Hedge fund fees typically include a fee based on the amount of assets being managed and a fee based on the fund’s performance. The performance based fee is typically 20% of the performance in excess of some minimum target. So, for example, a firm with $100 million in beginning assets is expected to earn at least 2% per quarter, and in a given quarter their return is 3% ($3 million.) Their performance based fee would be 20% of the difference between the $3 million actually earned and the $2 million (2%) minimum requirement – or $200,000.
If, in the following quarter, the fund loses money and returns to $100 million in assets, obviously they would not earn a fee in that period. However, investors would also be reluctant to pay a fee for the fund simply recovering the $3 million lost. After all, they already paid a performance fee when the fund reached $103 million the first time.
As a result, fund structures typically include a “high water mark” provision. This provision stipulates that the fund cannot charge additional performance fees until the previous high value has been surpassed.
In order to keep investors from seeking a “free ride” by investing in funds that have recently suffered a loss in order to avoid performance fees until the high water mark is recovered, most funds employ accounting methods known as fee equalization to ensure that all investors in the fund are charged incentive fees on an equitable basis.