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Top 4 mistakes in Performance Fee accounting

Everyone who has managed, manage or wants to manage some investment Fund (nonprofit or commercial, big or small, private or public) probably thinks about Performance Fee. And when it comes to practice — some questions arise: How to properly calculate Performance Fee? How to pay Performance Fee? Do I need to take Performance Fee from all investors at once or take from each investor separately? Do I need to take a performance fee before each Withdrawal? How to account performance fee easily? What tools and software exists for such fund accounting?

In this article, I will answer all the questions above and guide you through the processes of Performance Fees calculation, payment, and accounting. As a bonus — you will get the Google Spreadsheet Add-On for fund accounting and management. Let’s go!

What is Performance Fee?

A payment made to a fund manager for generating positive returns. The performance fee is generally calculated as a percentage of investment profits.

To measure investment return performance, the industry generally uses two concepts introduced here: measurement period and the high-water mark (HWM). The measurement period is a periodic time, usually annual, but sometimes quarterly. Actually, you can set any period in your fund.

For example, we have some cool Fund with:
Total Portfolio Value (TPV) at the beginning of the measurement period= \$10 000 — it will be our HWM
TPV at the end of the measurement period = \$12 000

Profits = TPV — HWM = 12 000 — 10 000 = \$2 000
Performance Fee in %= 20%
Performance Fee in \$ = 2 000 * 0.2 = \$400

The HWM is established at the beginning of a new measurement period. If the fund’s Total Portfolio Value at the measurement period’s end is higher than the measurement period’s HWM, the Current TPV becomes the new measurement period’s HWM and performance fees are charged. If this is not the case, there is no change to the HWM and no performance fees are charged. The HWM is like a step-function, which either stays flat or in the case of positive performance, increases step-wise but never decreases. The performance fee charged is calculated as a percentage of the difference between the Net Asset Value and the HWM.

Mistakes and Pitfalls of Performance Fee

Let’s look in detail at the mistakes and pitfalls in the typical Fund where we have mutual units (shares, NAV, tokens, etc). Call it what you want, the main thing to understand is that the entire portfolio of the Fund is divided into units with some arbitrary supply, and the price of this unit represents the whole portfolio performance.

For example in our cool Fund we have such actual numbers:

TPV = \$12 000
Mutual units supply = 10 000
Price per unit = 12000/10000 = \$1.2

The price per unit may changes every day, every hour or even every minute (depends on the tech of your cool back-office). Let’s fix the price on \$1.2 for today.

Mistake #1 “Payment of performance fee affects the price of the mutual unit”

In traditional mutual, hedge funds and ETFs, (1) performance fee is taken in some fixed fiat currency with the direct withdrawal of money from the Fund without burning mutual units.

Another approach is provided by Melonport — autonomous protocol for crypto assets management built on Ethereum smart-contracts: (2) performance fee is taken in mutual units with minting new mutual units directly to manager’s address without withdrawal of money from the fund.

So in both approaches, the price per unit will decrease a little after each performance fee take. In the first casecit caused by decreasing TPV, in the second case (Melonport) it caused by increasing the total supply of units. Thus, investors will lose money, although they may not have any profit again. So how to act fairly?

Just keep balance between your units supply and your TPV in order not to affect the unit price. We should burn units along with money withdrawal from the Fund or make a direct transfer of units from an investor to the manager without money withdrawal from the Fund.

PRO TIP: It will be better to pay Performance Fee by a direct transfer of units — because assets do not leave the fund, as would a cash payment. There are no unnecessary trading or cash management transactions. Investors and managers have access to real-time fee accrual metrics. Finally, the incentives to the manager are reinforced beyond a cash performance fee by being paid in the currency that is their own product.

Mistake #2 “Calculate performance fee by one total HWM for all investors”

Of course, we have many investors in our Fund. Each investor bought units by different price individually in his own time. For example:
John bought units per \$1
Sam per \$1.1
Bob per \$1.3

So someone can have a profit, and someone hasn’t. In our case Bob does not have any profit at the moment.

So if we want to take Performance Fee today —what the sum it will be?
You may ask — how much is our HWM? Great question, because actually:

We should keep the individual value of HWM for each investor and take performance fee individually.

Bob does not have to pay anything if he has no profit. All investors will have incentives to make deposits after Performance Fee event. Many Funds don’t care about that…I think the main reason is some complexity in the accounting of HWM individually (I will show you a solution for that later). So how to act better? You should account individual HWM for each investor. For example:

John’s HWM = \$1 per unit (profit 20%)
Sam’s HWM = \$1.1 per unit (profit 9.09%)
Bob’s HWM = \$1.3 per unit (loss -7.7%)

When we know each investor’s HWM we can calculate investor’s profit/loss amounts in some base currency (e.g. USD). To calculate it we need to know one more thing — the balance of units for each investor. For example:

John’s balance of units = 5000 (50% share)
Sam’s balance of units = 3000 (30% share )
Bob’s balance of units = 2000 (20% share)

And we will calculate profit/loss using these simple formulas:
Investor’s P/L in USD = Investor’s current value— Investor’s HWM value
Investor’s current value = Balance of units * Current price per unit
Investor’s HWM value = Balance of units * HWM price per unit

John’s P/L in USD = (5000 * 1.2)–(5000 * 1) = 6000–5000 = \$1000
Sam’s P/L in USD = (3000 * 1.2)–(3000 * 1.1) = 3600–3300 = \$300
Bob’s P/L in USD = (2000 * 1.2)–(2000 * 1.3) = 2400–2600 = -\$200

And finally we can get total profit from John and Sam = 1000 + 300 = \$1300
Proper performance fee amount will be:
1000*0.2 = \$200 for John
300 * 0.2 = \$60 for Sam

Mistake #3 “Missing performance fee before each withdrawal”

Let’s say we charge the performance fee every quarter in our cool Fund. Next take is coming soon. Our investor John with \$6000 balance and profit equals \$1000 understands that if he withdraws all his money before the performance fee event — he will get about \$6000 minus “some redeem fee”. But if he withdraws after the PF event — he will have to get \$6000 minus \$200 (performance fee) minus “some redeem fee”. So the investor has an incentive to withdraw money before performance fee event. You Fund will miss out its honestly earned money. What to do?

You should take personal performance fee automatically before each withdrawal of particular investor.
Of course, if Bob will withdraw money, we will not take the fee from him, because he has no profit.

DON’T FORGET: After the operation is finished, HWM of particular investor should become equal to the price per unit at the time of performance fee take.

Mistake #4 “Don’t change HWM after additional deposits”

An investor makes an additional Deposit to our cool Fund. We mint new units for him. For example Sam deposits new 7000\$. We mint 5833.33 units by the price \$1.2. Sam’s balance of units become equals 3000+5833.33 = 8833.33. But what the value of Sam’s HWM? He used to have 3000 units bought at \$1.1. And now he bought another 5833 unit at \$1.2.

We always should calculate the weighted average purchase price per after the investor’s deposit. This value will be the HWM for the particular investor.

WAP = (3000*1.1 + 5833.33*1.2)/8833.33 = 3300 + 6999.99/8833.33 = \$ 1.16603

NOTE: 3000 and 1.2 — are values from last HWM. So if we got another additional deposit we will use 8833.33 and 1.16603 to calculate new WAP regarding the amount in this additional deposit and actual price per unit.

Tools for proper fund accounting

Having searched the entire Internet, I have not found a single software that would satisfy me for proper fund accounting and fees management. Only a lot of outsourcing companies with armies of accountants, controllers, auditors, lawyers, back-office- and middle-office workers spent hours faxing, calculating, checking and double-checking all metrics with a price tag of up to 10,000 per month.

Of course, such a project like Melonport — is great! They are the pioneers of the future in asset management. But today they are not ready yet (works only with DEX, only Ethereum-based assets, performance fee mistake #1).

Finally, I have decided to build my own Google Spreadsheet. I wanted to make a tool that would give me the functionality, power, and flexibility I needed. And Spreadsheet in conjunction with the Google Apps Script — perfectly suited for my purposes.

This spreadsheet has evolved into a complete system for accounting and management of the Investment Fund. It can track portfolio of any assets (cryptocurrencies and stocks) in real-time, record & report Fund’s performance, account for all deposits, withdrawals, transfers, mutual unit’s minting, and burning, fee taking. And all this in a transparent, safe and automatic manner. You can use it for free as Gsheet Add-on: Spreadsheet Fund

Conclusion

There are not enough good and correct information about this topic. I would like to hear from readers — what you think about weaknesses in the approaches described before.

Thank you for reading! And sorry for my poor English. If the article was useful for you, please share it somewhere. Let’s spread the knowledge!

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