A performance fee is a compensation structure where investment managers earn fees based on the investment returns they generate, aligning their interests with those of investors.
In finance and wealth management, performance fees motivate portfolio managers to outperform relevant benchmarks or absolute return targets. By charging fees based on returns rather than assets alone, they aim to foster alignment of interests between managers and investors, encouraging active management and risk-taking within agreed parameters. However, the specific terms, such as hurdle rates, high-water marks, and fee percentages, greatly influence the effectiveness and fairness of the arrangement. High-water marks, for example, ensure that managers are paid performance fees only on new gains, preventing fees on recovered losses.
Governance matters when performance fees are involved, as clear agreements on fee calculation and payment conditions are vital to avoid conflicts. Family offices typically assess performance fees alongside other costs such as management fees to evaluate total expenses relative to realized value. Transparent communication around performance benchmarks and fee mechanics supports trust with investment managers and ensures alignment with the family office’s long-term goals.
Suppose a manager charges a 20% performance fee and there is a hurdle rate of 5%. If a portfolio grows from $10 million to $12 million in one year, the 20% fee applies only on the $1 million gain above the $500,000 hurdle (5% of $10 million). The performance fee would be 20% of $500,000, equaling $100,000.
Management Fee
Unlike performance fees, management fees are fixed charges based on assets under management regardless of investment performance, providing steady revenue to managers and covering operational costs.
What is the difference between a performance fee and a management fee?
A management fee is typically a fixed percentage of assets under management charged regularly, regardless of performance, whereas a performance fee is variable and based on the investment returns generated above a certain benchmark or hurdle rate.
How does a high-water mark affect performance fees?
A high-water mark ensures that a manager only earns performance fees on new net gains. If the portfolio suffers losses, the manager must recover those losses before receiving additional performance fees, preventing double charging on the same gains.
Are performance fees common in family office investments?
Yes, especially when family offices engage external asset managers or invest in private funds, performance fees are used to align incentives, though family offices often negotiate fee terms carefully to balance costs and benefits.
