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Matthias Knab, Opalesque for New Managers:

Paper by Francois-Serge Lhabitant (September 2025)

Core Problem

While performance-based fees (PBF) appear straightforward (typically 20% of profits above a high-water mark), their implementation becomes complicated when:

• Investors subscribe at different times during a performance period
• The fund needs to ensure each investor pays fees only on their own gains
• The fund wants to maintain a single NAV for all investors

Inequitable Fee Allocation

When calculated at fund level, investors entering mid-period may pay disproportionate fees. For example, an investor joining after gains have accrued might pay fees on profits they didn't benefit from.

Free Ride Syndrome

Investors joining when a fund is below its high-water mark may avoid fees on subsequent gains up to that mark, even though they personally profit.

Clawback Issues

When accrued fees are reversed due to losses, late investors may benefit from reversals of fees they never contributed to.

Solutions Examined

1. Partnership Accounting: Maintains separate capital accounts for each investor - precise but administratively demanding
2. Series of Shares: Issues different share classes for each subscription date - transparent but operationally complex with multiple NAVs
3. Simple Equalization: Maintains one NAV but issues free shares to compensate investors - reduces complexity but requires sophisticated calculations
4. Equalization Credit/Depreciation Deposit: New investors pay adjustments when entering above/below high-water mark - fair but complex and less intuitive
5. Equalization Share Adjustment Method: Modern variant using share mechanics rather than cash deposits - more efficient but still complex

Key Takeaway

No perfect solution exists. Each method involves trade-offs between fairness, operational complexity, transparency, and feasibility.

Lhabitant emphasizes that fund documents must clearly specify the chosen method, noting that many agreements simply state "20% of net profits" without addressing these critical implementation details. The choice of method significantly impacts both investor returns and manager compensation, making clear documentation essential. Until then, both allocators and managers need to ask the hard questions and scrutinize the fine print.

Source: Franois-Serge Lhabitant, "Equalization of Performance-Based Fees," September 2025.