Performance Fees and Incentives Tied to Returns

In our previous article, “Understanding Fees: Beyond the Headlines and into the Footnotes,” we provided an overview and checklist of the various fees and expenses typical in evergreen funds. Building on that foundation, this piece delves deeper into performance fees, incorporating broader asset class considerations, additional nuances, and practical enhancements to better equip investors.

Performance fees are pivotal in aligning interests between investors and managers – or exposing misalignments. At their core, these fees reward managers with a share of profits, often around 0-20%. However, in evergreen funds – perpetual structures without a fixed end date – the mechanics are more complex than in closed-end vehicles. Key questions include: What constitutes "profit"? When are fees triggered and paid? And crucially, how are investors protected from fees on fleeting gains that may reverse?

Realized Gains vs. Unrealized Gains: Navigating Paper Profits and Valuation Risks

In traditional closed-end funds, performance fees (often called "carry" or incentive allocations) typically stem from realized gains – profits from actual asset sales or distributions. Unrealized gains, by contrast, reflect asset value increases based on appraisals or market estimates, without a transaction occurring.

Evergreen funds often extend fees to unrealized gains to incentivize managers in open-ended timelines, with payouts triggered by periodic valuations (e.g., quarterly). This allows managers to receive cash based on "paper" profits. While this aims to maintain alignment in perpetual structures, it introduces risks: valuations may be manager-influenced, leading to overestimations and premature fees. To mitigate this, investors should scrutinize valuation processes. Independent third-party appraisers are preferable to internal models, reducing conflicts of interest.

Waterfall Structures: Sequencing Distributions with Evergreen Adaptations

Waterfall structures outline the order of profit distributions between investors and managers, with variations impacting alignment. In closed-end contexts, American-style waterfalls allow deal-by-deal payouts, enabling early manager compensation even if the portfolio lags overall. European-style waterfalls delay fees until the entire fund is profitable, providing stronger investor protections.

In evergreen funds, these concepts adapt. Without a fixed termination, "whole-fund" profitability is assessed dynamically through ongoing fund accounting, often at redemption or crystallization points. This dilutes some European safeguards, as there's no final reckoning. Hybrid models are increasingly common, such as rolling vintages (treating new subscriptions as separate cohorts) or NAV-based allocations at the investor level, which can complicate equitable treatment across classes.

Make-Whole Provisions: Ensuring Full Recovery Before Manager Payouts

As part of waterfalls, make-whole provisions ensure investors recoup their full invested capital – plus any hurdle rate – before managers earn performance fees. Strong provisions adjust for redemptions, leverage, and layered expenses (e.g., from underlying funds), promoting fairness. Weaker ones might only cover principal, exposing gaps in volatile markets. In credit-focused evergreens, make-whole could tie to loan repayments, adding another layer of scrutiny.

Hurdle Rates: Setting Minimum Return Thresholds

Hurdle rates establish a baseline return (typically 6-8% in PE, but 4-6% in credit evergreens) that must be achieved before performance fees apply, prioritizing investor returns. Key variations include fixed vs. floating rates (e.g., tied to benchmarks like SOFR for inflation adjustment) and compounding – simple vs. annual compounding, which affects long-term calculations.

Lower hurdle rates risk fees on subpar performance. Catch-up clauses are common: post-hurdle, managers may receive 50-100% of excess profits until reaching their full share (e.g., 0-20%). Aggressive catch-ups can favor managers, so evaluate for fairness. In low-rate environments, floating hurdles better align with economic realities.

High Watermark Provisions: Preventing Fees on Recoveries

High watermarks ensure fees apply only to new highs in net asset value (NAV), not recoveries from losses. This rewards true value creation over cycle rebounds. In evergreens, perpetual watermarks (without resets) are ideal; annual or vintage-based resets can allow repeated fees on the same capital.

Clawbacks: Retrospective Safeguards for Overpayments

Clawbacks mandate managers repay excess fees if later losses wipe out prior gains, fostering accountability. In evergreens without endpoints, enforcement relies on mechanisms like annual reviews, escrow holds (e.g., 20-50% of fees reserved), or GP guarantees – though the latter are rare. Weak implementation (e.g., no reserves) heightens investor risk, especially in rolling structures.

Summary

Ultimately, well-designed performance fees in evergreen funds align interests by rewarding durable, risk-adjusted value creation while tempering sensitivity to interim marks. Investors should seek independent valuation oversight; crystallization mechanics that approximate whole-fund discipline; make-whole provisions that return contributed capital and meet stated hurdles net of layered costs; well-calibrated hurdles with transparent catch-up; perpetual high-watermarks without resets; and enforceable clawbacks supported by escrow or holdbacks.