The growing problem with Performance Fees

December 29th, 2014
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Contributed by: Shane Brett, Global Perspectives
Hedge funds’ performance fees are a key component of every fund’s Net Asset Valuation calculation. Since the economic crisis of 2008, hedge fund performance and incentive fees have become more complex. The standard “2 and 20” fee model is often not the case anymore.

This has meant calculations on many funds have become more challenging and complex. Many fund administrators and managers are having to calculate increasingly complicated performance fees on spreadsheets – a step backwards in terms of automation and efficiency.

A problem of complexity

The growth of more complex performance fees represent a significant area of risk in back office administration. Transfer agencies and fund manager operations departments are faced with tracking and computing more and more complicated incentive fee calculations. Ironically the most complex, bespoke fees are often calculated on spreadsheets, as they are likely to be unsupported by existing shareholder servicing solutions.

Performance fees have become more elaborate since the global financial crisis, as hedge fund managers evolve their fee models. Fee models have come under pressure due to poor performance. Investors have demanded more hurdles, claw backs and higher levels of Alpha to be achieved before Performance fees are paid.

Some of the generic Transfer Agency packages have included performance fee modules in their applications, but these cannot support many of the newer, complex fee structures. These types of funds require a bespoke performance fee calculation solution to be built specifically for them. One that will enable timely and accurate NAV calculation to take place within a controlled, reliable process.

Where fund administrators are having to manually calculate some incentive fees, it makes business sense to automate and standardise the process across funds. This has often proved difficult without a holistic solution to manage the process.

The liquidity of hedge funds is increasing all the time, meaning performance fees need to be calculated on a more regular basis. This brings an increase in operational risk, even for funds with standard fee structures. While existing systems may be satisfactory for processing of live, day-to-day data, they are typically inflexible when it comes to historic recalculations.

The industry needs software to provide additional automation, verification and oversight to ensure investors are getting fair treatment in more complex funds. Fund managers are seeing increasing due diligence requirements from institutional investors in relation to transparency and risk management.

An increasing number of funds have introduced long term claw backs. These add considerable complexity in spreadsheet calculations, which can become unmanageable over time. Often a spreadsheet that is sufficient in a fund's early years will introduce errors when more complex claw back scenarios are encountered after a number of years.

If solution providers don’t address these problems the industry could be looking at mischarges and fines over time, as has been seen in other areas of financial services (for example in the Life and Pensions industry).

Hedge funds and their various stakeholders would also benefit from a performance fee solution that can easily model different scenarios, even simultaneously. This would allow managers and service providers to forecast potential outcomes by running “what if?” scenarios across the funds’ portfolios. This could been done in a “sandbox” environment from which the live data is securely separated, allowing “dummy runs” to be processed before live changes are made to the portfolios.

The industry requires dynamic new solutions to address these growing requirements.

The need for a dynamic solution

Hedge fund performance fee solutions should be robust, transparent and flexible. They should work in conjunction with existing shareholder servicing software to enable standardised procedures across all funds. They should also be able to calculate and verify all performance calculations, while being easily tailored for even the most bespoke, complex fees.

This means the calculation process should not interrupt existing systems but should support existing applications in a transparent manner. A Software-as-a-Service (SaaS) solution can reduce the overhead of in-house system maintenance. A well-defined interface enables a SaaS solution to run in parallel with existing systems for verification, oversight and additional reporting without the risk and upheaval of deploying traditional systems.

Also, a fully automated and customised performance fee solution can provide independent oversight of the entire performance fee calculation process. This would allow the hedge fund manager and depositary to verify their administrator’s calculations.

A dynamic performance fee solution should link in to a standard extraction process from the funds data warehouse, to achieve a single process for verification across all funds. This reduces operational risk while avoiding disruption to existing systems.

Such a set up could include “read only” functionality that enables potential fee scenarios to be modelled using both actual and test data without impacting live figures. Full historic recalculations could be run as easily as single valuations, facilitating moves between service providers or for business continuity support.

Ideally performance fee solutions should be utilised by other key fund service providers, not just the fund administration and shareholder servicing department. This could include auditors, custodians, and depositaries (for fee verification checks), hedge fund managers (for independent oversight) and investors (for improved reporting and transparency).

Conclusion

Hedge fund incentive and performance fees are seeing new variations and complexity, while at the same time hedge funds are becoming more liquid in their dealing cycle. Increasing complexity requires dynamic, flexible solutions to address this problem and reduce operational risk.

The use of more specialised performance fee software to manage complicated incentive fees would greatly assist the NAV turnaround process; which is often cumbersome at valuation points, particularly where funds with a complex performance fee structure are being calculated.

It would also assist with employee training and empower shareholder servicing staff to “own” their operational roles, by providing clearer reporting and visualisation of data and reducing the time spent manually reworking fee calculations.


About Fund Calcs:

FundCalcs performance fee solution is a robust cloud based, transparent and flexible system to calculate and verify performance fees. It can be tailored for any calculations, even the most bespoke, complicated performance fees including equalisation variations and private equity partnerships. It has a wide range of applications for managers, administrators, depositaries, auditors and investors.

Existing clients include leading global alternative investment managers and fund service providers.

About Global Perspectives:

Global Perspectives provides consulting, research and development to the asset management and alternative investment & industry. These services include software implementation, product and project management, as well as regulatory and operational consulting. Previous clients include leading asset managers, service providers and software vendors throughout the investment fund industry.
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