Performance fees and hurdles: "you are paid before we are"

Performance fees and hurdles: "you are paid before we are"

A performance fee is a share of returns paid to the manager of an investment, on top of any flat management fee. A hurdle rate is the minimum return investors must receive before the manager earns any performance fee at all. Together they decide who gets paid first, and that decides whose interests come first.

How it actually works

Take a simple structure: a 10% hurdle and a 20% performance fee.

• If the investment returns 8%, investors keep all 8%. It didn't clear the hurdle, so the manager earns no performance fee.
• If it returns 15%, investors first receive their 10%. The 5% above the hurdle is then split according to the terms.

What happens to that excess depends on two choices.

Hard hurdle. The manager takes 20% of only the return above the hurdle. On a 15% return: investors get 10% + 4% = 14%, the manager gets 1%.

Soft hurdle with catch-up. Once the hurdle is cleared, the manager receives a larger share, sometimes 100%, of the next slice of returns until it has "caught up" to 20% of the total profit. After that, the split returns to 80/20. On a 15% return with full catch-up: investors get 12%, the manager gets 3%.

The difference between the two is the manager's incentive. Under a hard hurdle, the manager is only rewarded for what it adds beyond the hurdle.

High-water marks

A high-water mark stops a manager being paid twice for the same gains. If an investment rises, falls, and then recovers to where it was, the manager earns no performance fee on the recovery. Fees only apply to new highs.

Hurdles and high-water marks are often used together. One makes sure investors are paid first. The other makes sure they're not charged again for getting back to where they started.

Why it matters

The structure of fees tells you how a manager makes money, which tells you what it's motivated to do.

A large flat fee rewards gathering assets, whatever the returns. A performance fee with no hurdle rewards taking risk, because the manager shares in gains but not in losses. A performance fee behind a meaningful hurdle rewards only returns above what investors were promised.

Rekord's approach to its own instruments follows the last of these. The principle is simple: you are paid before we are. Investors receive their contractual return first. Only what's left after that goes to the manager. If the underlying assets don't clear the hurdle, the manager's performance compensation is zero.

That order shows up in the distribution waterfall, which sets out exactly which party receives which dollar, and in what sequence. When you review any investment, read the waterfall before you read the target return. The target tells you what's hoped for. The waterfall tells you who gets paid when the hope doesn't come true.