Returns on Alternative Investments

A hedge fund has the following fee structure:
Annual management fee based on year-end AUM - 2%
Incentive fee - 20%
Hurdle rate before incentive fee collection starts - 4%
Current high-water mark - $610 Million
The fund has a value of $583.1 million at the beginning of the year. After one year, it has a value of $642 million before fees. The net percentage return to an investor for this year is closest to:

  1. 6.72%.
  2. 6.80%.
  3. 7.64%.

Answer: 7.64%
Can someone please help me understand the calculation steps?

It appears that the correct answer is 6.80%.

Where did you get this question?

What does their explanation say?

This is the explanation given, but I can’t understand the net return to investor part of it.

The management fee for the year is
$642 × 0.02 = $12.84 million.

Because the ending gross value of the fund of $642 million exceeds the high-water mark of $610 million, the hedge fund can collect an incentive fee on gains above this high-water mark but net of the hurdle rate of return. The incentive fee calculation becomes
{$642 − [$610 × (1 + 0.04)]} × 0.20 = $1.52 million.

The net return to the investor for the year is

[($642 − $12.84 − $1.52)/$583.1] − 1 ≈ 0.07638 ≈ 7.64%.

They’re treating the 4% return as a hard hurdle rate: they earn their incentive fee only on returns that are above the hurdle rate.

I was treating the 4% as a soft hurdle rate: if the return exceeds the hurdle rate, they earn their incentive fee on the total return.

With the high watermark provision, their incentive fee is computed based on returns above the watermark, not on returns above the beginning-of-the-year value.

They didn’t specify whether the hurdle rate is hard or soft; it’s not a well written question.

1 Like

Thanks for the clarification. :slight_smile:

My pleasure.

1 Like

Would you please explain why they deduct 610*(1+4%) when calcuate incentive fee?
In my opinion only deduct 610.

I did:

I was taught that hard/soft hurdle was calculated based on AUM not high-water mark.
Eg: if (1+4%)AUM > high water mark=> deduct (1+4%)AUM and mgmt fee to calculate incentive fee.
If high water mark is higher than deduct this amount.

Here it’s stipulated that they have a high-water mark provision. Therefore, they don’t get any fees until they return to the high-water mark plus the hurdle rate.

(OK: they didn’t actually say that, but the answer shows that they clearly meant that. On the exam, it will be clear.)