Performance Fee

A performance fee (also called an incentive fee) is a percentage of a fund’s profits that the manager charges in addition to the management fee. A hedge fund charging “20 and 20” takes 20% of profits above a hurdle rate, plus 20% of overall profits if the return is above the hurdle rate. Performance fees align manager incentives with investor returns but can incentivize excessive risk-taking.

How performance fees work

A hedge fund charging “2 and 20” charges:

• 2% management fee: Annual charge on assets under management.
• 20% performance fee: 20% of profits if the fund outperforms.

Example: A fund with $100 million in assets returns 15% in a year:

Gross profits: $100M × 0.15 = $15M
Management fee (2%): $100M × 0.02 = $2M
Performance fee (20%): $15M × 0.20 = $3M
Total fees: $2M + $3M = $5M
Net return to investor: ($15M - $5M) / $100M = 10%

The investor receives 10% net; the manager captures 5 percentage points (one-third of the gross returns).

Hurdle rates and high-water marks

Many funds employ two mechanisms to make performance fees less onerous:

Hurdle rate. A performance fee is charged only on returns above a threshold, often the risk-free rate (Treasury yield) or a specific benchmark. A fund might charge 20% performance fee only on returns above 5% (the hurdle rate). Returns below 5% pay no performance fee.

High-water mark. The fund remembers its peak net asset value. Performance fees are charged only on new highs above the prior peak. If a fund drops 20% from $100 million to $80 million, then rallies 20% back to $96 million, no performance fee is charged because the fund is below its high-water mark.

These provisions protect investors from paying fees on recoveries from losses.

Who charges performance fees

Hedge funds. Standard fee structure is 2% management fee + 20% performance fee.

Private equity. Standard fee structure is 2% management fee + 20% performance fee (called “carry”).

Mutual funds. Rare; SEC rules limit the use of performance fees in mutual funds to protect retail investors from incentive misalignment.

Closed-end funds. Some use performance fees, but less common than in hedge funds.

Why performance fees align incentives

In theory, performance fees solve an agency problem:

Without performance fees, a fund manager is paid the same whether returns are 5% or 15%. The manager might take excessive risk (investing recklessly to boost returns) or not invest enough effort.

With performance fees, the manager participates in upside and downside, aligning their incentives with yours. A manager earning 20% of profits has strong incentive to maximize returns.

Why performance fees can misalign incentives

In practice, performance fees can create perverse incentives:

Excessive risk-taking. A manager down 15% by year-end might double down and take huge risks to try to end the year with a 0% return (and avoid the year counting as a loss). The risk is borne by investors; the manager’s downside is capped at the loss they already have.

“Heads I win, tails you lose” dynamics. If a manager’s career is on the line, they might take outsized risks. If it works, they capture 20% of the profits and look like a genius. If it fails, they still collect their management fee next year and move to another fund.

Gambling mentality. In the last quarter of the year, if a manager is close to beating the hurdle rate, they might take excess risk to capture the performance fee. If they miss, they do not bear the full cost of the risk.

Short-termism. A manager might focus on beating a benchmark this year (and capturing the performance fee) rather than building long-term value.

The 2008 financial crisis

Performance fees came under scrutiny during the 2008 financial crisis. Many hedge funds had taken extreme risks with leverage, capturing performance fees in boom years (2003–2007) and suffering massive losses (sometimes shutting down) in 2008.

Investors realized that performance fees had incentivized excessive risk without adequate protection. This led to:

• Demands for higher hurdle rates and high-water marks.
• Preference for “alternative” fee structures (fixed management fees without performance fees).
• Growth of lower-fee index funds as alternatives to hedge funds.

Performance fees vs. active management

Performance fees are supposed to compensate active managers for outperformance. However, the evidence suggests:

• Most active managers underperform indices net of fees.
• Performance fees amplify the total cost, making it even less likely for active managers to outperform.
• Index funds with 0.03% expense ratios consistently outperform active funds with 2% management fees and 20% performance fees.

For most investors, paying performance fees to a manager who underperforms is a losing bargain.

Regulatory context

The SEC limits performance fees in mutual funds to protect retail investors. Hedge funds and private equity funds, which serve only accredited investors (high net worth), have fewer restrictions.

Some regulators and investor advocates have called for performance fee reforms or restrictions due to the misaligned incentive risks demonstrated during financial crises.

See also