Hedge fund manager fees typically consist of (i) an annual management fee and (ii) a performance allocation, also referred to as incentive allocation, or carried interest. The latter is not technically a “fee,” but rather a capital allocation, as will be discussed below. This blog post describes the role of both compensation components.
Hedge Fund Management Fees
A management fee is assessed annually, typically ranging from 1% to 2%, of the aggregate assets under management of a fund, regardless of the performance of the fund. The management fee is intended to cover manager salaries and general overhead. The management fee is deducted from each investor’s account periodically (usually in advance) as set forth in the offering documents.
Prior to 2008, a 2% management fee was standard for most funds, with some funds even charging up to 3%. Following the economic contraction, there was a general trend to significantly lower management fees, and rely more heavily on performance allocations, where compensation is earned only when funds perform in positive territory. In recent years, we have seen the management fees creep back up to the 1.5% to 2% range for established funds. Emerging funds seeking to entice investors occasionally elect to initially maintain a low management fee or to forgo it entirely until the fund has shown proven success.
The Performance Allocation
The performance allocation is one of the defining characteristics of hedge funds and private equity funds and distinguishes them from mutual funds, which charge only a management fee. A performance allocation is a percentage of the increase in the value of the fund assets (usually around 20%) allocated to the fund’s general partner as an incentive for positive performance. The performance allocation is intended to align the interests of the fund manager with that of the investor and provide significant upside potential for fund managers. As with the management fee, there is variance among funds in the percentage charged, can range from 10% to 50% in extreme cases, but is typically in the 20% range.
Tax Advantages of the Performance Allocation
As mentioned above, the performance allocation is not designated as a “fee,” but rather a “capital reallocation of the profits” of the fund, which, if permitted by the offering documents, can be drawn by the manager at the manager’s discretion or at regular intervals. The distinction is for tax purposes. A fee is compensation for services rendered. For a fund manager, the investment management fee is always subject to ordinary income rates and is considered self-employment income and subject to FICA taxes (in addition to the Unincorporated Business Tax for fund managers located in New York City).
A properly drafted performance allocation is not considered a fee, but a reallocation of partnership profits from an investor’s capital account to the fund manager’s capital account. In other words, the investors are never allocated the 20% profit allocation, and the amount is treated as profit allocated directly to the fund’s general partner. In a private equity context, where the fund holds long-term investments, the performance allocation can result in long-term capital gains treatment. For hedge funds, which usually hold short-term investments, the allocation would be considered short-term capital gains (which is the same as ordinary income). However, short-term capital gains are not considered self-employment income and with certain exceptions are not subject to Social Security taxes.
