The same high-water mark and the same 20 per cent fee, crystallised four times a year instead of once, on one illustrative path.
Run the fee both ways on the same quarterly path: crystallised quarterly, every gain above the high-water mark is paid out and stays paid even if the next quarter gives it back. On an illustrative fund returning +7.5, −4.5, +7.5 and −4.5 per cent a quarter, 5.40 per cent gross for the year, a 20 per cent incentive fee costs 1.08 on 100 crystallised annually and 2.06 crystallised quarterly, 38.3 per cent of the gain instead of 20.0.
Worked in full in Alternative Investments by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
An incentive fee is accrued in the NAV every time the fund is valued, but it only becomes the manager's money on the crystallisation date. Before that date a fall in the fund reverses the accrual. After it, the high-water mark resets to the post-fee NAV and the fee is gone for good. So the frequency decides how many chances the manager has to lock in a gain before the market takes it back. Offering documents state it in one line, often next to the fee rate, and allocators compare the rate and skip the line. On a volatile strategy the line can be worth almost as much as the rate itself.
| Input | Value |
|---|---|
| Starting NAV | 100.00 |
| Incentive fee on gains above the high-water mark | 20% |
| Quarterly returns, gross | +7.5%, −4.5%, +7.5%, −4.5% |
| Built as: drift per quarter ± swing | 1.5% ± 6.0% |
| Gross return for the year / gross NAV at year end | 5.40% / 105.40 |
At each crystallisation date: fee = MAX(0, assets before fee − high-water mark) × 20%
Assets after fee = assets before fee − fee; new high-water mark = MAX(old mark, assets after fee)
Between dates: assets = previous assets × (1 + quarterly return), no fee taken
In Excel, with assets before fee in C, the mark in E and a crystallisation flag in F: =IF(F5=1, MAX(0, C5-E4)*20%, 0)
Quarterly crystallisation. In Q1 the fund rises to 107.50. The gain of 7.50 above the mark of 100 is crystallised: a fee of 1.50, assets of 106.00, and the mark moves to 106.00. Q2 loses 4.5 per cent, to 101.23: below the mark, no fee, but the 1.50 is not returned. Q3 lifts assets to 108.82 before fee, 2.82 above the mark, for a fee of 0.56, assets of 108.26 and a new mark of 108.26. Q4 falls to 103.39. Total fees 2.06.
Annual crystallisation. Assets compound untouched through the year: 107.50, 102.66, 110.36 and 105.40. Only on the last day is the fee charged, on 5.40 of gain: 1.08, leaving 104.32.
| Crystallisation | Fees paid | Ending NAV | Net return | Fee as % of gross gain |
|---|---|---|---|---|
| Annual | 1.08 | 104.32 | 4.32% | 20.0% |
| Quarterly | 2.06 | 103.39 | 3.39% | 38.3% |
| Difference | 0.99 | 0.93 | 0.93 pts |
Quarterly crystallisation adds 0.99 to the fee bill, 91.3 per cent more than the annual fee, and costs the investor 0.93 points of net return. The ending NAV gap is slightly smaller than the fee gap because the fee paid in Q1 left the fund before the Q2 and Q4 losses, so those losses fell on a smaller base. The headline rate is 20 per cent in both cases. The rate actually paid on the year's gain is 38.3 per cent in one of them.
Keep the drift at 1.5 per cent a quarter and change only the swing around it. The gross return falls a little as the swing grows, which is ordinary volatility drag; the quarterly fee rises sharply.
| Swing | Gross return | Annual | Semi-annual | Quarterly | Quarterly, % of gain |
|---|---|---|---|---|---|
| 0.0% | 6.14% | 1.23 | 1.22 | 1.22 | 19.9% |
| 3.0% | 5.95% | 1.19 | 1.19 | 1.51 | 25.3% |
| 6.0% | 5.40% | 1.08 | 1.08 | 2.06 | 38.3% |
| 9.0% | 4.47% | 0.89 | 0.89 | 2.58 | 57.7% |
Three readings. First, with no reversals the frequency is irrelevant: on a smooth path the quarterly fee is marginally lower, because each payment leaves the fund before it can compound. Second, semi-annual crystallisation costs the same as annual here, because each half-year on this path is a gain; what matters is not the number of dates but whether a loss follows a crystallised gain inside the year. Third, the effect compounds over time but does not run away: repeat the base path for a second year and annual crystallisation takes 2.20 of an 11.08 gross gain, 19.9 per cent, while quarterly takes 3.23, or 29.1 per cent. The high-water mark does its job across years; it is within each year that the frequency leaks.
Treating the high-water mark as full protection. It stops the manager being paid twice for recovering the same loss, but it measures from the last crystallised NAV, and a fee once crystallised is never clawed back. The other mistake is in the comparison sheet: two funds quoted at 20 per cent are put side by side on the fee rate alone, when one crystallises quarterly on a strategy whose quarters regularly reverse. Run your own expected path through both terms before calling them equal. Where the quarterly frequency cannot be negotiated away, deferring part of each crystallised fee into a reserve that later losses can claw back achieves much the same.
One investor from launch, no subscriptions or redemptions, no hurdle, no management fee. Equalisation for investors entering mid-period changes who bears the accrual but not the size of the leak described here.
A 20 per cent incentive fee crystallised quarterly can cost close to double the same fee crystallised annually when returns reverse within the year: 2.06 against 1.08 on this path, 38.3 per cent of the gross gain. Ask for the crystallisation frequency alongside the rate, and price it on a realistic path. The book follows fees through to the return that reaches the investor, and the free workbooks for the book do the same arithmetic on a private fund. See also the gross return a hedge fund needs to net 8 per cent after 2 and 20 and how an evergreen fund's performance fee is calculated.
It is the date on which the accrued incentive fee becomes payable to the manager and can no longer be reversed by later losses. Between crystallisation dates the fee is only an accrual: if the fund falls, the accrual falls with it. On the worked path an annual crystallisation charged exactly 20.0 per cent of the year's 5.40 per cent gross gain.
Only partly. The high-water mark stops the manager being paid twice for recovering the same loss, but it resets upwards each time a fee is crystallised. Gains paid out in a good quarter stay paid when the next quarter gives them back, so on the worked path the investor paid 2.06 against 1.08, an effective rate of 38.3 per cent.
When returns do not reverse inside the year. On a smooth path earning the same 5.40 per cent gross, quarterly crystallisation costs 1.07 against 1.08 annually, slightly less because the fee leaves the fund earlier. The extra cost comes entirely from losses that follow a crystallised gain within the same year.
This article is one calculation from Alternative Investments. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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