Should investors avoid funds and trusts with performance fees?

Such fees are still surprisingly common among investment trusts. Cherry Reynard examines whether extra charges are worth paying.

The management team of specialist private equity investment trust Chrysalis Investments (LSE:CHRY) recently drew some unwelcome attention after its managers pocked a £60.5 million performance fee. The trust had seen a strong year, but this was equivalent to more than 8% of the FTSE 250 trust’s net asset value. It has revived a dormant debate on performance fees.

Performance fees have typically been associated with hedge funds. The old ‘2 and 20’ model (2% ongoing fee and 20% performance fee) has made a number of hedge fund managers very rich. Investors often didn’t care very much if they were making good returns as well, but performance fees have come under more scrutiny when investor returns have weakened and the fund managers still appear to be drawing chunky fees.

Performance fees are still surprisingly common. Almost 30% of investment trusts (93 out of 337) have performance fees, of which 44% paid out in their last financial year. It tends to be associated with private equity and hedge fund strategies rather than plain vanilla stock market funds and is often seen as a reward for a more activist approach, where a fund manager helps with the strategy of a company or takes a seat on the board.

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Criticism of performance fees has tended to focus on either rewards for failure or rewards for very short-term performance. The Chrysalis example has been problematic both for the size of the award and because it was levied on one-year performance. An additional problem is that the performance fee was based on the value of private equity holdings. Unlike normal shares, the prices assigned to these assets may not be immediately realisable.

Signs of a move away from performance fees

In recent years, various trusts have moved away from performance fees or to restructure them to make them more robust. Matthew Read, senior analyst, QuotedData, says: “To simplify fee structures and to make funds more appealing to investors, the trend in recent years has been to do away with performance fees and to make do with a simple base management fee. The best of these are tiered (if a fund doubles in size it doesn’t cost twice as much to run) and charged on the lower of NAV or market cap, which gives managers an incentive to keep discounts tight.”

However, the issue is not clear-cut. As Dan Brocklebank, head of Orbis UK, points out, fixed fees also have their share of problems: “If you just charge a percentage of assets under management, your incentive as a fund manager is to grow the fund to be as big as possible. And yet most investors don’t want the fund to become too big.” Too often, it compromises an investment manager’s process and dents performance. The whole idea of a performance fee is that it links what clients want to the success of the asset management firm.

There have been examples where performance fees do go hand in hand with good performance. The Medallion fund, managed by Renaissance Technologies has an extraordinarily high management and performance fee. However, the exclusive range of current and former partners that can access the fund haven’t quibbled with the 40%+ performance fee as they raked in 40% annual returns. Brocklebank points out that investors could have paid Warren Buffett a vast 4% annual fee and still have been ahead of the market. Performance fees don’t have to be a bad thing if they are structured properly.

Read says: “We don’t mind performance fees as, when they are designed properly, they help align the manager’s and shareholders’ interests and reward superior performance. That said, performance fees must be sufficiently challenging to earn and should not reward managers for failure.”

Skewed incentives

This has been the biggest problem with performance fees. If they are not structured correctly, managers can earn vast fees one year, and then significant losses the next. Earning a big fee one year, but not giving any of it up. This creates skewed incentives. Brocklebank says: “The wrong fee structure can incentivise risk-taking. If you have a 0.25% yearly fee and 30% of the outperformance, the fund manager may load up on risky stuff. After all, they only need one great year.”

Equally, with many performance fee structures, says Brocklebank, the fixed-fee structure is still too high. If, as many hedge funds do, the charging structure is 2% fixed and 20% of any outperformance, they still have the incentive to grow the fund to be as big as possible.

A third problem is fees being paid twice. This could happen where, in year one, the fund manager outperforms by 10% and receives a fee equivalent to 20% of that outperformance. The next year, they lose 20%, there is no clawback. If they outperform again in the third year, they will get another performance fee, even though the investor may not have seen any appreciation in their investment. “The problem is not linking performance fees to cumulative outperformance,” Brocklebank adds.

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Investors are caught between a rock and a hard place. Brocklebank says: “There is no such thing as a perfect fee structure. Investors need to be aware of the problems of both and watch out for the issues on both sides.” Mark Northway, investment manager at Sparrows Capital, says that investors also need to watch out for managers gaming the system. He says this has been particularly prevalent in the Venture Capital Trust industry, where the tax incentives can immunise people against the fees.

What does a good performance fee look like? Read says: “Any performance hurdle should be at an appropriate level and any benchmarks employed should have a similar risk and return profile to the portfolio whose performance is being evaluated.”

For example, if a fund manager is focused on global equity income stocks, they should have a global equity income benchmark, rather than one based on general global equity. In the UK, specialist small and mid-cap managers should be benchmarked to small and mid-cap indices, for example, rather than the FTSE All-Share, which takes in a lot of stodgy large caps.

Equally, Read adds, a high watermark prevents managers from being paid to achieve the same thing twice. If they generate good performance, but then poor performance, the asset value of the fund has to get back to a certain level before the performance fee is paid again. He adds: “Clawbacks – losing the right to all or part of a performance fee earned in one year if the portfolio underperforms in the next year – may be a good idea.”

Should performance fees be capped?

Northway believes fees should be capped. Managers shouldn’t be incentivised to secure the equivalent of a lottery win one year. After all, if this happens, they may lose all incentive to outperform the following year. Brocklebank says investors need to look at the length of the crystallisation period: “How often are the fees paid to the manager – the longer the better. Is there a refund mechanism if a manager outperforms and then underperforms.” Paying fees back to investors seems far-fetched, but Orbis has put in place a mechanism to do just that.

Northway says investors need to be very careful where performance fees are charged on private assets: “Fund managers should always be charging a performance fee on realised profit, not on mark to market prices.”

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He believes that good performance fees do exist. He cites Orbis as an example of a performance fee that works to align manager and investor. There is an appropriate benchmark, there is a clawback mechanism, it is based on cumulative performance rather than a single year. However, he says that this is the exception rather than the rule and in many cases performance fees don’t appear to fulfil their primary function – incentivising the manager to deliver better performance for investors. “Too often, it doesn’t improve performance to the extent it justifies the fee or promote alignment of interests with the client.”

Ultimately, performance fees cannot operate on a ‘heads we win, tails you lose’ basis. Those fees come out of investors’ capital and, while they can be used to incentivise good performance, they can be a tool for greedy fund managers to fill their boots at the expense of their unit-holders. Brocklebank says: “We can only win as fund managers if you win as a client…The industry needs to take the risk on performance, not the client.”