Catch-up and no catch-up

A Portfolio Management Service (PMS) often charges a performance fee, but only once the portfolio's return crosses a minimum level called the hurdle rate. Below the hurdle, no performance fee is charged at all.

Once the hurdle is crossed, there is a choice in how much of the gain the fee applies to. Under no catch-up, the fee applies only to the portion of the return above the hurdle. Under catch-up, once the hurdle is crossed, the fee is calculated on the entire gain, right from the very first rupee of profit — the manager catches up on the fee they would have earned on the early gains too.

The hurdle rate is set out in the PMS agreement. Say the hurdle is 8%: under both catch-up and no catch-up, if the portfolio's return stays at or below 8%, no performance fee is charged.

The two methods diverge once the return exceeds 8%. No catch-up charges the agreed performance-fee percentage only on the slice of return above 8%. Catch-up charges the performance fee on the whole return, once the 8% threshold has been crossed, effectively removing the hurdle's protection retroactively for that period. Catch-up is therefore more expensive for the investor whenever the fund crosses the hurdle at all.

A PMS has a hurdle rate of 8% and a performance fee of 20% of the applicable gain, on a corpus of Rs 50 lakh. In a year, the portfolio returns 15%, or Rs 7,50,000.

No catch-up: fee applies only to the return above 8%, that is, the 7 percentage points above the hurdle, or Rs 3,50,000.

Performance fee = 20% x Rs 3,50,000 = Rs 70,000

Catch-up: once 15% has crossed the 8% hurdle, the fee applies to the entire 15% return, or the full Rs 7,50,000.

Performance fee = 20% x Rs 7,50,000 = Rs 1,50,000

The catch-up structure costs this investor Rs 80,000 more in the same year, for the identical 15% return, purely because of how the fee is calculated once the hurdle is crossed.

Chapter 12 (Portfolio Manager), section 12.6, introduces the catch-up and no catch-up concept immediately after explaining the hurdle rate and the high watermark principle. Expect a question that gives a hurdle rate, a performance fee percentage and an actual return, and asks you to compute the fee under both the catch-up and no catch-up methods.

• Catch-up is always more expensive than no catch-up for the investor whenever the return exceeds the hurdle — it is never the cheaper option once the hurdle is crossed.
• Do not confuse catch-up and no catch-up with the high watermark principle — the hurdle rate governs whether and how much fee applies within a year; the high watermark governs whether a fee applies again after a year of losses, so the manager cannot charge fees twice on the same gains.
• If the return does not cross the hurdle rate at all, neither method charges any performance fee — the distinction only matters once the hurdle is crossed.