A performance incentive fee is the key compensation for a hedge fund manager. Many people may not understand the concept of “alignment of interest”. For example, an investor recently told me they only invest in private funds because of alignment of interest. Essentially they want the fund manager to profit when they do. For example, if a $50 million private fund earns a 10% net return, the fund manager would earn $1 million of the profit as a performance incentive. If the fund manager earned a 100% return, his compensation would be $10 million. If the fund manager has a loss he gets no performance incentive fee until the loss is fully recovered and the fund reaches a new high. You can probably see why some money managers focus on growing the fund through the process of trading rather than trying to find more and more new investor money. I know people across various sides of the money management industry – the incentives and motivations are vastly different depending on their business structure and specialization. A wealth manager that measures success by assets under management will focus on gaining new clients. An alternative portfolio manager pursuing asymmetric investment returns may have an incentive to focus more on the profits they generate. That is, if you really believe you’ve got some skill, you’ll want to align your rewards in that direction. At least, that’s what an entrepreneur who sells a business for $100 million may tell you.
And believe it or not, Pensions & Investments Magazine shows these performance incentive fees may indeed matter in Hedge funds charging highest performance fees provide best returns. They say:
A comparison by Preqin of hedge fund net returns categorized by the performance fees they charge shows that funds charging more than 20% in performance fees actually outperform those that charge 20% or less. Funds charging higher fees appear to be producing higher, and more consistent net returns…
And the chart speaks for itself:
Source: Pensions & Investments