Fees and waterfalls: hurdle, catch-up, high-water mark, clawback

How are alternative fund managers paid?

The manager knows far more than the investor, and the investments last for years. Pay is therefore more complex than the flat percentage a normal fund charges. Alternative funds combine a higher management fee with a performance fee, then add terms that protect investors against overpaying.

GP compensationcomplex structures align manager and investor over long periods

• Management fee Memorize usually 1% to 2% a year, paid even when returns are poor
  • Private equity Memorize on committed capital
  • Hedge funds and REITs Memorize on assets under management
• Performance fee (carried interest) Memorize often 20% of profits
  • Hurdle rate (preferred return) Memorize minimum return before the fee applies
    • Hard hurdle Memorize fee only on the return above the hurdle
    • Soft hurdle Memorize fee on the whole return once cleared, via a catch-up clause

What are the two fees?

The management fee is a percentage of a base, often 1% to 2% a year. The base matters. Hedge funds and real estate investment trusts (REITs) charge on assets under management (AUM). Private equity funds charge on committed capital: the amount limited partners (LPs) have promised. Funds draw that money down over about three to five years, so committed capital is a steady base from day one. It removes any urge for the GP to invest quickly just to raise fees, and lets the GP be selective.

$$F = f \times B$$

The performance fee is a share of profits (often 20%) that rewards results. It is also called an incentive fee or carried interest (“carry”). The partnership agreement usually makes it payable only above a hurdle rate. Missing the hurdle costs the GP the performance fee, but never the management fee.

What are hard and soft hurdles?

The hurdle rate, also called the preferred return, is the minimum return before the performance fee applies. There are two kinds.

With a hard hurdle rate , the GP earns the fee only on the return above the hurdle. With a soft hurdle rate , once the fund clears the hurdle the fee applies to the whole return. A catch-up clause is how a soft hurdle works in the cash flow: LPs get 100% of distributions until the hurdle, then the GP gets 100% until it holds its full share of the profit so far, then the profit is split (for example 80/20).

Below the hurdle the GP earns no performance fee in either case.

$$r_{GP} = \max\left[0,\; p\,(r - r_h)\right]$$

$$r_{cu} = \dfrac{p \times r_h}{1 - p}$$

$$r_{GP} = \max\left[0,\; r_{cu} + p\,(r - r_h - r_{cu})\right]$$

Exam tip Shortcut for a full catch-up: once the return is large enough, the GP simply gets p × r. Here 0.20 × 14 = 2.8. The hard hurdle result is smaller by p × r_h = 1.4.

Go deeper What happens inside the catch-up band

The catch-up formula assumes the return is big enough to finish the catch-up. Below the hurdle the GP gets nothing, whatever the formula would give if you plugged the numbers in. If the return clears the hurdle by less than r_cu, the GP takes all of the excess. With a 7% hurdle and a 7.8% return, the GP gets the 0.8% above the hurdle, not the full 1.75% catch-up. The solver above handles this case.

What do the high-water mark and the clawback do?

Both stop investors paying twice for the same performance, but at different moments.

A high-water mark is the fund’s highest value on which a fee was charged, net of fees. If the value then falls, no performance fee is due until the value climbs back above that mark. It protects investors from paying fees on the recovery of losses.

$$\text{fee} = p \times \max\left[0,\; V - H\right]$$

A clawback lets LPs reclaim part of the performance fees the GP has already received, when later losses show the GP was overpaid. It matters when a GP exits successful deals early and loses money on later ones. Clawbacks are common in private equity and real estate, over the whole life of the portfolio. In hedge funds, fees already paid for earlier years are usually not clawed back, though the high-water mark carries into new years.

$$CB = \max\left[0,\; C_{paid} - p \times P\right]$$

What is a waterfall?

A waterfall is the order in which cash goes to LPs and the GP. There are two types.

	Deal-by-deal (American)	Whole-of-fund (European)
When the GP gets carry	as each profitable deal exits	only after LPs get all contributed capital back plus the hurdle
Favors	the GP	the LPs
Needs a clawback?	often, to fix overpayment	rarely

The deal-by-deal (American) waterfall pays the GP deal by deal. The whole-of-fund (European) waterfall pays the GP only after the fund as a whole has returned LPs’ capital and the hurdle.

Go deeper Why commitment fees can drag early returns

Fees are charged on commitments from the start, but only part of the capital is invested and earning in the early years. Net returns can therefore be negative early on and rise later, a pattern called the J-curve, which the performance lesson uses.

Go deeper 2 and 20, and drifting fee levels

“2 and 20” means a 2% management fee and a 20% performance fee. Many funds now charge less, with a lower management fee or a higher hurdle, but the structure of the fee is the same.