A recent eye-popping payout for the managers of the Chrysalis Investment trust has revived a dormant debate on performance fees. Ostensibly a tool to align the fund manager’s interests with those of its clients, they have become increasingly controversial, with poor construction appearing to skew incentives. Yet around a quarter of investment trusts still charge them.
What does a ‘good’ performance fee look like?
The Chrysalis trust raked in £112m in performance fees as its net asset value rose 57%. The payout was even more controversial because the trust holds private companies. As such, the gains were based on revaluations from recent funding rounds, rather than on realised profits. Equally, the fees were calculated over a single year rather than reflecting cumulative gains over many years. Uncomfortably, the trust has seen a difficult start to 2022, caught in the crosshairs of the January sell-off.
This case highlights some of the shortcomings of performance fees. If the fees are charged over too short a period of time, there is a danger that a manager makes hay in one year, generates a big performance fee, but that fee is not clawed back if performance is weak in subsequent years.
Matthew Read, senior analyst at QuotedData says: “Earning a performance fee should not be like winning the lottery – you want your managers to be incentivised to outperform the following year, not thinking about early retirement.”
Peter Toogood, chief investment officer, The Adviser Centre, agrees: “The upside of performance fees is the alignment of the fund manager’s interests with the performance of the fund. They earn if you earn […] but the downsides are numerous. The most obvious is undue risk-taking to create outsized returns.”
Not rewarding market performance
High watermarks, where the manager has to achieve a cumulative performance hurdle over multiple years, have been a way to tackle this problem. When constructed properly, a fund manager cannot gain 20%, be paid a performance fee, then lose 30%, collect their normal fee, and then gain 10% and be paid another performance fee.
Dan Brocklebank, head of Orbis UK, says the length of the crystallisation period is important: “Investors need to look at how often fees are paid to the manager – the longer the better. Is there a refund mechanism if a manager outperforms and then underperforms?”
The benchmark against which performance is set is also crucial; a fund manager should not be getting paid for market performance. Mark Northway, investment manager at Sparrows Capital says: “Performance fees should not be paid for tracking beta. The hurdle rate needs to take account of how the market has moved and create a mechanism to give it back. I’ve seen a lot of game-playing with high watermarks.”
Toogood adds: “If [high watermarks] apply, that is fairer to the client but may be demotivating if they are too far away. Indeed, funds have been shut in the past where the mark is so far away from the current unit price. If they are applied, it seems reasonable that a degree of outperformance of the stated benchmark should be achieved before any fee is applied – this seems fair to all concerned.”
Another problem for Chrysalis is that the fees have been charged on revaluations rather than realised gains. Northway believes that performance fees should always be charged on realised profits rather to market valuations. While the valuations of private equity holdings will be independently audited, they are, by their nature, subjective.
Northway raises a more existential problem with performance fees – they may not work to motivate the investment manager. Given that this is the strongest argument for using them, this is potentially a significant problem. He says: “The research suggests that they don’t increase the motivation of the manager and they don’t affect performance. In most cases, they don’t improve performance sufficiently to justify the fees and simply eat into the return of investors.”
It is always possible to find exceptions, where performance fees have gone hand in hand with good performance, but unless this happens routinely, it suggests many of them aren’t operating to align manager and shareholder interests.
Clawback mechanisms and appropriate benchmarks
As it stands, there are 93 investment trusts with a performance fee, out of a universe of 337 investment companies. It is par for the course in sectors such as private equity and hedge funds, particularly where the fund manager is involved in company’s strategic direction or sits on the board. In the last financial year, 41 of the 93 trusts were paid a performance fee. In other words, even if performance fees are controversial and complex, investors need to get to grips with them.
The board should help. Annabel Brodie-Smith, communications director of the Association of Investment Companies (AIC), says: “One of the board’s most important jobs is to negotiate fees with the manager, and they have a clear legal duty to make sure this is done in shareholders’ interests. In recent years there’s been a clear trend of boards negotiating fee cuts from fund managers to benefit shareholders.”
Does the perfect fee structure exist? Northway believes the Orbis has designed its fee structure well. It is based on cumulative performance with a high watermark in place. It has a clawback mechanism should outperformance be followed by underperformance. It is set against an appropriate benchmark. This, he says, is a “fantastic fee structure” – it puts the right incentives in place and aligns the fund manager with its clients.
Too often performance fees have done nothing to align fund manager and client, but instead have simply encouraged bumper paydays for the fund manager at the expense of the investor. Nevertheless, good performance fee structures do exist, as long as a clear set of rules are followed.
