A performance fee is a fee that an investment fund

Collective investment scheme

A collective investment scheme is a way of investing money alongside other investors in order to benefit from the inherent advantages of working as part of a group...

 may be charged by the investment manager

Investment management

Investment management is the professional management of various securities and assets in order to meet specified investment goals for the benefit of the investors...

 that manages its asset

Asset

In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...

s, calculated by reference to the increase in the fund's net asset value

Net asset value

Net asset value is a term used to describe the value of an entity's assets less the value of its liabilities. The term is most commonly used in relation to open-ended or mutual funds because shares of such funds registered with the U.S. Securities and Exchange Commission are redeemed at their net...

 (or "NAV"), which represents the value of the fund's investment

Investment

Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...

s. Performance fees are widely used by the investment managers of hedge fund

Hedge fund

A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...

s, which typically charge a performance fee of 20% of the increase in the NAV of the fund.

Worked example

An example might be as follows:
An investor

Investor

An investor is a party that makes an investment into one or more categories of assets --- equity, debt securities, real estate, currency, commodity, derivatives such as put and call options, etc...

 subscribes for shares

Share (finance)

A joint stock company divides its capital into units of equal denomination. Each unit is called a share. These units are offered for sale to raise capital. This is termed as issuing shares. A person who buys share/shares of the company is called a shareholder, and by acquiring share or shares in...

 worth $1,000,000 in a hedge fund. Over the next year the NAV of the fund increases by 10%, making the investor's shares worth $1,100,000. Of the $100,000 increase, 20% (i.e. $20,000) will be paid to the investment manager, thereby reducing the NAV of the fund by that amount and leaving the investor with shares worth $1,080,000, giving a return of 8% before deduction of any other fees.

High water marks

The highest NAV of a fund to date is known as the "high water mark". If the NAV of a fund declines during a year, no performance fee will be payable to the investment manager. If the NAV subsequently increases over the following year back to the high water mark (but no higher), it would be objectionable for the investor to be charged a performance fee on that increase because the investor has not yet made any return on its investment. Therefore, to address this concern, hedge funds will typically only charge a performance fee on increases in NAV over the high water mark.

Hurdles

A hurdle, in the context of a performance fee, is a level of return

Returns (economics)

Returns, in economics and political economy, are the distributions or payments awarded to the various suppliers of the factors of production.-Wages:...

 that the fund must beat before it can charge a performance fee. It may be a set percentage or it may be referenced to an index

Index (economics)

In economics and finance, an index is a statistical measure of changes in a representative group of individual data points. These data may be derived from any number of sources, including company performance, prices, productivity, and employment. Economic indices track economic health from...

. The index would typically be either LIBOR (or an equivalent) or an index reflecting the underlying market

Financial market

In economics, a financial market is a mechanism that allows people and entities to buy and sell financial securities , commodities , and other fungible items of value at low transaction costs and at prices that reflect supply and demand.Both general markets and...

 in which the fund is investing. The purpose of the latter is to reward the fund for generating returns that are better than the market (alpha

Alpha (investment)

Alpha is a risk-adjusted measure of the so-called active return on an investment. It is the return in excess of the compensation for the risk borne, and thus commonly used to assess active managers' performances...

) rather than for returns generated simply by movement in the market as a whole.

If, in the worked example, there had been a hurdle of 4%, the performance fee would only have been charged on the additional 6% increase rather than the full 10% increase in NAV.

As hurdles reduce the size of performance fees and reward successful active management, they are popular with investors. However, as demand for hedge funds has been high in recent years, fewer hedge funds have needed to resort to their use to attract investors.

Other fees

As well as a performance fee, a hedge fund will charge a management fee, typically calculated as 2% of the NAV of the fund, regardless of whether the fund has generated any returns for the investor. Hedge funds may also pay fees to administrators, prime brokers

Prime brokerage

Prime brokerage is the generic name for a bundled package of services offered by investment banks and securities firms to hedge funds and other professional investors needing the ability to borrow securities and cash to be able to invest on a netted basis and achieve an absolute return...

, lawyer

Lawyer

A lawyer, according to Black's Law Dictionary, is "a person learned in the law; as an attorney, counsel or solicitor; a person who is practicing law." Law is the system of rules of conduct established by the sovereign government of a society to correct wrongs, maintain the stability of political...

s, accountant

Accountant

An accountant is a practitioner of accountancy or accounting , which is the measurement, disclosure or provision of assurance about financial information that helps managers, investors, tax authorities and others make decisions about allocating resources.The Big Four auditors are the largest...

s and other service providers.

Terminology

While this article uses the term "NAV" for simplicity, in reality a performance fee would be charged by reference to the NAV per share (being the net asset value divided by the number of shares in issue). The NAV will fluctuate as investors subscribe for and redeem shares, whereas the NAV per share will only fluctuate as the underlying investments increase or decrease in value, making the latter the appropriate measure for calculating a performance fee.

Where a hedge fund is structured as a limited partnership

Limited partnership

A limited partnership is a form of partnership similar to a general partnership, except that in addition to one or more general partners , there are one or more limited partners . It is a partnership in which only one partner is required to be a general partner.The GPs are, in all major respects,...

 or unit trust

Unit trust

A unit trust is a form of collective investment constituted under a trust deed.Found in Australia, Ireland, the Isle of Man, Jersey, New Zealand, South Africa, Singapore, Malaysia and the UK, unit trusts offer access to a wide range of securities....

, the terms "interest" and "unit" should be substituted for "share" .