3 Tips for Designing Performance Fees as an Asset Manager

Trends in the use of performance fees in the asset management industry

November 27, 2019 |

Introduction

“When the sword is once drawn, the passions of men observe no bounds of moderation.”

— Alexander Hamilton, First US Treasury Secretary

 

Performance fees for asset managers can be seen as a double-edged sword – driving revenue when markets are rising but slicing away profits in flat or falling markets. As with Hamilton’s bared sword, the debate over performance fees has threatened to disrupt the asset management industry.

Despite the risks inherent in current market conditions, there has been a growing expansion in the use of performance fees. Because calculating performance fees can be more complex than asset-based billing, staying proactive is necessary to ensure such fees are correctly computed. Additionally, some billing systems have difficulty handling these complex calculations.

In this article, we discuss trends in the use of performance fees in the asset management industry. While their usage may be increasing, there are pitfalls that make it imperative to review and implement best practices before putting such fees into effect. To aid you in aligning your performance fee billing policies with industry best practices, we’ve outlined 3 best practices tips gleaned from our experience with these fees.

Asset Manager Fee Trends

The shift towards an increase in the use of performance fees is occurring within an overall trend of decreasing fees for asset managers, largely due to the popularity of passive investing strategies. As more money moves to managers and vehicles using anon-active approaches, pressure is exerted on fees charged by active managers. For instance, Fidelity’s launch of no-fee index funds in 2018 has, along with moves by other passive asset managers to reduce or eliminate fees, caused many institutional investors to seek fee reductions from their active managers.

Another sign of this trend comes from the commissions front, where Charles Schwab has eliminated commissions entirely for some customers. While asset managers’ billing strategies aren’t directly affected because they don’t charge commissions, Schwab’s move does demonstrate the push to cut costs wherever possible that is rippling through the investment industry. As asset managers find their fee-charging practices subject to ever more rigorous scrutiny, the ability of performance fees to justify themselves via their direct relationship to client returns has added impetus to the adoption of such fees.

Another trend we’ve noticed is the attempt to increase fee standardization by consultants working for large investment clients. This effort has been resisted, to some degree, by asset managers who prefer that their fee structures remain as they are. Still, given the prevalence of the use of consulting firms to select and manage asset manager relationship by many major investors, this trend is one to keep an eye on.

Why is the Use of Performance Fees Rising in Popularity?

Given that performance fees are typically more complex to calculate than straight percentage of AUM fees, why is their use rising in popularity? As alluded to above, one reason is that the rise of low cost passive investing options has caused institutional investors to increasingly look to justify the fees they pay active managers by compensating them with performance fees.  Including this factor, we see the five main drivers of increases in performance fee usage as follows:

  • They help align client and asset manager interests more strongly: When asset managers directly benefit from improved client performance there is a strong incentive to deliver superior performance.
  • Pressure from institutional investors: The disparity between ultra-low-fee passive strategies and comparatively higher active manager fees has been exerting downward pressure on active manager compensation. The use of performance fees can help them circumvent, to some degree, the downward trend in fees.
  • They offer the chance to significantly increase asset manager compensation: With the opportunity to boost their compensation, performance fees are often attractive to asset managers. This is the case during bear markets, as performance accounts position investment managers to reap significant profits from a recovery or market bounce.
  • Better billing software makes fees easier to compute: As more sophisticated billing software has been developed, it has become less cumbersome for asset managers to charge performance fees.
  • Avoiding ERISA lawsuits. Legal challenges have been raised regarding the fees paid to asset managers by plan sponsors and fiduciaries. The introduction of performance fees in these accounts could serve as a way to justify asset management fees paid by a plan. As a result, some pension consultants are instituting performance-based management fees.

3 Performance Fee Best Practices Tips

Once you’ve decided to use performance fees as an asset manager, what are the best methods of implementing them? Following are some best practices tips from our perspective:

  1. Avoid excessive use of special clauses: While asset managers naturally want to accommodate as many client requests as possible, it’s best to avoid tying your operations team in knots by using needlessly byzantine clauses. These clauses add expense by increasing calculation time and, their complexity can lead to client disputes if they’re misunderstood.
  2. Clearly communicate to clients the reasoning behind and the functioning of fees: Even if straightforward performance fee calculations are used, if your firm and its clients aren’t on the same page with regard to why such fees are being charged and how they work, it can lead to client dissatisfaction and, in the worst case, loss of client relationships.
  3. Foster robust communication between the sales/marketing and billing/operations departments: This is crucial to ensuring that performance fee agreements can be supported by the billing system and follow firm policy. Your sales team may feel pressure from clients and their consultants to agree to certain fee clauses that operations can’t support. While client wishes should be accommodated, if your operations and sales teams don’t communicate what can and can’t be done, it can lead to difficulties in managing client expectations and keeping new business.

 

Challenges Faced by All-in-One Tools

While comprehensive, all-in-one practice management software may offer some billing functionality, the billing solutions offered by these tools often fail to meet client expectations. This is especially the case for sophisticated clients who prefer to play a part in the design of their billing criteria.

Such tools often provide limited flexibility when it comes to handling a variety of billing scenarios. While these systems may provide the convenience of a unified tool, this can come at the cost of limiting your firm’s ability to provide sophisticated clients with the type of performance fee arrangements they prefer.

How a Specialized Billing Solution Can Optimize Performance Fee Application

A specialized billing solution can optimize your ability to offer your clients performance fee billing by enabling the type of performance fee arrangements these clients prefer. A key reason for this is the wide variety of performance fee clauses that can pertain when calculating performance fees. For instance, a billing software solution that only offers five performance fee billing clauses will be at a disadvantage when compared to a solution that can handle up to 50 or more such clauses. These specialized billing solutions can typically be integrated with your practice management software, enabling you to seamlessly provide your clients with best-in-class billing solutions.

A Specialized Solution for Performance Fee Billing

Redi2 offers a high-end billing solution that can handle complicated performance fee billing arrangements. Our asset manager billing platform was designed with the multitude of factors modern wealth management firms face in the billing process in mind. If you’re looking for a billing solution that can handle complex performance fee calculations, enabling your firm to productively integrate, or expand, the use of performance fees in your business, email our team at Redi2 for more information.