Explanation:
A high-water mark clause states that previous losses must first be recouped and hurdle rates surpassed before incentive fees once again apply.
In the first year, the fund managers earned a management fee of $2m (= 100 * 0.02). However, it earned $0 in incentive fees since it made a loss. Incentive fees would only have applied to any profits earned above a 1.25% return, meaning that only an ending balance higher than $101.25 million would have triggered the 20% incentive fee.
The management pocketed $1.8m in management fees in the second year (= 90 * 0.02). As per the fund's high-water mark clause, investors expected its total worth to be above $102.5 at the end of year 2 before any incentive fees can be earned (i.e., 100 + 1.25 + 1.25). In other words, the high-water mark for year 1 is $101.25m and $102.5m for year 2. At $110m, at the end of the second year, therefore, the fund has outperformed by a margin of $7.5m (i.e., 110 - 102.5). As such, 20% of this less the management fee [i.e., 0.2 * (7.5 - 1.8) = $1.14m] is earned as incentive fees.
Total fees earned in year 2 = $1.8m + $1.14m = $2.94m
Q.4933 On January 1, 2020, a hedge fund began with $100 million in assets from investors. The 10-year Treasury, yielding 1.25% at the time, was chosen as the hurdle rate for the next five years. In addition, the fund operates on a 2 plus 20% fee structure and is bound by a high-water mark clause. In the first year of operation, a combination of a challenging macroeconomic environment and some bad decisions culminated in end-of-year assets under management dropping to $90 million after payment of the management fee. In 2021, the fund bounced back, with its total assets coming at $110 million by the end of the year. Calculate the total fees earned by the management in 2021. (Assume that the management fee is calculated on the assets at the beginning of the year and that the incentive fee is calculated after subtracting management fees)
A
$5.8m
B
$1.8m
C
$3.5m
D
$2.94m
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