% annualized its 6% above \$15 right? 6% annialized to me means \$11.91 (\$10 * 1.06 * 1.06 * 1.06 etc). Or did i not understand something. Or do people mean 6% annualized starting from each high water mark, which would in all practical purposes mean the same thing (\$15 * 1.06 or 6% above \$15)

hy

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Or do people mean 6% annualized starting from each high water mark, which would in all practical purposes mean the same thing (\$15 * 1.06 or 6% above \$15)

Yes. Just look at it this way: as an investor, you'll only pay a fee if YOU'VE achieved 6% annualized. Meaning, if you you were a new investor at an NAV of \$15, the old \$10 high water mark would be meaningless, and the 6% compounds forward from the \$15.

And if the HWM is \$15 and you invest at \$13, you're getting a "free ride" until the NAV gets back up to \$15+6% annually.

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thanks for your reply, base on what you said your fund will treat new money coming in at \$14 with the same high water mark of \$15 as the old money then. I think that is how mohnish does it.

also this statement "and the fund has to achieve the equivalent of 6% annualized before any incentive fee is paid." always confused me a little. In mohnish and your case its not really 6% annualized its 6% above \$15 right? 6% annialized to me means \$11.91 (\$10 * 1.06 * 1.06 * 1.06 etc). Or did i not understand something. Or do people mean 6% annualized starting from each high water mark, which would in all practical purposes mean the same thing (\$15 * 1.06 or 6% above \$15)

hy

Exactly as Max described.  So whenever the high watermark is reached, that is where the compounding continues from.  So any new investor coming in when the fund is down to \$14/unit, would have the benefit of the high watermark being at \$15, as well as the 6% annualized compounding from \$15.

I think it's the most equitable way to compensate the manager...if you don't perform, you don't eat...and the greater you outperform, the more you make.  This forces the manager to minimize losses (as you don't want to be underwater long), and make bigger bets when they believe it is more advantageous.  Cheers!

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folks,

thanks for your responses, its been very helpful

hy

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