Understanding Hedge Fund Fees: Implications for Hedge Fund Managers
K&L GATES
OUTPERFORMANCE OF BENCHMARKS
In portable alpha and certain other institutional products, the Performance Fee is calculated based
on "outperformance" of an index. The Performance Fees unilaterally have to be calculated on an
income statement rather than a balance sheet basis. This is because cash flows in and out of the
Fund affect the future profits and losses which will be generated for the investors. There is no
balance sheet HWM because performance is not based on the amount in the Fund but rather on
outperformance of the Benchmark.
Benchmark Performance Fees are calculated in a manner similar to hurdle rates; there are
distinct periods during which the "base" to which the index is applied remains included. These
periods are defined by additions and redemptions as well as by the profit and loss of the Fund.
During each Benchmark Period, the return produced by multiplying the Performance Fee base by
the change in the index is determined and applied to the profit and loss.
In certain cases, Benchmark Performance Fees are calculated year-to-year; in certain cases, they
are cumulative. In either case, if a redemption is made, any shortfall between the performance of
the Fund and the indexed performance should be reduced pro rata as the Fund has less capital
with which to earn back such shortfall. Whether Performance Fees are paid or crystallized but not
paid upon redemption is a matter of negotiation, not mechanics. Many institutional accounts may
pay redemption fees annually and terminate, rather than having to adjust the cash balance. This is
particularly true in the case of institutions which make their own margining arrangements and
need the flexibility to move cash around on a daily basis.
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