Investors have seen fixed-income yields pushed lower as central banks venture into uncharted policy waters. Meanwhile, equities are once again vacillating in the face of multiple economic headwinds, following years of barely a rest on their march to ever-greater heights from their 2008-09 nadir.
In response to decreasing yields and increasing volatility, institutional investors continue to reduce their holdings of traditional fixed-income and equity assets in favour of private investments that promise the holy grail of higher returns and lower volatility. But the holy grail comes with a catch.
Private investments (whether debt, equity or real assets) usually have base management fees of between one and two per cent. With few exceptions, private investments also charge a performance fee — also known as carried interest — that often includes a nasty thing called a catch-up provision. All of these fees contrast with traditional actively managed fixed-income and equity investments that generally have base management fees that rarely exceed 0.8 per cent. With so many components to the fees for private investments, it’s often difficult to realize how much they’re biting off of returns.
Adding up the fees
Regardless of how well a private investment performs, its manager always charges the base management fee. For the purposes of this article, the term return will consider the base management fee already charged. After removing the base fee, the manager levies the performance fee only if the return exceeds a minimum amount.
If the manager doesn’t have a catch-up provision, it simply multiplies the return above the hurdle by the performance fee. For example, in Table A, the return for the manager with no catch-up provision is 10 per cent, so the two per cent of the return above the hurdle is subject to its 20 per cent performance fee. Consequently, the manager’s cut of the performance is 0.4 per cent.
When the manager catches up, you fall behind
Recall that the manager doesn’t receive a performance fee until the return exceeds the hurdle. Until then, managers with catch-up provisions consider themselves to have fallen behind in their cut of the performance. A catch-up provision does exactly what its name suggests: it permits the manager that has fallen behind to catch up on its cut of the performance.
Also in Table A, under the full catch-up scenario (the final column), the manager takes all of the return above the hurdle until its cut reaches its performance fee. Returns above this point are then split between the investor and the manager, based on the performance fee.
For an easier way to think about how a performance fee escalates under that situation, simply apply the manager’s performance fee to the entire return and then cap it by the return above the hurdle. For example, if Table A’s full catch-up manager achieves a nine per cent return, applying its 20 per cent performance fee to the entire return would give it 1.8 per cent. But then capping that by the return above the hurdle limits it to only one per cent. If, however, the return reaches 10 per cent, the manager takes the two per cent of the return above the hurdle. Its cut of the return has now reached its 20 per cent performance fee and it has now fully caught up. Any returns above 10 per cent would be split 20 per cent to the manager and 80 per cent to the investor.
A 50/50 catch-up scenario permits the manager to take only 50 per cent of the return exceeding the hurdle. The manager is still catching up but more slowly than under the other scenario. Table A’s full catch-up manager caught up once the return reached 10 per cent. But the partial catch-up manager catches up if and when the return finally reaches 13.3 per cent. If the return doesn’t reach 13.3 per cent, the manager’s cut of the performance never reaches 20 per cent and the investor keeps more of the return.
Once the performance exceeds the hurdle, an investor always fares best when there’s no catch-up provision. The faster the manager catches up, the faster the investor falls behind.
If the manager with full catch-up is promising higher returns than someone without such a provision, the unwary investor may instinctively prefer the former because both managers’ fee schedules appear to be similar. Only the detail about their catch-up provisions differs. However, if the first manager achieves an 11 per cent return, the investor would have done just as well with only a nine per cent return under the second manager.
Fees in schedule are larger than they appear
Let’s consider another example (in Table B below) that compares a more aggressive strategy targeting 15 per cent before fees with another less aggressive manager targeting 12 per cent. Without considering their fee schedules, the unwary investor may again prefer the more aggressive manager. However, should both managers attain their return targets, the investor will just end up receiving the same return. The more aggressive manager’s fee schedule eats up all of the additional return generated. A higher return, then, doesn’t always end up being a higher return.
Managers with harsh catch-up provisions often fail to make mention of it in their pitch decks, despite their dramatic effect on the return the investor ends up receiving. The investor should always insist on modelling it clearly before considering the manager’s product any further.
Table A’s three fee schedules are only a small sample of the many varieties found in the marketplace. By arming themselves with the knowledge of how much fees cut into performance, investors have better insight to select the most suitable managers for their investments.
Charles Manty is an investment consultant at PBI Actuarial Consultants Ltd.