Performance fees are integral to hedge funds, designed to align the interests of fund managers closely with those of investors. Yet, calculating these fees fairly presents its challenges. To tackle this, hedge funds utilize one of two main accounting approaches: series accounting and equalization accounting. Let’s delve into these methods to see how they differ and what impact they have on investors.
The Importance of Performance Fees
Performance fees are essentially rewards for fund managers who generate returns that surpass a predetermined benchmark. The complexity arises when investors come on board at different times, which can lead to unfair fee distributions—a situation often described as a "free ride." To resolve this, funds opt for accounting methods like Series Accounting or Equalization Accounting to ensure a level playing field for all investors. But are these systems as fair as they claim to be?
Evolving Industry Trends: Performance Fees Post-2008
The financial crisis of 2008 brought sweeping changes to the hedge fund sector. Investors became more demanding, seeking better returns and hesitating to pay hefty fees for mediocre performance. Consequently, there have been notable shifts in fee structures:
- The Decline of the 2%/20% Model: The once-standard 2% management fee paired with a 20% performance fee model has undergone modifications.
- Customization Comes to the Fore: Lower, often tiered management fees have become more common, combined with higher performance fees contingent upon benchmarks, hurdles, or layered returns.
- Increased Calculation Complexity: There’s been a growing trend to add complexity, using tiers and hurdles, and experimenting with combining series and equalization accounting to attract diverse investors.
A Closer Look at Series Accounting
Series Accounting is crafted to ensure performance fees benefit both fund managers and investors fairly. It functions by issuing a new series of shares for new subscriptions. This setup guarantees that fees are based on each investor’s timing, maintaining fairness universally.
Each series calculates performance fees independently, preventing new investors from unfairly capitalizing on prior gains. This approach effectively stops “free rides” and ensures contributions are proportional to each investor’s specific performance.
At the close of the performance period, fees for profitable series are crystallized—finalized and deducted. Once done, these series merge into the lead series. This ensures equitable treatment of investors within the same series, linking fees to specific timing and performance.
A crucial feature of Series Accounting is the absence of a unified NAV/share across series. Every series operates autonomously, reflecting its unique performance and entry timing. If a series underperforms, it may not rack up performance fees, sparing investors from unjust charges. Over time, underperforming series might be integrated with the lead series, keeping fairness intact while accurately representing investment outcomes.
Equalization Accounting: Ensuring Consistent Fairness
Equalization Accounting has a distinct method to ensure fairness, aligning performance fees for everyone using a single net asset value (NAV) per share. By calculating fees at both the fund and investor levels, it addresses discrepancies in subscription timing, fostering equitable treatment.
A pivotal aspect of this method is equalization credits and contingent redemptions. When an investor’s high-water mark (HWM) surpasses the fund’s, they owe fewer fees and may receive an equalization credit, resulting in more shares on the crystallization date. Conversely, if an investor’s HWM is lower, they owe more and may experience a contingent redemption, where shares are redeemed and allocated to the manager.
Through these mechanisms, Equalization Accounting assures equal treatment for all investors, regardless of their entry time into the fund.
Though both methodologies aim for equitable performance fee calculations, the debate about superiority persists. Series Accounting offers clarity by isolating the fees within each series, reflecting returns at an investment date level, while Equalization Accounting consolidates to a single fund-level fee and NAV, albeit with more complexity (especially with hurdles). The choice ultimately depends on the fund’s structure and investor preferences.
Performance fees are crucial in motivating fund managers to achieve outstanding returns. Whether utilizing Series Accounting or Equalization Accounting, the key goal is to maintain fairness and harmony between managers and investors. As the hedge fund sector evolves, these accounting practices will continue to play a central role in building trust and sustaining investor confidence. For more insights into how SS&C can assist, feel free to reach out.
