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Is Running a Hedge Fund Profitable?
Yes. Hedge fund managers typically demand management fees of 1% to 2% of assets under management (AUM) as well as performance fees of 20% to 50% of net trading gains.  This income can be substantial!  If you had $2 million AUM and a 1% management fee and a 20% performance fee, you would have combined fee income of fee income of $140,000 from a $20,000 management fee ($2 million x 1%) and (assuming fund performance of 30%) performance fee income of $120,000 ($2 million AUM x 30% performance=$600,000 x 20%).  If you had $5 million under management, you would have combined fee income of $350,000. If you had $1 billion AUM, you would have $50 million in combined fees, assuming fund performance of 20%.

Paying Hedge Fund Management
Hedge fund managers receive a management fee (typically between 1%-2% annually) plus a percentage of the fund's performance (often set at 20%). Performance is typically calculated on a cumulative basis (with incentive fees calculated against a ceiling or  "high-water mark") so that any losses experienced by a hedge fund in one or more prior years must first be recouped (in whole or in part) by compensating gains before further (or full) incentive fees are paid. An example would be a $15 million loss in one year followed by a $20 million gain in the next year for which an incentive fee would be assessed only on the net $5 million gain. In addition, hedge fund managers allocate expenses to their funds and the investors in those funds.

Hedge Fund Performance and Management Fees:  Best Practices
The fund's offering materials and legal documents must clearly spell out the manager's approach to charging fees.   Click Here to Learn About Hedge Fund Offering Documents   Include a description of the fee schedule; the exact formula used to calculate fees owed, including where appropriate example calculations; the time period for fee calculations; and the source of information to be used to calculate the fee payments.  Hedge fund fees should be calculated based on audited portfolio valuations.  Click Here to Learn More About NAV Calculations   Where the period of audited financial valuations does not coincide with the fee calculation period, investors should familiarize themselves with the hedge fund manager's portfolio valuation methodologies and the processes used to prepare the fee calculation.  Once audited financials become available, the fee calculations should be reviewed and adjusted for any valuation differences.  Calculate performance fees based on dollars of value added, not percentage returns or average capital invested for the calculation period.  Performance fees computed as carried interest should be calculated on net value added as opposed to gross value added.
 
Offering documents should adequately define "net value added" upon which performance fees are calculated (gross value added less any other expenses charged to the hedge fund).  Offering documents should also adequately delineate all types of possible expenses and other charges that potentially could be deducted from fund assets.  These expenses may include, but are not limited to: legal expenses, accounting expenses, trustee fees, administrative fees, marketing and sales fees, custodial fees, and general investment management charges.
 
Performance fees should be calculated over a period of time that is appropriate given the volatility of the hedge fund strategy's returns and any lock-up period required by the hedge fund manager. Generally, the more volatile the investment strategy, the longer the period included for calculating the performance fee.

Charging Fees
The Investment Advisers Act of 1940 prohibits a registered fund manager (including a state registered manager) from entering into an advisory contract that provides for a performance fee.  Click Here to Learn More About Hedge Fund Law  Section 205(a)(1) provides that "no investment advisor...shall...enter into, extend or renew any investment advisory contract...if such contract provides for compensation to the Investment Advisor on the basis of a share of capital gains or capital appreciation of the funds or any  portion of the funds of the client."  The point behind this law is to prevent fund managers from being compensated based on appreciation of the fund's assets.

Management Fees
Section 205(b)(1) provides that the prohibition on performance fees shall not be construed to prevent an investment adviser receiving compensation based upon the total value of a fund averaged over a definite period, or as of definite dates, or taken as of a definite date.   This provision allows for management fees based on a percentage of assets under management.  The management fee is paid whether the fund loses money or makes money.

Performance Fees (Incentive/Performance Allocations)
Section 205-3 of the Investment Advisers Act allows for performance-based fees (or incentive allocations) to be charged to qualified clients. The point behind this law is to allow sophisticated investors who are capable of evaluating and understanding investment risks to enter into performance based fee contracts.  Click Here to Learn More About Qualified Clients
 
When determining whether a hedge fund is a qualified client the SEC has specific requirements to  insure that non-qualified clients do not pool their assets and form a company or hedge fund to become qualified for this exemption. To avoid this, the SEC requires that all equity owners of the company or fund qualify on their own as qualified clients.  More detailed rules apply to multiple tiers of hedge funds where again each equity owner of each fund needs to be a qualified client.
 
Rule 205-3(b) thus requires a registered investment adviser intending to charge a hedge fund relying on ICA section 3(c)(1) to look through the hedge fund to ascertain that an investor is a qualified client when the investment is made (this test applies to individuals and companies).

Qualified Purchasers
The net worth test is also met if the investor is a qualified client under ICA Section 2(a)(51)(A) (this is the test for qualifying as an investor under ICA section 3(c)(7)). As a practical matter, this means that, if the fund is a section 3(c)(7) fund, a performance fee can always be taken against each investor.  Click Here to Learn More About Qualified Purchasers
 
However, in a section 3(c)(1) fund, this is not necessarily true.  A purpose of the subscriber questionnaire is to provide written guidance from each investor on its status on many vital issues including whether it is a qualified purchaser.  When conducting a compliance examination, the SEC audit team may review the procedures that a fund manager uses to ensure that any clients charged performance meet the applicable criteria and evidence of satisfaction of these tests should be on hand.  Keep good records.

Drafting Your Performance Allocation
The performance allocation of profits in a U.S. hedge fund is not a fee, but rather an allocation of profits (separated into all of its components) from a tentative allocation to an investor's capital account to the manager's capital account.  From the standpoint of partnership tax law, it is as though the investor never saw the re-allocated amount.  Click Here to Learn More About Hedge Fund Taxes
 
In an offshore hedge fund, the incentive share is in fact a performance fee.  To convert the performance fee to a performance allocation, a mini-master fund may be used.  Click Here to Learn More About the Mini-Master Fund
 
Example 1
Hedge Fund, LP, has a General Partner LLC. On January 1, 2008, new limited partner RL makes his only capital contribution of the year of $1 million.  His ending book capital account prior to reallocation is $2 million. He is subject to a 20% performance re-allocation.  As of December 31, 2008, $200,000 of capital account value is re-allocated from RL's account to LLC's.  RL's ending book capital account is $1.8 million.
 
High-Water Mark
It is common for the performance allocation to be subject to a "high-water mark" provision.  The high-water mark's function is to ensure that a manager who has made money for an investor and then loses part of that capital cannot take a performance allocation (or fee) until the loss has been made up.  Thus, performance can be taken only on the profits above the high-water mark. Investors must recall that performance is always calculated on the fund's economic performance, which will include the net of the yield (e.g., dividends, interest) less fees and expenses chargeable to the investor, and both realized and unrealized profits and losses.  When investing in a fund, investors should determine whether performance fees are subject to a high-water mark. Investors should determine the period of time to which the high-water mark limitations apply, and confirm that it is consistent with their redemption rights and investment objectives.  High water marks are widely used and are considered a market standard best practice.  Further, since investors may join a hedge fund investment at different times, investors should confirm that high water marks are specific for each investor and separately tracked.

Example 2
Same as Example 1, except that in 2009 RL's capital account is now $900,000 because the fund lost 50%.  No incentive fee is chargeable. In 2010, RL's capital account increases to $1.35 million because the fund was up 50%.  If there is a high-water mark provision, LLC gets no performance allocation.  If there is no high-water mark provision, LLC gets a performance allocation of $90,000 even though RL is still in the hole.

Example 3
Same as Example 2, except that in 2020, the fund makes 100% (economic) return and RL's (tentative) book capital account is $2.7 million.  LLC is entitled to a re-allocation of $180,000 ($2.7 million  less the high-water mark of $1.8 million x 0.20).  If there is no high-water mark, LLC's re-allocation is $270,000 ($1.35 million x 0.20) and RL would have been subject to a re-allocation twice on the same amount.  If the investor is a fiduciary account (trust account, pension plan, endowment, etc.) the prudential concerns of the fiduciary may well require that the fiduciary invest in a fund that has a high-water mark.  In any event, the absence of a high-water mark provision may be viewed as indicative of a fund manager not overly concerned with issues of fairness to investors.

Hurdle Rate
Many funds also have a "hurdle rate" provision.  Hurdle rates are also used to guarantee that the hedge fund achieves a minimum investment performance before the fund's adviser may receive any incentive allocation.  Hurdle rates establish a floor that the investment adviser must exceed to obtain the incentive allocation or performance- based fee.  The underlying concept is that an investor could keep its funds in tax-exempt bonds and earn a safe, tax-free return (assume 3.5%).  The investor demands that the incentive allocation be calculated only if the manager makes at least that rate -- a hurdle rate.  There are two basic types: 1. The incentive allocation is charged only on economic profits made above the hurdle rate. 2. Once the hurdle rate is achieved, the performance is based on the entire economic profit.

Combing a Hurdle Rate and a High Water Mark
A high-water mark and a hurdle rate can be combined.

Example 4
Same as Example 1, except that the incentive allocation is chargeable only after RL's book capital account earns a rate exceeding the federal funds rate plus 200 basis points, determined each year based on the rate in effect on the first business day of that year, and that the performance is chargeable only to profits exceeding that hurdle rate.  With a hurdle rate of 4.5% for 2008, the incentive reallocation of profit is $155,000 ($1 million x [0.2 - 0.045]).

Example 5
Same as Example 4, except that the incentive allocation is chargeable in full to the profits, provided that the hurdle rate is met for that year.  The incentive allocation is $200,000 (same as Example 1).  The hurdle rate is optional; it provides an additional layer of computational complexity to whichever of the two alternatives is chosen, although the first alternative is clearly more complex. In some funds, the hurdle rate is quarterly, or even monthly, which is certainly an additional complexity and administrative expense as these calculations must be checked by the fund's accountants.  Further, in some funds, the hurdle rate is cumulative; thus in Example 3 above, RL's hurdle rate would have to be calculated separately to determine what the performance allocation is when profitable years kick in.

Withdrawals
Many issues go into the performance's calculation.  For example, how is performance calculated when an investor withdraws, in whole or in part, prior to the end of the tax year; if there is a hurdle rate, should it be annualized or applied in full?

Example 6
Same as Example 4, except that RL withdraws June 30, 2008.  Should the hurdle rate be 4.5% or 2.25%? Proration is the standard practice.

What about the high-water mark when an investor withdraws only part of their capital?

Example 7
Same as Example 2, except that RL withdraws half his (much depleted) capital account of $900,000 on December 31.  Should his high-water mark be $1.8 million or prorated to $900,000? If $1.8 million, the manager is unlikely to realize a penny of performance from RL for a very long time, if ever. If prorated to $900,000, LLC at least has a fighting chance of making good and earning performance.  Again,  proration is the standard practice.

Keep Fund Accounting Simple
The manager who has a highly complex performance allocation and expects the financials and tax returns by March 1 is tempting fate.  The manager must recall that once the investor is promised something, less cannot be given.  At the very least, no manager wants to go back to investors and ask them to sign amended fund documents about how the manager's own cut of the profits is determined.

The preceding examples discuss critical points to be considered in drafting the performance/incentive provisions, both from the manager's and the investor's standpoint.  The foregoing examples do not discuss the rules for commodity pool operators (CPOs) under the jurisdiction of the CFTC.  The CFTC (and the industry self-regulatory organization, National Futures Association) have no comparable restrictions on a CPO's entitlement to performance, provided that the investor receives appropriate disclosure and consents in writing to a performance-based compensation (or allocation of profits).  Because many funds trade both securities and commodities, the SEC rules on performance typically govern the outcome.

Written By Hannah Terhune, Esquire (Copyright 2008 - All Rights Reserved)  Reprinted with Permission. Portions of this article were originally published in part "Derivatives: Financial Products Report" an RIA publication, September 2005, as 'Hedge Funds - Do's and Don'ts for Crafting Hedge Fund Performance Allocations' by Hannah Terhune, Esq. and Roger Lorence, Esq.

Customer Testimonial
I had a tremendous experience with Hannah and the Capital Management Group. They were timely, courteous, and extremely knowledgeable; and, if Hannah was busy, Michelle made quick work to resolve my problems. I will invariably use CMSG in the future for all my hedge fund needs! I can't thank Hannah enough for making my dream of a hedge fund come to fruition. William B Hoagland, Trend Discovery Capital Management. July 06, 2011

State Law Impact on Fees
Many investment advisers are confused when they read their home state securities statutes.  Most states have law similar to federal law with respect to taking performance allocations.  In fact, state statutes read almost verbatim to the federal statutes. Most states, with a few twists, have followed the federal exemption for performance fees and have either incorporated them into their state securities statutes or in their state securities regulations.  Click Here to Learn More About Investment Adviser Registration  The end result is that  state securities laws often provide the same exemptions offered at the federal level.  However, sometimes the actual drafted provisions of the performance fee (and calculations thereunder) are subject to intense review by and negotiation with the state regulators.  Some states use the older federal law definition of "qualified client" with the result that in some states, a registered investment adviser can charge the performance fee to what is in today's currency, an "accredited investor."   Click Here to Learn More About Accredited Investors

ARE YOU AFRAID OF WHAT YOU DO NOT KNOW? Get answers to your specific questions by speaking directly to Hannah Terhune, an experienced hedge fund and international tax attorney. Ms. Terhune's hard-earned knowledge and experience can be put to work to save you unnecessary steps and costly wasted effort. The consultation is an invaluable opportunity to speak to Hannah one-on-one and learn how to achieve more in less time. As a result, you can anticipate that the return on your investment will far outweigh the costs associated with our unsurpassed services. Ms. Terhune's credentials reflect an invaluable resource that combines a well-informed professional practitioner with sound ethical judgment that cannot be overestimated. The expertise required to recommend best solutions and provide sound advice should never be taken lightly. when you are finished with your consultation, you will be impressed and informed about your business plans.  Contact Hannah Terhune now!

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MEET ATTORNEY HANNAH M TERHUNE Hannah Terhune, a hedge fund and international tax attorney, contributes her expertise, experience and thoughts to many digital content media and magazine repositories. Hannah Terhune's articles are widely circulated on the Internet and recommended by TheStreet.com and other respected media.  Hannah Terhune's articles will advance your knowledge and understanding of the industry. They are embraced worldwide as a definitive and reliable source of critical information.  Contact Us for Articles & Reprint Rights

Strategic Hedge Fund Planning by Hannah Terhune.  Canadian Hedgewatch (March 2012).

Offshore Hedge Funds: Focus on Master/Feeders by Hannah M. Terhune (2006)

Temas Sobre Impuestos de Sociedades Colectivas para Hedge Funds en Paraiso Fiscal by Hannah M. Terhune (2006)

Gestion de los Hedge Funds de Forex by Hannah M. Terhune (2006)

Forex-Trader to Forex-Fund Manager: The Path to Success by Hannah M. Terhune (2006)

Introducing Brokers and Hedge Funds by Hannah M. Terhune (2006)

Establish a Marketable Track Record with an Incubator Fund by Hannah M. Terhune (2006)

Must I Register as a Commodity Pool Operator? by Hannah M. Terhune (2006)

Do’s and Don’ts for Crafting Hedge Fund Peformance Allocations by Roger D. Lorence Hannah M. Terhune. Derivatives Financial Products Report (an RIA publication) (September 2005)

Trading Foreign Index Contracts? Know the Tax Rules Before You Trade by Hannah M. Terhune and Roger D. Lorence. Stocks, Futures and Options (June 2005)

Practical Strategies For Section 475(f) Elections by Roger D. Lorence and Hannah M. Terhune. Derivatives Financial Products Report (WG&L/RIA,a Thompson Company) (March 2005)

Forex Hedge Fund Management by Hannah Terhune and Roger D. Lorence.  Currency Trader (March 2005).

Advising Clients on Internet Server Co-Location Agreements, Practical International Tax Strategies (March 15, 2004)

Structuring and Financing International Operations Using Hybrid Entities and Tax-Efficient Financing. Practical International Tax Strategies (Jan. 15, 2004)

Hedge Fund Compensation Arrangements. Practical U.S./Domestic Tax Strategies (Dec. 2003)

U.S. Inbound Investment – The Portfolio Interest Exemption. Practical International Tax Strategies (Dec. 15, 2003)

Business Acquisitions: Key Tax Planning Issues. Practical U.S./Domestic Tax Strategies (Sept. 2003)

Foreign Futures Planning: The 60/40 Question. Practical International Tax Strategies (Sept. 30, 2003)

Key Tax Aspects of International M&A – Planning Scenarios Involving Tax Acquisitions. Practical U.S./International Tax Strategies (Sept. 15, 2003)

Update on Spanish Holding Companies. Practical European Tax Strategies (Aug. 2003)

Reducing Operational and Exit Taxes On Closely-Held Businesses. Practical U.S./Domestic Tax Strategies (August 2003)

Coming Ashore – Establishing U.S. Operations: Practical U.S./International Tax Strategies (July 31, 2003)

Financing U.S. Business Operations Using Cross-Border Income Trust: Practical U.S./International Tax Strategies (July 15, 2003)

Methods of Compensating the Executive – An Overview of Various Tax Features: Practical U.S./Domestic Tax Strategies (May 2003)

Managing Offshore Hedge Funds – A View from the Beach: Practical International Tax Strategies (June 15, 2003)

A Practical Defense of the Family Limited Partnership: Practical U.S./Domestic Tax Strategies (May 2003)

Offshore Hedge Funds – Master/Feeder Compliance Issues: Practical International Tax Strategies (May 15, 2003)

Want a Multinational Corporation In Your Backyard? Strategic Tax Planning for Countries Without a Clue. Practical International Tax Strategies (June 15, 2001)

Planning Notes for U.S. Businesses Operating Overseas: U.S. Outbound Tax Issues. Practical International Tax Strategies (May 31, 2001)

U.S. Strategic Tax Planning and Other Modern Day X Files An FSA to Remember. Practical International Tax Strategies (May 15, 2001)

More on International Tax Planning for Highly Compensated Individuals Combining Individual Leasing Programs, Deferred Compensation and Rabbi Trusts. Practical U.S./International Tax Strategies (April 30, 2001)

International Tax Planning for Highly Compensated Individuals Taking Advantage of Special Treatment for "Rabbi Trusts." Practical U.S./International Tax Strategies (April 15, 2001)

More on Dealing with Passive Foreign Investment Companies Using Inter-Company Loans, Handling Start-Up Costs and Other Matters. Practical U.S./International Tax Strategies (March 31, 2001)

Dealing with Passive Foreign Investment Companies How the System Works and Strategies to Avoid PFIC Status. Practical U.S./International Tax Strategies (March 15, 2001)