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Introduction

Hedge funds generally charge 15 percent to 25 percent of profit as an in-
centive fee. Suppose a fund makes 2 percent or $2 million on assets of
$100 million in a particular month before incentive fees but after the
management fee has been deducted. If the fund collects a 20 percent in-
centive fee, the fund will pay $400,000 ($2 million
x 20%) to the man-
agement company.
Funds usually charge no incentive fee on profits that offset prior losses.
This is called a high-water mark provision. For example, suppose a hedge
fund started with a net asset value (NAV) of $1,000. Over several months,
the NAV rose to $1,500 and the management company charged incentive
fees based on this return. If the NAV declined to $1,400, the manager
would refund no incentive fees, but the fund would pay no incentive fees
on any returns until the value to investors rose above the previous high-
water mark of $1,500.
Sometimes a fund pays incentive fees on returns above a certain mini-
mum return. Suppose a $100 million hedge fund pays a 20 percent incen-
tive fee on returns above the London Interbank Offered Rate (LIBOR). If
LIBOR was 3 percent (annualized to 3%/12 or .25% for a month) and
the fund return was 3.5 percent in one month, the fund would collect an
incentive fee on 3.25 percent; thus, $100 million
x (3.5% ­ .25%) x
20% = $650,000.
A fund may subject previously paid incentive fees to a look-back pro-
vision. In this case, a manager may be required to refund incentive fees
back to the fund if the fund experiences a loss shortly after an incentive
fee is paid. Look-back provisions are not common, and the specific provi-
sions can vary from fund to fund. For example, one fund limits the look-
back to three months. Another fund limits the incentive fee look-back to a
calendar quarter.
Hedge fund managers may charge other fees, such as commissions, fi-
nancing charges, and ticket charges. The management company may keep
some or all of these fees or may pay out part of these fees as sales incen-
tives to individuals who market the hedge fund to investors. The existence
and the magnitude of these fees vary from fund to fund. The fund should
disclose these fees to investors, but investors may nevertheless have trouble
determining how much these fees affect the return of the fund.
Other Hedge Fund Provisions
Funds may impose a lockup, meaning that investors may not withdraw
their investments for a period of time, usually between one and three years.
Often, the fund will let an investor withdraw gains but require the investor
to keep the initial capital in place during the lockup period.
Introduction
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