The performance fee is paid on a quarterly or annual basis, and it typically must be paid if and only if the manager reaches certain investment goals such as a high-water mark or a hurdle rate.
Most hedge fund managers receive performance fee payments conditional upon the investor’s share value exceeding a high-water mark, which represents the previously reached maximum share value since the investor’s investment.
In practice, the high-water mark level is reset on a quarterly or an annual basis. Many funds apply a hurdle rate, that is, benchmark performance, such as the T-bill rate that the fund’s return must exceed before the performance fee becomes effective.
The rationale behind this fee lies in the very nature of hedge funds. While mutual fund managers participate from an above average performance through new investors and increased portfolio assets due to the fixed percentage management fee, hedge funds often limit their assets under management and do not accept new money.
Consequently, performance-oriented compensation must be directly performancelinked to align the manager’s interest to that of the investors, because the manager receives the extra payment only if the investor benefits from positive performance. The motivating character of the performance fee is intensified by an option-like payment structure when combined with the highwater mark.