incentivefee

Incentive fee, also known as a performance fee, is a fee charged by investment managers based on fund performance. It is designed to align manager incentives with investor returns by awarding compensation for above-average results. The term is most commonly used in hedge funds and private equity, with variations appearing in other managed accounts.

The standard structure combines a base management fee with an incentive fee. The management fee, typically a percentage of assets under management, covers ongoing operations. The incentive fee is usually a share of profits, often in the range of 10% to 20%, and is paid only if performance exceeds a hurdle or high-water mark. In private equity, the incentive fee is commonly referred to as carried interest and is typically around 20% of profits, subject to preferred return terms. Some funds apply the fee to net profits after expenses and after the management fee. Many approaches include a high-water mark, which requires the fund to recover prior losses before the incentive fee can be earned again. A catch-up provision can allow the manager to receive a large fraction of subsequent profits until the target share is reached, after which future profits are shared at the agreed split.

Variations exist in hurdle design. A hard hurdle requires the performance to exceed the hurdle rate before any incentive fee is charged, while a soft hurdle allows the manager to take a portion of profits even if the hurdle is not fully met. Hurdles can be annual or cumulative over the life of the fund.

Critiques focus on potential misalignment of interests, inducement of excessive risk-taking, and complexity in fee calculations. Proponents argue incentive fees reward skill and performance and can improve capital allocation.