How to take Performance Fee from investors properly?

Everyone who has managed, manage or wants to manage some investment Fund (nonprofit or commercial, big or small, private or public) probably thinks about Performance Fee. And when it comes to practice — some questions arise: How to properly calculate Performance Fee? How to pay Performance Fee? Do I need to take Performance Fee from all investors at once or take from each investor separately? Do I need to take a performance fee before each Withdrawal? How to account performance fee easily? What tools and software exists for such fund accounting?

In this article, I will answer all the questions above and guide you through the processes of Performance Fees calculation, payment, and accounting. As a bonus — you will get the Google Spreadsheet Add-On for fund accounting and management. Let’s go!

A payment made to a fund manager for generating positive returns. The performance fee is generally calculated as a percentage of investment profits.

To measure investment return performance, the industry generally uses two concepts introduced here: measurement period and the high-water mark (HWM). The measurement period is a periodic time, usually annual, but sometimes quarterly. Actually, you can set any period in your fund.

For example, we have some cool Fund with:
Total Portfolio Value (TPV) at the beginning of the measurement period= $10 000 — it will be our HWM
TPV at the end of the measurement period = $12 000

Profits = TPV — HWM = 12 000 — 10 000 = $2 000
Performance Fee in %= 20%
Performance Fee in $ = 2 000 * 0.2 = $400

For example in our cool Fund we have such actual numbers:

TPV = $12 000
Mutual units supply = 10 000
Price per unit = 12000/10000 = $1.2

The price per unit may changes every day, every hour or even every minute (depends on the tech of your cool back-office). Let’s fix the price on $1.2 for today.

In traditional mutual, hedge funds and ETFs, (1) performance fee is taken in some fixed fiat currency with the direct withdrawal of money from the Fund without burning mutual units.

So in both approaches, the price per unit will decrease a little after each performance fee take. In the first casecit caused by decreasing TPV, in the second case (Melonport) it caused by increasing the total supply of units. Thus, investors will lose money, although they may not have any profit again. So how to act fairly?

Of course, we have many investors in our Fund. Each investor bought units by different price individually in his own time. For example:
John bought units per $1
Sam per $1.1
Bob per $1.3

So someone can have a profit, and someone hasn’t. In our case Bob does not have any profit at the moment.

So if we want to take Performance Fee today —what the sum it will be?
You may ask — how much is our HWM? Great question, because actually:

Bob does not have to pay anything if he has no profit. All investors will have incentives to make deposits after Performance Fee event. Many Funds don’t care about that…I think the main reason is some complexity in the accounting of HWM individually (I will show you a solution for that later). So how to act better? You should account individual HWM for each investor. For example:

John’s HWM = $1 per unit (profit 20%)
Sam’s HWM = $1.1 per unit (profit 9.09%)
Bob’s HWM = $1.3 per unit (loss -7.7%)

When we know each investor’s HWM we can calculate investor’s profit/loss amounts in some base currency (e.g. USD). To calculate it we need to know one more thing — the balance of units for each investor. For example:

John’s balance of units = 5000 (50% share)
Sam’s balance of units = 3000 (30% share )
Bob’s balance of units = 2000 (20% share)

And we will calculate profit/loss using these simple formulas:
Investor’s P/L in USD = Investor’s current value— Investor’s HWM value
Investor’s current value = Balance of units * Current price per unit
Investor’s HWM value = Balance of units * HWM price per unit

John’s P/L in USD = (5000 * 1.2)–(5000 * 1) = 6000–5000 = $1000
Sam’s P/L in USD = (3000 * 1.2)–(3000 * 1.1) = 3600–3300 = $300
Bob’s P/L in USD = (2000 * 1.2)–(2000 * 1.3) = 2400–2600 = -$200

And finally we can get total profit from John and Sam = 1000 + 300 = $1300
Proper performance fee amount will be:
1000*0.2 = $200 for John
300 * 0.2 = $60 for Sam

Let’s say we charge the performance fee every quarter in our cool Fund. Next take is coming soon. Our investor John with $6000 balance and profit equals $1000 understands that if he withdraws all his money before the performance fee event — he will get about $6000 minus “some redeem fee”. But if he withdraws after the PF event — he will have to get $6000 minus $200 (performance fee) minus “some redeem fee”. So the investor has an incentive to withdraw money before performance fee event. You Fund will miss out its honestly earned money. What to do?

DON’T FORGET: After the operation is finished, HWM of particular investor should become equal to the price per unit at the time of performance fee take.

An investor makes an additional Deposit to our cool Fund. We mint new units for him. For example Sam deposits new 7000$. We mint 5833.33 units by the price $1.2. Sam’s balance of units become equals 3000+5833.33 = 8833.33. But what the value of Sam’s HWM? He used to have 3000 units bought at $1.1. And now he bought another 5833 unit at $1.2.

WAP = (3000*1.1 + 5833.33*1.2)/8833.33 = 3300 + 6999.99/8833.33 = $ 1.16603

NOTE: 3000 and 1.2 — are values from last HWM. So if we got another additional deposit we will use 8833.33 and 1.16603 to calculate new WAP regarding the amount in this additional deposit and actual price per unit.

Having searched the entire Internet, I have not found a single software that would satisfy me for proper fund accounting and fees management. Only a lot of outsourcing companies with armies of accountants, controllers, auditors, lawyers, back-office- and middle-office workers spent hours faxing, calculating, checking and double-checking all metrics with a price tag of up to 10,000 per month.

There are not enough good and correct information about this topic. I would like to hear from readers — what you think about weaknesses in the approaches described before.

Thank you for reading! And sorry for my poor English. If the article was useful for you, please share it somewhere. Let’s spread the knowledge!

Ask me any question by email spreadsheetfund@gmail.com

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