Another week, another interesting note from Matt Hose over at Jefferies on investment trusts. This time he’s highlighted an interesting peculiarity relating to performance fees. In simple terms most investment trust managers tend to charge two sets of fees, one uncontroversial, the other less so. Annual management fees across the investment trust universe have been coming down steadily over the last few years, prompted by lower fees for clean unit trusts and the rise of ETFs. Its now rare for any mainstream equities fund to charge more than 1% per annum, with many active managers pushing that fee closer to 0.75% or even 0.50%.

In addition many, but not most, fund managers also charge a performance fee. This is usually in addition to the annual fee and is charged when performance in the fund is in excess of a target or threshold, usually either an abstract number – like say 8% per annum – or a margin over LIBOR rates.

These performance fees are much more controversial. We’ve already had quite a few blow ups in the sector when boards try and reduce performance fees – the recent row at Invesco Perpetual’s Select income fund is not untypical. Many of the bigger funds are now doing away altogether with performance fees whilst others are tightening up their criteria. Some are trying even more radical ideas.

I’m a NED on the Aurora Investment trust. Here the manager – Phoenix – charges no annual management fee but only a performance fee based on a UK equities benchmark. Crucially this performance fee is monitored carefully over every period and is subject to a clawback if the period subsequent to a performance fee hurdle being hit the fund then underperforms. I quite like this pure alpha strategy – the manager only gets paid if they consistently beat the benchmark.

My own feeling is that we should move to a twin track system. Either you charge a flat annual fee OR you only charge a performance fee. Not a mutant mix of the two.

But the devil, of course, is in the detail even with a performance fee – as Matt Hose (who also reports on rival fund VPC) discovers with P2P Global Investments. The backdrop to this is that P2PGI – no small fund by any measure and now managed by Pollen Street – has had a disappointing track record. It’s a novel access idea that was supposed to deliver abundant income to investors. The dividend yield subsequently disappointed and new managers were brought in – Pollen Street. They seem to be doing a steady job of making the fund much more viable and the dividend yield looks much more sustainable. Recent interims though disclosed that the fund

“had accrued a performance fee during the six month period. This represented £1.87m, or 2.4p per share, and is despite the introduction of a 5% performance fee hurdle with effect from 01/01/18. During the six months, P2P delivered a NAV total return of 1.66%, or c.1.1% if we adjust for share buybacks, and so returns have clearly fallen short of the hurdle. Having spoken to the manager, the answer lies in the fact that P2P is accruing a performance fee based on the return outlook for the year. If this outlook is missed, the accrual will be reversed, or effectively ‘written-back’. We see this as an unconventional accounting treatment, as while it is certainly more prudent (i.e. initially resulting in a lower NAV) than waiting until the hurdle has been surpassed, it entails the accrual of a performance fee where the fee has not yet been technically ‘earned’. Other than for P2P’s sister-fund Honeycomb IT (HONY), which appears to share the approach, we haven’t seen this applied elsewhere. Interestingly, if we back out P2P’s assumed performance from the accrual on a straight-line basis it isn’t enough the surpass the hurdle, meaning the managers are likely to be factoring in a higher run rate of performance over H2. This is consistent with the fund’s returns over recent months.

We suspect this treatment could be due to the catch-up feature of the hurdle. Once the 5% hurdle has been surpassed, all of the subsequent returns are directed to the performance fee until the manager is placed in a situation whereby its fee is equivalent to what would have been earned if the hurdle hadn’t existed – so that it is effectively ‘caught up’. The returns are then split pro-rata in accordance with the fee level, 15% in this case. If the fund were to wait until the hurdle had been surpassed to start accruing, the NAV returns, all things being equal, would be visibly lower during the catch-up phase. Unlike private equity fees, which commonly apply catch up provisions, and where, gearing aside, arguably all of the value creation is attributable to the manager, credit returns directly benefit from the risk-free rate. This element of the return should be provided for in the hurdle no matter what the end result is.”

I have to agree with Hose that basing your performance fee using return outlook is a bit unusual. There are lots of technical issues surrounding how performance fees are accrued but the principal is usually that boards base their analysis on actual reported earnings or NAV. Clearly with a credit related fund that is more problematic because payments come in all the way through the year. But nevertheless, it leaves me slightly worried that those targets might not be hit. In that case, the performance fee is then clawed back but this still strikes me as a slightly odd way of accounting for a performance fee. More to the point, P2PGI also charges an annual management fee in addition to the performance fee, which means that it’s in line to make a very substantial amount of money from running this large fund.