As with any niche or industry, the alternative investment industry has its own terminology. In fact, it would be almost impossible to understand a private placement memorandum or subscription document without familiarizing one’s self with this industry specific verbiage. Below are some specific terms that are consistently used in the industry which every investor or new industry professional must adopt into their own vocabulary.
A management fee is a fee charged by fund managers to cover investment advisory services. Non-registered investment funds typically charge 2% as a percentage of the fund’s net asset value. Management fees are not to be confused with performance fees (sometimes called incentive fees or carry), explained below. Management fees are shown as an annual percentage, but are typically calculated and paid on a monthly basis. They are paid to investment managers regardless of fund performance. The management fee is paid directly from the fund to the management company and automatically deducted from the fund’s NAV and the investor’s return. This is why it is important to look at a fund’s performance both gross and net of fees.
A performance fee is a fee which is calculated based on the increases in Net Asset Value (“NAV”) of the fund and represents compensation to the manger for achieving some threshold of positive performance. In many funds the threshold is zero, meaning any positive performance at all will result in an incentive fee or allocation being made to the manager. Like the management fee described above, the performance fee is paid directly from the fund to the management company. A typical fee for investment managers of non-registered investment companies is 20% of the annual increase in NAV. Performance fees are an incentive for investment managers to seek higher gains on the fund’s they manage.
An example of how a performance fee might be calculated is as follows: Assume an investor contributes $100,000 to a fund and one year later the fund’s NAV increases by 10% to $110,000. Assume the investor is subject to a 20% performance fee. In that case, 20% of the $10,000 increase in NAV ($2,000) would be paid to the investment manager, leaving the investor with $108,000.
Note, in some funds the performance fee is an actual fee paid from the fund to the management company. In other funds the fee is called a “carry” or “carried interest” and is a grant of a profits interest in the fund itself. In that case, income and gains of the fund are diverted from the investors and allocated to the management entity. Either way, the manager is compensated for the positive performance of the fund and the return of the investors is diminished by the amount of the fee or carry.
A high-water mark (“HWM”) is a threshold over which the NAV must increase before a performance fee is payable from the fund to the manager. For example, what if the fund goes up 10% in year one and a performance fee is paid to the manager but then in year two the fund drops 15%. Does any positive performance in year three trigger a performance fee to be paid? Well, that depends on whether the fund’s documents include a HWM provision. If it does, then no performance fee will be payable to the manger until the NAV of the fund exceeds the 110% high point achieved in year one (there are variations of thresholds but this is typical).
The high-water mark protects investors from overpaying performance fees by preventing performance fee charges for NAV increases already compensated for in previous periods. Note, not all funds have a high-water mark provision in their documents.
For any further information related to fund documentation or any other issues related to the alternative investment industry please contact your regular WithumSmith+Brown partner.