Monday, August 8, 2011

Performance Fees and Step Functions

Fund managers might be missing out on performance fees if their variable dividends are based on a stepped performance scheme (i.e. one that rewards a higher share of the proceeds for higher levels of return).

Aggregate Equalisation Redemption (AER) is a common mechanism to tackle the free rider issue, which can occur when an investor subscribes for shares below the watermark. Without such a mechanism,  these investors would enjoy a "free ride" and pay no fees as the fund returns to the watermark.

AER solves this problem by redeeming (at par) a number of shares equal in value to performance fee due on the increase from the subscription price to the watermark and adding the equivalent sum to the variable dividend. This works fine if the performance fee is a fixed percentage of the upside, but causes all sorts of mayhem if your fees are stepped in any way.

Consider a fund that pays 20% fees, but only on returns above 5%. If an investor subscribes when the fund is 4% below the watermark, and the fund subsequently closes the period 4% above the watermark, the new investor has enjoyed a return of 8.3% and should pay fees on the 3.3% above the 5% trigger.

However, the model will first look at the return above the watermark, in this case 4% and so award no fees. AER will then look at the return for the new investor up to the watermark, in this case 4.17%, and again award no fee since this is also below the 5% trigger.

Fund managers, administrators and lawyers should pay particular attention to their equalisation mechanisms for stepped reward schemes, and look to redesign them if necessary to ensure all parties are compensated as intended.

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