CFA Program Level I

Hedge fund and private equity fees, high-water marks: CFA Level I

Hedge funds and private equity funds usually charge a management fee on assets (often 1-2%) and a performance fee or carried interest of around 20% of profits. A high-water mark means the performance fee is paid only on value above the highest previous fee-paying level. A clawback makes a private equity manager return carry paid on early deals if the fund's overall profit does not support it.

The basic structure

Investor.gov says hedge fund investors typically pay an asset management fee of 1-2% of net asset value and a performance fee of 15-20% of the fund's profit. A high-water mark or a hurdle rate can limit when the performance fee is earned.

In private equity, management fees range from 1.2% to 2%, and smaller funds often charge 2 and 20. Cambridge Associates data reported to the SEC's advisory committee found that net IRR to investors trailed gross IRR by over 600 basis points on average over 28 years, mostly because of the 20% profit share.

A performance fee can also push a manager to take more risk in pursuit of a larger return.

Worked example: high-water mark

New trading profit is the increase in value over the high-water mark. The new high-water mark is the highest value after deducting the fee paid.

An investor's high-water mark is USD1,000,000. The account starts the year at USD900,000 and ends at USD1,100,000 before fees. The fee is 20%.

Fee = 0.20 x (1,100,000 - 1,000,000) = USD20,000. The first USD100,000 of the gain only recovered earlier losses, so it pays no fee. New high-water mark = 1,100,000 - 20,000 = USD1,080,000.

A fund registration statement filed with the SEC gives the same mechanics at 25%: high-water mark USD20,000, start USD19,000, end USD22,000; fee 25% x 2,000 = USD500; new high-water mark USD21,500.

Worked example: management fee then performance fee

Terms: 2% management fee on beginning net asset value; 20% performance fee on the gain after the management fee.

Start USD50 million, end USD56 million before fees. Management fee = 0.02 x 50 = USD1.0 million. Gain after it = 56 - 50 - 1.0 = USD5.0 million. Performance fee = 0.20 x 5.0 = USD1.0 million. Total = USD2.0 million.

If the performance fee were charged on the gross gain of USD6 million instead, it would be USD1.2 million. Read which base the terms specify.

Waterfalls and clawbacks in private equity

A whole-fund (European) waterfall pays investors until they recover all contributed capital plus a preferred return before the manager takes carry. A deal-by-deal (American) waterfall pays carry as each deal is realised, so the manager is paid sooner.

A clawback requires the manager to return performance pay above its entitlement, typically above an agreed share such as 20% of the fund's aggregate profits. With a clawback, both waterfalls should give the same final split; they differ in timing.

Example: Deal A makes USD30 million and pays USD6 million carry. Deal B later loses USD20 million. Fund profit is USD10 million, so the manager is entitled to USD2 million and returns USD4 million.

Where the exam catches people

Believing the performance fee is charged on the whole year's gain under a high-water mark: only the value above the high-water mark is fee-bearing.
Believing the new high-water mark is the year-end value before fees: it is the value after deducting the fee paid.
Believing a clawback cancels all carry when later deals lose money: the manager keeps its agreed share of the fund's overall profit.
Believing the gap between gross and net private equity IRR comes mainly from the management fee: the SEC committee report attributes it largely to the 20% profit share.
Believing deal-by-deal and whole-fund waterfalls give different final splits when there is a clawback: they differ mainly in when the manager is paid.

Written from CFA Institute's documentation

Try 3 questions on this

Pick an answer to see why each option is right or wrong.

A hedge fund charges a 20% performance fee each 31 December, subject to a high-water mark. An investor's high-water mark is USD500,000. The investor's account was worth USD460,000 at the start of the year and USD540,000 at year-end before the fee. After this year's fee, the investor's new high-water mark is closest to:
Right. In the game that’s Renown for your Alternative Investments building.
Not that one: C is right. In the game your Alternative Investments building would lose a little Renown, and this question would come back later.
Your answerA.USD500,000The high-water mark is reset to the highest value after the fee at each calculation date. The account ended at USD532,000 after the fee, above USD500,000, so the mark rises.Your answerB.USD524,000This charges 20% of the year's full USD80,000 gain, a USD16,000 fee, giving 540,000 − 16,000 = USD524,000. The first USD40,000 of the gain only recovers earlier losses up to the high-water mark and bears no fee.The answerC.USD532,000The fee applies only to new trading profit, the increase in value over the high-water mark: 0.20 x (540,000 − 500,000) = USD8,000. The new high-water mark is the highest value after deducting the fee then paid: 540,000 − 8,000 = USD532,000.
Written from www.sec.gov/Archives/edgar/data/1471270/000090514810001711/efc10-550_1012ga.htm
A hedge fund charges a management fee of 1.5% of beginning-of-year net asset value and a performance fee of 20% of the year's gain after deducting the management fee. An investor's account has a net asset value of USD80 million at the start of the year and USD92 million at year-end before fees. Total fees for the year are closest to:
Right. In the game that’s Renown for your Alternative Investments building.
Not that one: A is right. In the game your Alternative Investments building would lose a little Renown, and this question would come back later.
The answerA.USD3.36 millionManagement fee = 1.5% × 80 = USD1.20 million. Gain after the management fee = 92 − 80 − 1.20 = USD10.80 million. Performance fee = 20% × 10.80 = USD2.16 million. Total fees = 1.20 + 2.16 = USD3.36 million.Your answerB.USD3.50 millionUSD3.50 million bases the management fee on the USD92 million year-end value: 1.5% × 92 = 1.38, then 20% × (12 − 1.38) = 2.12, total 3.50. The fee is set on the beginning value of USD80 million.Your answerC.USD3.60 millionUSD3.60 million applies the 20% to the whole USD12 million gain: 1.20 + 2.40 = 3.60. The stated terms take the performance fee only after the management fee is deducted, so the base is USD10.80 million.
Written from www.investor.gov/introduction-investing/investing-basics/investment-products/private-investment-funds/hedge-funds
A private equity fund pays its adviser carried interest of 20% of profits on a deal-by-deal basis, and its governing agreement contains a clawback. The early exits are highly profitable and pay the adviser carry, but later investments are sold at a loss, although the fund remains profitable over its life. When the fund winds up, the adviser's carried interest is most likely:
Right. In the game that’s Renown for your Alternative Investments building.
Not that one: C is right. In the game your Alternative Investments building would lose a little Renown, and this question would come back later.
Your answerA.Repaid in full, since the later deals' losses cancel all carryThe clawback recovers only the excess. The fund made a profit over its life, so the adviser is still entitled to its 20% share of that profit and returns only what it received beyond it.Your answerB.Kept in full, since each early deal's profit was already realizedCarry paid on the early exits is not final. Under a clawback the adviser must restore whatever it received above its agreed share of the fund's aggregate profits once the later losses are counted.The answerC.Cut back to the agreed share of overall profitA clawback obliges the adviser to give back performance compensation it received beyond what the fund agreement entitles it to, typically anything above the agreed percentage (here 20%) of the fund's aggregate profits.
Show the full explanation and doc quotes
Because the fund is profitable over its life, the adviser keeps 20% of the overall profit and returns the carry paid on the early exits that exceeds it.
Written from www.sec.gov/files/rules/proposed/2022/ia-5955.pdf