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How does the incentive allocation work? Are there different options I can choose from?

There are several possibilities, which reflect the several variables that managers need to consider:

  • Incentive allocation percentage – The industry standard is for the manager to earn 20% of all net profits, subject to a high water mark, though successful managers at some of the largest funds charge as high as 50%. A reduced incentive allocation rate, however, may enhance the marketability of a new fund.
  • Frequency – Most hedge fund managers calculate incentive allocations at the end of each fiscal year (normally December 31), in order to align the long-term interests of the manager with investors. We have noticed an uptick, however, in the number of managers who calculate incentive allocations on a quarterly basis.
  • High water mark – An industry-standard provision that requires prior losses to be restored before an incentive allocation may be assessed. For a typical example, assume an investor’s account balance declines by $100,000 during his first fiscal year in the fund. If the investor’s account balance appreciates by $200,000 in the following fiscal year, the manager would earn an incentive allocation of only $20,000 (20% of $100,000), not $40,000. Although $200,000 of net profits were generated during the second year, the first $100,000 merely restored the first year’s loss.
  • Hurdle rate (hard) – A hurdle rate is a benchmark that must be surpassed in order for an incentive allocation to be assessed. The most common rate we see is 5%. When the hurdle rate is “hard”, the incentive allocation is based only on net profits in excess of the hurdle rate. For example, if a 5% “hurdle” return amounts to $50,000 and $60,000 in net profits is allocated to an investor for a fiscal year, the manager’s incentive allocation will be $2,000, which amounts to 20% of the $10,000 in net profits above the “hurdle.” Net profit calculations remain subject to a “high water mark” calculation, meaning that prior-period losses must be restored before an incentive allocation may be assessed. No “restoration” is required if the investor earned a net profit during a prior period that was less than the hurdle rate (for example, a 4% return when the hurdle rate is 5%), though no incentive allocation will have been charged for that prior period.
  • Hurdle rate (soft, or sometimes referred to as a “preferred return”) – This works the same as the “hard” hurdle, except that the incentive allocation is based on the investor’s entire net profit if the hurdle rate is exceeded, not merely on the excess above the hurdle rate. For example, if a 5% “hurdle” return amounts to $50,000 and $60,000 in net profits is allocated to an investor for a fiscal year, the manager’s incentive allocation will be $12,000, which amounts to 20% of the $60,000 net profit allocated to the investor.

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