Eight things to understand about private investment structures and fees

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Alternative investments are becoming more accessible in Canada, but the associated terminology and fee structures can be confusing.

These investments include liquid alternative funds that behave like mutual funds or exchange-traded funds (ETFs), with a fee structure familiar to most investors. But they also include hedge funds and private market funds with more complex structures.

Although most investors are familiar with management fees for investment funds, the fees charged by hedge funds and private market funds are complex and require scrutiny.

Here’s some of the terminology investors need to understand:

Closed-end or drawdown structures: Investors commit a certain amount to these funds but managers don’t invest the entire sum from the outset, says Kazuki Nohdomi, private equity and venture capital portfolio manager with Nicola Wealth Management Ltd. in Vancouver.

For example, an investor could commit $1-million to a private fund that will “draw down” on that commitment over a period of time (also called a capital call or investment period) of about two to five years as the managers find worthwhile investment opportunities, he says. Investors aren’t able to withdraw from the funds during that time.

“That’s a very typical structure,” Mr. Nohdomi says.

Investors pay the management fee (often around 2 per cent) on their total commitment right from the start, even if the managers haven’t invested all the money, he notes. So, on a $1-million commitment, that fee is $20,000 a year, even if only $200,000 is invested.

“That’s a fixed amount you have to pay, regardless of performance and how much money has been put to work,” he says. “What that management fee is charged on – and how much the fee is relative to how much of your capital is being put to work and generating a return – is critical.”

Reinvestment period: If a fund has a quick win on a private investment, the managers can reinvest the proceeds into the fund instead of having to pay that out to investors right away. That usually applies within the drawdown period.

Harvest period: Many private equity and similar funds aim to sell or exit all their investments over a period of time, often starting in year four of a seven- to nine-year fund. That can be called a “harvest period,” says James Burron, founding partner of the Canadian Association of Alternative Strategies and Assets.

“They’re trying to liquidate all investments by the end of the term; otherwise they need to distribute underlying company shares into the hands of fund investors,” he says.

However, there’s typically a clause that allows managers to stretch the harvest period out a year or two if it makes sense for the investments they hold.

Evergreen funds: These relatively new funds act more like a mutual fund, with an investor’s money put to work immediately, often in a diversified portfolio, Mr. Nohdomi says.

Private funds are typically long-term investments, but with evergreen funds, there are more options for liquidity. That’s different from closed-end funds or drawdown structures in which investors don’t have liquidity – investors get their money back when the manager decides.

The management fees on evergreen funds range from 0.5 to 1.5 per cent, Mr. Nohdomi says, while performance fees range from 5 per cent to 20 per cent, depending on the strategy.

Performance or incentive fees: Most private market funds and hedge funds have performance fees that are paid when the fund surpasses a particular after-fee return threshold, sometimes called a “hurdle.”

“The industry calls it a ‘preferred return,’” Mr. Nohdomi says.

That can be around 5 per cent for private debt and about 8 per cent in private equity, he notes.

The 2/20 structure: Stated as “a two and 20,” it’s the most common form of performance or incentive fee. The management fee is 2 per cent and the performance fee is 20 per cent, so the fund manager gets paid 20 per cent of profits above a certain threshold, Mr. Burron says.

Variations include a 1/10 structure or even 1.5/15, which can be the case with hedge funds, he adds.

For example, a $100 investment rises to $200 in five years, which works out to about a 15-per-cent rate of return – above the fund’s cumulative “preferred return” of 8 per cent a year. With a 2/20 structure, $20 of the $100 gain goes to the performance fee and $180 to the investor – the initial $100 investment plus $80 in gains after the fee is paid, Mr. Nohdomi explains.

But if the investment only goes to $140 over that same time period, which works out to about a 7 per cent rate of return, then the entire $140 goes to the investor (after management fees have been deducted) and no incentive fee is paid.

Hard hurdle versus soft hurdle: A soft hurdle is when the performance fee is calculated on all the profits earned if a fund exceeds the set hurdle rate, Mr. Burron says.

For example, if a fund with a 2/20 fee structure has a hurdle rate of 10 per cent and the fund earns 11 per cent, the investor pays the 20-per-cent performance fee on the 11-per-cent gain. (The 11 per cent is net of the management fee.)

A hard hurdle rate only takes a performance fee on gains exceeding the hurdle rate. Using the example above, if a fund’s hurdle rate is 10 per cent and it earns 11 per cent net of management fees, the fund is making 20 per cent on the 1-per-cent gain above the hurdle rate, Mr. Burron says (instead of 20 per cent of the 11 per cent gain).

High-water mark: A high-water mark ensures that if the fund goes down, the investor doesn’t pay incentive fees until those losses are made up, Mr. Burron says. While the investor still pays management fees, “you don’t pay incentive fees on anything until the fund trades higher than the highest price during the holding period.”

For example, an investor buys into a fund at $100. The fund goes to $110 but then drops to $90. “You’re not paying any incentive fees until it hits above $110,” he says, “so that’s fair.” It also means investors aren’t “double-charged” for gains the fund had reached previously.

“The back-office process can seem like an accounting nightmare, but they figured out how to do it,” he says.

For more articles on alternative investments, visit Globe Advisor’s Alternative Investments section.