On Managing Performance Fees with Mid-Quarter Entries
Hi all,
For fund managers dealing with performance fees and investors joining mid-quarter, here’s a practical guide to ensure fairness and GAAP compliance using equalization:
Understand Your Fee Structure:
Apply a management fee (e.g., 2% annually, pro-rated monthly) based on entry timing.
For performance fees (e.g., 20% on profits above a high-water mark), use equalization to account for staggered entries.
How Equalization Works:
Set Individual High-Water Marks (HWM): Each investor’s HWM is their entry NAV, marking their profit baseline.
Quarter-End Profit Check: Compare current NAV to each investor’s HWM to calculate gains.
Calculate Fees: Apply the performance fee (e.g., 20%) only to profits above the HWM.
Adjust for Fairness: Issue “adjustment shares” to late entrants to offset fees for gains before they joined, ensuring they only pay for their actual profits.
Example Scenarios:
Case 1: Early Investor Buys Low, Late Investor Buys High:
Early investor: Joins at $9/share, NAV rises to $12 by quarter-end. Their profit is higher, so their fee is larger.
Late investor: Joins at $10/share, gets adjustment shares (e.g., 333 shares) to offset pre-entry gains ($9 to $10), aligning their fee with their $2/share gain ($10 to $12).
Case 2: Early Investor Buys High, Late Investor Buys Low:
Early investor: Joins at $11/share, NAV dips to $9, then rises to $12. Their profit is smaller, so their fee is lower.
Late investor: Joins at $9/share, gets adjustment shares (e.g., 714 shares) to offset fees for pre-entry recovery ($9 to $11), tying their fee to their $1/share gain ($11 to $12).
Accounting Entries:
For fees: Debit Performance Fee Expense, Credit Cash.
For equalization: Debit Adjustment Expense, Credit Equity (for adjustment shares).
Example: Late investor’s equalization might debit $8,568 for 714 shares credited to equity at $12/share.
Why This Matters:
Fairness: Ensures each investor pays only for their gains, avoiding overcharges for pre-entry profits.
GAAP Compliance: Fees must reflect earned profits (ASC 606). Equalization keeps books accurate.
Audit Safety: Consistent HWMs and adjustments prevent audit flags.
Investor Trust: Transparent adjustments avoid disputes or regulatory issues (e.g., SEC Rule 10b-5).
Avoid Common Pitfalls:
No Favoritism: Don’t adjust fees to shield specific investors—it risks GAAP violations and complaints.
No Speculative Fees: Don’t charge performance fees at subscription; profits must be realized (ASC 606).
No Clawbacks: Issue adjustment shares instead of reclaiming shares to fix errors or fees, per your policy.
Transparency Tip:
Disclose adjustments in audit financials (e.g., “Adjustment shares issued for fee fairness, no shares reclaimed”) to maintain trust.
This equalization method is standard for hedge funds with performance fees, ensuring fairness across entry timings. It’s worked well for us—hope it helps you too!