Performance fee

Most portfolio managers charge a fixed percentage of the assets they manage, whatever the portfolio does. A performance fee adds a second layer that only bites when the manager actually delivers: a share of the profit, and often only the profit above a minimum return.

The workbook's own illustration charges a performance fee of 20% of profits over the hurdle rate, without catch-up. Two ideas are doing the work here: the hurdle rate, the minimum return the fund must clear before any performance fee applies at all, and the high water mark, which stops a manager charging twice for the same gains after a fall and recovery. A performance fee means little without knowing both.

Where it sits in the fee list (Chapter 8 and Chapter 10, section 10.1.4). Among the items in the workbook's fee and expense illustration: upfront fee, setup fee, other expenses, fixed management fee, and performance fee, using 20% of profits over a 10% hurdle rate, with no catch-up, in the worked example.

"Without catch-up" matters. A catch-up clause, where used, lets the manager take 100% of the profit just above the hurdle until it has "caught up" to its full percentage share of the whole profit. The workbook's illustration has no such clause. The manager earns 20% only of the amount actually above the hurdle, nothing more.

How the fee is computed, per the workbook's own worked figures: performance fee equals 20% multiplied by the difference between the portfolio value after the fixed management fee and the hurdle-rate value, the capital contribution compounded at the hurdle rate. See Due diligence and Gross return for the full fee cascade this fits into.

On a ₹1,00,00,000 portfolio growing 20% over a year, after other expenses and a 1.5% fixed management fee, the portfolio stands at ₹1,17,75,000.

The hurdle value is the original capital compounded at the 10% hurdle rate: ₹1,00,00,000 × 1.10 = ₹1,10,00,000.

Performance fee = 20% × (₹1,17,75,000 − ₹1,10,00,000) = 20% × ₹7,75,000 = ₹1,55,000.

Now compare a portfolio that grows only 8% in the year, below the 10% hurdle. Even after the fixed fee, its value never reaches the ₹1,10,00,000 hurdle line, so the performance fee is nil, regardless of how large the fixed fee was. The manager is paid its fixed percentage either way, but the performance fee is earned only on the slice of return the hurdle was actually cleared by.

Performance fee appears in Chapter 8's list of permissible PMS charges and is worked through in full in Chapter 10, section 10.1.4's gross-versus-net return illustration. Expect a calculation question applying a stated hurdle rate and performance fee percentage to a given portfolio value, and a conceptual question on the difference a catch-up clause would make.

• Performance fee applies only to profit above the hurdle, not to the whole profit: 20% of ₹7,75,000, not 20% of the full ₹20,00,000 gain in the worked example.
• "Without catch-up" means the manager never gets more than its stated percentage of the excess over the hurdle. Do not assume a catch-up clause exists unless stated.
• If the return does not clear the hurdle, the performance fee is nil, however large the fixed management fee charged.
• A performance fee is separate from a high water mark, which stops performance fees being charged again on gains that merely recover an earlier loss. The workbook's illustration is a single-year example and does not itself carry the high water mark forward across years.