Fees are where a hedge fund's terms turn into money. They decide how much of the fund's return reaches investors, they drive the manager's incentives, and they are one of the most common subjects of investor questions. Getting them right is also one of the administrator's most detailed jobs, because fees are worked out every time NAV is struck.
This lesson covers the two main fees, the high-water mark that stops investors paying twice for the same gain, and the related terms you will see in offering documents: hurdles, crystallization and equalization. The examples use the course's fictional Kessling Harbor Equity Long/Short Fund. All figures are illustrative, and fee terms vary between funds and share classes.
Management and performance fees
Hedge fund managers are commonly paid two fees:
- A management fee: a percentage of the fund's assets, charged whatever the performance. It is usually worked out on NAV and charged monthly or quarterly, and it pays for the manager's staff, systems and offices.
- A performance fee (sometimes called an incentive fee, or an incentive allocation when paid to the GP of a partnership): a percentage of the fund's gains in a period. It rewards the manager for making money.
"2 and 20" is the historical shorthand for a 2% management fee and a 20% performance fee. It describes how the industry has traditionally been priced, not what every fund charges today. Many funds now charge less, especially for large investors, early investors or classes with longer lock-ups, and some platforms instead pass their costs directly through to investors (lesson 2.4).
Illustratively, a class of the Kessling Harbor fund with $200m of NAV and a 1.5% annual management fee would pay about 1.5% × $200m = $3m a year, charged in instalments on each period's NAV.
As in private equity, fund expenses such as administration, audit and legal costs are commonly charged to the fund on top of these fees. The offering memorandum sets out which costs the fund bears.
The high-water mark
Imagine a fund that loses money one year and earns it back the next. Without a safeguard, the manager would earn a performance fee on the recovery, even though investors are only back where they started. The high-water mark prevents this.
The high-water mark is the highest NAV per share on which a performance fee has been paid (or the starting price, for a new investor). The manager earns a performance fee only on gains above that level. After a loss, the fund must first earn it back.
This is the course's shared example. The performance fee is 20% of gains above the high-water mark, charged annually, and management fees are ignored for simplicity. NAV per share starts at $100.00.
| Year | NAV before fee | High-water mark at start of year | Gain above high-water mark | Performance fee | NAV after fee | High-water mark at end of year |
|---|---|---|---|---|---|---|
| 1 | $110.00 | $100.00 | $10.00 | 20% × $10.00 = $2.00 | $108.00 | $108.00 |
| 2 | $95.00 | $108.00 | None | $0 | $95.00 | $108.00 |
| 3 | $112.00 | $108.00 | $112.00 − $108.00 = $4.00 | 20% × $4.00 = $0.80 | $111.20 | $111.20 |
Three points to notice:
- The high-water mark is set after the fee. At the end of year 1, investors hold shares worth $108.00, so that is the level the fund must beat next.
- No fee on the recovery. In year 3 the NAV rises by $17.00, from $95.00 to $112.00, but $13.00 of that only makes up the earlier loss. Without a high-water mark, the fee would have been 20% × $17.00 = $3.40 rather than $0.80.
- Losses can weigh on the manager. When a fund is well below its high-water mark, the manager may go a long time without a performance fee. That can put pressure on the business, and some managers have closed funds rather than work back to an old high-water mark.
In practice, the high-water mark is tracked for each investor or each series of shares, because investors buy in at different prices. Terms such as whether a high-water mark can ever be reset vary, so always check the offering documents.
Hurdles
Some funds add a hurdle: a minimum return the fund must earn before the performance fee applies. It may be a fixed rate, such as 5% a year, or a benchmark such as a short-term interest rate. The idea is that investors should not pay a performance fee for returns they could have earned in cash.
There are two common types:
- With a hard hurdle, the fee applies only to returns above the hurdle.
- With a soft hurdle, once the fund clears the hurdle, the fee applies to the whole gain.
Illustratively, take a share at a high-water mark of $100.00, a 5% hurdle and a 20% fee. NAV rises to $112.00 before the fee, so the hurdle level is $100.00 × 1.05 = $105.00:
| Hurdle type | Gain subject to the fee | Performance fee | NAV after fee |
|---|---|---|---|
| No hurdle | $12.00 | $2.40 | $109.60 |
| Soft hurdle (cleared) | $12.00 | $2.40 | $109.60 |
| Hard hurdle | $112.00 − $105.00 = $7.00 | $1.40 | $110.60 |
Hurdles work alongside the high-water mark: the fund commonly has to beat both. Many hedge funds have no hurdle at all, so this is a term to look for rather than assume.
Crystallization
A performance fee accrues in the NAV as the fund makes gains: each month, the administrator estimates the fee earned so far and deducts it, so the NAV investors see is after fees. But the fee is only crystallized, meaning fixed and paid to the manager, at set points.
The crystallization period is commonly annual, though some funds use quarterly or other periods. Until crystallization, an accrued fee can shrink or disappear if the fund loses money later in the year. After crystallization it belongs to the manager, and the high-water mark moves up.
Performance fees are also commonly crystallized when an investor redeems, for the shares being redeemed. The crystallization period matters to investors: the more often fees crystallize, the more a fund with volatile returns can end up paying on gains that later reverse.
Equalization
Because a hedge fund is open-ended, investors join at different times and at different NAVs. A single fund-wide performance fee can then be unfair.
Go back to the shared example. An investor who subscribed during year 2 at $95.00 gains $17.00 per share by the end of year 3, but the fund-wide fee is based on the $108.00 high-water mark, so that investor pays only $0.80. This is sometimes called a free ride. The reverse problem also exists: an investor who joins when an accrued fee is already built into NAV can end up bearing part of a fee earned on gains made before they arrived.
Equalization covers the methods funds use to make each investor pay a fair fee for their own gains. Common approaches include issuing a separate series of shares for each subscription, with its own high-water mark, which are later consolidated when possible, or making equalization adjustments to each investor's holding. Onshore partnerships usually track this through each investor's capital account. The mechanics are technical and are handled by the administrator; the point for most readers is that a fund should have some method, and its offering memorandum should explain it.
How this differs from private equity carry
PE101 2.3 covered carried interest, the private equity manager's share of profits. Both reward performance, but they work differently:
| Feature | Hedge fund performance fee | Private equity carried interest |
|---|---|---|
| Fund type | Open-ended, investors come and go | Closed-end, fixed life |
| Measured on | Gains in each period, commonly including unrealized gains | Realized profits as investments are sold, over the fund's life |
| When paid | At each crystallization, commonly annually | As distributions are made through the waterfall |
| Main protection against paying twice | High-water mark | Waterfall order, preferred return and clawback |
| Hurdle | Sometimes; many funds have none | Common, typically a compounding preferred return |
The key difference is timing. A hedge fund manager can earn a fee on a good year's gains even if they are never realized, but the high-water mark ensures it cannot be paid again on the same gains after a loss. A private equity GP usually waits until investments are sold and LPs have their money back.
Key terms
- Management fee: A fee charged as a percentage of the fund's assets, whatever the performance.
- Performance fee (incentive fee): A fee charged as a percentage of the fund's gains in a period.
- "2 and 20": The historical shorthand for a 2% management fee and 20% performance fee.
- High-water mark: The highest NAV per share on which a performance fee has been paid; fees are charged only on gains above it.
- Hurdle: A minimum return the fund must earn before a performance fee applies; hard or soft.
- Accrual: The estimated performance fee built into NAV before it is fixed.
- Crystallization: The point at which an accrued performance fee is fixed and paid, commonly annually.
- Equalization: Methods that make investors who join at different times each pay a fair performance fee.
- Series of shares: Shares issued for each subscription date so each can track its own high-water mark.
Key takeaways
- Managers are commonly paid a management fee on assets and a performance fee on gains; "2 and 20" is the historical shorthand, and many funds now charge less.
- The high-water mark means fees are charged only on new gains: in the shared example, NAV goes $100.00 → $108.00 → $95.00 → $111.20, with fees of $2.00, $0 and $0.80.
- A hurdle sets a minimum return before the fee applies; a hard hurdle charges only on the excess.
- Performance fees accrue in NAV and crystallize at set points, commonly annually and on redemption.
- Unlike PE carry, which is commonly paid on realized profits over a fund's life, hedge fund performance fees are charged on each period's gains in an open-ended fund.
This lesson is for educational purposes only and is not investment advice.