Determine what a hedge fund investment returns, and describe how the fund's incentive fee is set up, with reference to the hurdle rate, high-water mark and clawback.

FRM® Part I · Financial Markets and Products · Fund Management · FRM1.FM.3.e

The idea

A typical hedge fund charges a management fee on assets, say 2 percent, and an incentive fee on profits, say 20 percent: the so-called 2 and 20. The investor's return is the gross return less the management fee, less the incentive fee on what remains. When the return after the management fee is positive, and with no hurdle, net return = (gross return − management fee) × (1 − incentive rate). A hurdle rate means the incentive fee is charged only if the return exceeds a threshold. With a hard hurdle the fee applies only to the return above the hurdle, while with a soft hurdle it applies to the entire profit once the hurdle is cleared. A high-water mark means the fee is charged only on gains above the highest previous NAV, so losses must be recovered first. A clawback requires the manager to return earlier incentive fees if later losses mean the fee was not earned over the whole period. A common mistake is to charge the incentive fee on the whole gain in a year that only recovers earlier losses, ignoring the high-water mark.

Formulas

Net hedge fund return with no hurdle

Net return = (G − m) × (1 − k)

G: the gross return before fees
m: the management fee rate
k: the incentive fee rate

Holds when the return after the management fee is positive and no hurdle or high-water mark binds. The incentive fee is on the return after the management fee, not the gross return.

Net hedge fund return with a hard hurdle

Net return = R − k × (R − h)

R: the return after the management fee
k: the incentive fee rate
h: the hurdle rate

Holds when R is above h. With a soft hurdle the fee is on the whole of R once the hurdle is cleared, so the investor keeps less.

A practice question

From the question bank, with the reason each wrong option is wrong.

What does a high-water mark in a hedge fund's incentive fee provide?

An incentive fee is charged only if the return exceeds a fixed minimum return.Why not: Describes a hurdle rate, not a high-water mark.
An incentive fee is charged only on gains above the highest NAV previously reached, so earlier losses must be recovered first. - correct
The manager must repay fees received earlier if later results are poor.Why not: Describes a clawback, which reverses fees already paid.
The management fee is waived whenever the fund makes a profit.Why not: The management fee is on assets and is not linked to the high-water mark.

A high-water mark links the fee to new peaks in value: after a loss the fund must exceed its prior NAV before the manager earns another incentive fee.

A harder one

A fund charges a management fee of 2 percent of assets and an incentive fee of 20 percent of profits after the management fee, with no hurdle. The fund earns a gross return of 18 percent before fees. What is the return to the investor, closest to?

12.4 percentWhy not: Applies the 20 percent incentive fee to the gross return of 18 percent instead of to the return after the management fee.
14.4 percentWhy not: Deducts the incentive fee but ignores the 2 percent management fee.
12.8 percent - correct
16.0 percentWhy not: Deducts the management fee but no incentive fee.

After the management fee the return is 18 - 2 = 16 percent. The incentive fee takes 20 percent of that: 3.2. Net return = 16 - 3.2 = 12.8 percent.

The hardest tier

A fund starts with 100. In year 1 it makes a profit of 40 and the manager is paid an incentive fee of 20 percent of it. In year 2 it loses 60. The agreement has a clawback so the manager must return any incentive fee not justified by 20 percent of cumulative profit over the two years. How much is returned?

12Why not: Takes 20 percent of the year 2 loss, which is more than the fee actually received.
8 - correct
0Why not: Assumes the high-water mark alone lets the manager keep the year 1 fee.
4Why not: Takes 20 percent of the net cumulative loss of 20 instead of reversing the fee received.

The year 1 fee is 8. Cumulative profit over two years is 40 - 60 = -20, so the manager is entitled to nothing and returns the 8 received. A high-water mark alone would only prevent new fees; the clawback reverses old ones, capped at the amount received.

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