Incentive allocation

Hedge fund managers earn compensation in two main ways: a management fee Management fee Management fee refers to a recurring fee, typically calculated as a percentage of assets under management, that hedge funds charge investors to cover operational and administrative expenses regardless of fund performance. (usually 1-2% of assets annually) and performance-based pay tied to investment profits. This performance-based compensation is typically structured as an "incentive allocation" in domestic hedge funds.

The standard incentive allocation gives the general partner—the entity that manages the fund—20% of the fund's net profits above its previous peak value, known as the high-water mark High-water mark High-water mark is the highest value that an investment in a hedge fund has previously reached. This benchmark ensures that fund managers only receive performance-based compensation when they generate new profits that exceed this previous peak. The high-water mark protects investors from paying performance fees multiple times on the same gains. . This means managers only receive incentive compensation when they generate new profits for investors, not when they simply recover from previous losses.

The way managers receive incentive compensation depends on the fund's legal structure and tax considerations. Domestic hedge funds typically use incentive allocations that flow directly to the general partner as partnership income. Offshore funds may pay the investment manager through direct fees, though allocation structures are often still used for the general partner.

Funds that accept money from employee pension plans (called ERISA ERISA ERISA (Employee Retirement Income Security Act) is a 1974 U.S. federal law that sets strict rules for how employee retirement and benefit plans must be managed. This law significantly affects hedge funds that take money from pension plans, especially when these retirement plan investments make up more than 25% of the fund's ownership. investors) require special structuring to comply with federal regulations. Tax considerations generally determine which compensation structure the fund uses and which entity receives the payments.

While the standard "2 and 20" fee structure (2% management fee, 20% incentive allocation) remains common, many funds now offer modified terms. Large investors or those willing to accept longer lock-up periods Lock-up period A lock-up period is a specified timeframe during which investors in a hedge fund are prohibited from redeeming their investment, designed to provide the manager with stable capital to execute the investment strategy. often negotiate reduced fee levels, fee limitations that only apply to profits exceeding certain benchmark returns, or fees measured against market indices.

Long-only investment strategies—those that only buy securities rather than also betting against them—often feature lower fees or fees that only apply to performance that beats relevant market benchmarks.

Fund managers often structure their general partner entities as limited liability companies that receive incentive compensation as profit allocations rather than fee income. This approach provides significant tax advantages compared to having all revenue flow through the management company as fees.

For management companies located in New York City, this structure may reduce exposure to the New York City Unincorporated Business TaxLocal business tax imposed by New York City on unincorporated businesses operating within the city., which imposes a 4% tax on business income sourced to the city. This tax typically applies to businesses that receive fee income but generally not to passive entities that receive profit allocations.

Some funds include a "hurdle rate Hurdle rate A hurdle rate is the minimum return a hedge fund must earn before its managers can collect performance fees from investors. This requirement protects investors by ensuring managers only receive incentive compensation after achieving a specific performance threshold. "—a minimum return threshold that must be exceeded before the manager receives any incentive compensation. When hurdle rates are applied, funds may include a "catch-upPerformance fee mechanisms that allow fund managers to receive their full incentive compensation on all gains after crossing the hurdle rate threshold." provision that allows the manager to receive an accelerated allocation rate on returns above the hurdle until they have received their full incentive allocation rate on all profits for the year.

For example, consider a $100 million fund with an 8% hurdle rate and a 20% incentive allocation. The first $8 million in profits would go entirely to investors. The next $2 million would go entirely to the fund manager as "catch-up." Any profits over $10 million would be split 80% to investors and 20% to the manager.

Funds with a catch-up provision are sometimes described as having a "soft hurdle." Those without catch-up provisions are described as having a "hard hurdle."

Investors in funds with multi-year lock-up periods sometimes request clawback provisions Clawback provision A clawback provision is a contractual term that requires hedge fund managers to return previously received performance compensation if the fund later experiences losses that reduce its overall performance below the level that originally justified those payments. similar to those used by private equity funds. These provisions require managers to return incentive compensation if the fund later experiences losses that reduce overall performance below the threshold for earning incentive fees.

Some managers have responded by offering funds with performance measurement periods that match the lock-up periods or liquidity terms of the interests purchased by each investor.

For funds taxed as partnerships under U.S. tax law, the allocation process works as follows: the manager receives a provisional incentive allocation at the end of the first year, which is then adjusted at the end of subsequent years based on further profits or losses. The provisional incentive allocation amount continues to be invested in the fund's strategy. Any gains or losses from that invested amount are allocated back to the investors, not the manager. The manager cannot withdraw money from the provisional incentive allocation until the end of the lock-up period, except for distributions to cover tax obligations.

Offshore fund structures that use intermediate entities may create a special class of shares or interests. These special interests receive both a proportional return on the fund's capital investment and an incentive allocation, similar to how the general partner receives incentive compensation in a domestic partnership or limited liability company structure.

Funds that accept investments from employee pension plans must comply with specific Department of Labor requirements to pay performance-based compensation to managers. These requirements include: the investment manager must be registered under federal securities law, each pension plan investor must have total assets of at least $50 million, no more than 10% of each pension plan's total assets can be invested in the fund, and the incentive fee arrangement must comply with federal securities regulations governing performance-based compensation.

Current regulations require that investors receiving performance-based fee arrangements either have at least $1.1 million under management with the adviser or possess a net worth exceeding $2.2 million.

Performance-based compensation creates certain potential conflicts of interest for fund management teams. The incentive structure may encourage investment teams to make riskier or more speculative investmentsHigh-risk investments that rely on market sentiment and price appreciation rather than fundamental business value, often characterized by significant potential for both gains and losses. than they would make without the compensation arrangement, since managers share in the upside but investors bear the full downside of losses.

Additionally, fund managers typically bear responsibility for valuing the fund's assets, particularly illiquid investments that do not trade on public markets. Performance-based compensation may create incentives for managers to use optimistically high valuations for portfolio positions, since higher valuations directly increase their compensation.