Hedge Funds-hurdle rate

CFA Level I Alternative Investments
#1

Hi,

Could anyone help me to understand why we are not deducting 5% of $60 million in the 2nd year to get to the incentive fees in the below question?

The hedge fund had an initial investment of $60 million and at the end of first year, value was $70 million after fees. At the end of second year, value was $80 million before fees. The fund has 2 and 20 fee structure and incentive fees are calculated using a high watermark and a soft hurdle rate of 5%. Calculate the total fee paid for year 2.

a) 2.5 million

b) 3.6 million

c) 4.8 million

Correct answer is: b

#2

It depends on whether it is a soft hurdle rate or hard hurdle rate.

For a soft hurdle rate , as long as the gain for the year exceeds the soft hurdle rate, the incentive fee is on the total gain.

Soft hurdle in Year 2 = 5% x $70 m = $3.5m

Gain in Year 2 = $80m - $70m = $10m

Since $10m > $3.5m, therefore the incentive fee is 20% x $10m = $2m.

For a hard hurdle rate of 5%, then the incentive fee is 20% x ($10m - $3.5m) = $1.3m

#3

I didn’t pay attention to the difference between soft and hard hurdle rates! Thanks, millions for clarification and bringing that to my attention.

#4

Also just a note: The answer is not $3.4m as you must take the 2% fixed fee from the Y2 end value ($80m, 2% = $1.6m) rather than the Y2 start value ($70m, 2% = $1.4m)

#5

At the end of the second year, the assets are $80M and profit for the year was $10M or 14.2%.
14.2% is greater than 5% (the hurdle rate) so the investor has to pay 20% of the profit in fees.

The total fee is
2% * Assets + 20% * Profits
=2% * 80 + 20%*10
=1.6 + 2
=3.6 M

The 5% refers to the profits ($10M) not the assets ($80M) and since the profits exceed the 5% hurdle rate, the 20% fee on the profits is paid