Known broadly for the "2-and-20" model, hedge funds quote headline fees. These fees include both a management fee and performance (or incentive) fee. As the hedge fund industry has grown, poorer relative performance and increased competition have created substantial pressure on headline fees. In certain areas, such as '40 Act liquid alternatives, there has also been a push for a management-fee-only, or flat fee model.
Nevertheless, performance fees are still relatively common for hedge funds. Performance fees are somewhat more complex than flat fees, as they require a manager to define "performance." As a result, behind headline performance fees there are payment terms related to the calculation and frequency of fee payments.
The frequency of performance fee payment is often called by the fancy name "fee crystallization frequency." It describes how often managers get to "crystallize" fees. Put simply, this is how often fund managers can get paid for performance, whether it's daily, monthly, quarterly, semiannually or annually. As we all learned in Finance 101, more frequent compounding increases the total amount of interest paid. For hedge funds the same concept applies. The more frequent the marking of performance, the higher the potential for fees to be paid. From this perspective, given the same headline fees, on average, the more frequent the crystallization, the higher the total fee paid to the hedge fund manager. All other things equal, a manager might prefer to mark performance more often instead of seldom.
Does the timing and frequency of performance fees payments matter? Absolutely. Let's consider a hypothetical Fund XYZ. Assume that Fund XYZ charges "zero and 20" or no management fee and a 20% performance fee and has a high water mark of 110. The fund has stellar performance in year one and until the second quarter of year two, after which it gives back a large portion of prior gains. For both monthly and annual performance fee crystallization, Figure 1 plots the gross return and net return, as well as the net fees paid for Fund XYZ during this two-year period. For the first year, the investor would pay roughly 2% net regardless of the payment frequency. In year two, the investor would pay no fees with annual payments and 182 basis points with monthly payments. What investor would like to pay 1.8% in fees in a 10% down year? Note, for the same structure, the actual fee loads are very different: zero or 182 bps.