Friday, July 22, 2011

Fun with Fees - Incidental Leverage

While helping a client design a fund performance fee model for a family office, I had to explain an interesting anomaly that can inflate a managers fees, common in most models but not well documented. Probably because it's quite subtle and something most people would rather not think about.

If an investor redeems shares that have increased in value, there will likely be some performance fee due. That portion of the fee essentially becomes "locked in" but stays in the fund until the variable dividend is paid out at the year end.

What this means is that the fund is effectively leveraged (I call this "incidental leverage") by the amount of these accrued fees. Now, most MA&A will simply say that fees are due on the NAV per share of the fund after fixed but before variable dividends. Consequently, the NAV per share before variable dividends will rise simply because an investor redeemed some shares. This, in turn, will increase the accrued variable dividend for the remaining investors.

Consider a fund with 3 investors (A,B and C) where all three investors joined at the same time by investing $10m. The fund has now risen to $33m and variable fees are 20%.

If investor A wants to sell out, he will receive $10.8m. ($11m less 20% of the increase).

The $200k performance fee, however, stays in the fund which now has an NAV of $22.2m, or $11.1m per share, which yields fees of $220k each. If the fund stays flat and investor B wishes to sell out the following month, he would only receive $10.78m.

One way to solve this would be to redefine the MA&A so that fees are calculated on the NAV per share after fixed and confirmed variable fees arising from redemptions.

Perhaps a more interesting solution, however, would be to use those locked-in fees to issues shares to the fund manager, so that the NAV per share is the same and the fund manager shares some of the risk with his investors?

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