Management Fee vs Performance Fee: Paid on Size or Outcome

A management fee is charged on the size of the money held, so it is paid in every period whatever the outcome. A performance fee is charged on whatever part of an outcome clears a reference fixed in advance, so it is paid only in periods that clear it. Vaidehi Asset Managers Limited, an invented manager, charges a blended fee of 0.55 per cent of assets under management. The blended fee is a charge of the first kind.

Four conditions on a charge linked to the outcome are set by the Securities and Exchange Board of India (SEBI), and every one of the four moves: whether such a charge may be taken at all for a given arrangement, what reference it may be measured against and on what base it may be struck, what stops one rise being charged for twice, and what a manager discloses about its charges and how often. Each of the four is named below against SEBI and the site it publishes on. The Association of Mutual Funds in India (AMFI) publishes the industry aggregate of assets and flows. The Institute of Chartered Accountants of India (ICAI) settles the narrower question of when a charge earned across a period is recognised as revenue.

Two charges, two names, and the names are the problem. One of them contains the word management and is not payment for managing well. The other contains the word performance and is not payment for performing well. The quantity each one is multiplied by is what actually separates them, and every other difference between the two follows from that.

What is each of the two charges actually struck on?

Start with the charge on size, the one Vaidehi Asset Managers Limited actually levies. Vaidehi Asset Managers Limited runs assets under managementThe total value of the money a manager holds and runs for other people, measured at a date rather than across a period. of Rs 1,80,000 crore and charges a blended rateOne rate that is the weighted average of everything a manager runs, rather than the rate charged on any single arrangement inside it. of 0.55 per cent of those assets under management for the year. The rate applied to that base produces revenue of Rs 990 crore for the year. Notice what had to be known to get that number: a rate, a base and a period. Nothing about what the money did. Nothing about whether the year was good. A management fee is a rate applied to the size of the money held, for a stated period, and the outcome is not one of its inputs.

Now the other one. A charge on the outcome starts by ignoring the size of the money altogether and asking a different question: how much of what happened sits above a level fixed before the period began? Call that level the reference, the plain word for it. The market usually calls it a hurdle. Whatever sits above the reference is the excess. The charge is an agreed share of that excess and nothing else. A performance fee is a share of a difference, and a difference can be zero. A value held can never be zero while the arrangement exists.

Here is the same pair standing in one building. A shop pays its landlord a fixed rent every month and pays its manager a share of anything the shop takes above last year's takings. Both are charges on the same business. Rent is struck on the premises rather than on the trade, so the landlord is paid in the month the shutters stay down. There was no excess over last year to share, so the manager is paid nothing that month, and nothing in any ordinary month either. The landlord and the shop manager are the two charges under comparison, and which of them gets paid in a bad month is already clear.

What has to be fixed in advance before either charge can be worked out?

Fixing the terms in advance is where the two charges are least alike, and it is the part a reader skips. A charge on the size of the money needs one thing agreed: the rate, together with the base it is struck on. The rate and its base are genuinely all. Hand somebody the rate of 0.55 per cent for the year and the base of assets under management and they can work the charge out for any arrangement, in any period, without asking another question.

A charge on an outcome needs four things, and every one of them has to be in writing before the period starts. The first is the reference, meaning the level the outcome is measured against. A reference of nothing at all makes every rise chargeable. A reference set high makes most periods produce no charge. The same manager, the same year and the same result produce completely different charges under two different references. The reference is not a detail.

The second is the share, meaning what part of the excess is taken. The third is the period over which the whole thing is measured. An outcome measured across a quarter and the same outcome measured across three years are different quantities with different chances of clearing anything. And the fourth is what happens after a period that fell short. The fourth choice decides whether an earlier fall has to be made good before the charge starts again, and the failure block below turns entirely on it.

Three of those four are choices somebody makes rather than facts anybody could look up, and a charge on an outcome with any of them left vague is not a charge on an outcome at all. The reference is chosen. The share is chosen. The treatment of an earlier fall is chosen. Only the period tends to arrive already decided. Most arrangements measure over the reporting period they were going to report on anyway. Whether any of these may be set at all, and how, for a given arrangement, sits with SEBI at sebi.gov.in.

How do the two charges answer the same seven questions?

Side by side, each one asked the same thing, one row at a time. The comparing happens row by row, and the surprise is how much of the table agrees.

Take the sixth row before anything else. A charge on the outcome quietly invites a reader to misread that row. The outcome belongs to the investor under both charges. A charge on the outcome does not move any part of a fall onto the manager. In a period that lost value the investor carries the whole fall and pays the charge on size on top of it, and the manager simply does not receive the second charge. Not receiving a payment is not the same thing as sharing a loss, and no charge structure described here turns the manager into a co-owner of the outcome.

Now the last row. Four questions settle where any party in this business stands: whose money is it, whose decision is it, whose risk is it, and who is paid regardless. The money is the investor's under both charges. The decision to keep it there is the investor's under both. The risk of the value falling is the investor's under both. Of the four, the two charges answer three identically and part company only on the fourth, the last row of the table. That single row is what the whole comparison comes down to.

What shape does each charge draw as the outcome moves?

Draw the two charges against the outcome for the period and the difference stops being an argument about words. A charge on size draws a flat line and a charge on an outcome draws a line that lies on the floor and then turns upward at the reference, and the kink is the entire design.

The flat line first. At Rs 0.55/- per Rs 100.00/- of value at the start, the management fee is the same rupee amount at minus 5.00 per cent as it is at plus 24.00 per cent. Fairness has nothing to do with the flatness. The line is flat because the outcome is not in the arithmetic. The value it is struck on moves, so in a real period the management fee moves too. The management fee never moves because of the outcome relative to any reference.

The kinked line is the interesting one. The stretch from minus 5.00 per cent to plus 4.00 per cent is 9.00 percentage points of an outcome range 29.00 percentage points wide. Across all of it the charge on the outcome is Rs 0.00/-. Not a small number. Nothing. Then, at exactly plus 4.00 per cent, it leaves the floor and rises at one fifth of every point above. The charge is absent across a wide band of perfectly ordinary periods and then arrives all at once. A reader told that a charge is a share of the outcome imagines something quite different.

What do the three cases come to on Rs 100.00/- of value at the start?

Everything here is worked per Rs 100.00/- of value at the start of the period, and that is a deliberate choice rather than a shortcut. The figures above cover one manager and no single arrangement inside it, so putting a rupee total against a pooled arrangementA vehicle where the money of many holders is run as a single block, each of them entitled to a proportion of it. What it is and how it works are covered separately. would mean inventing one. The missing total costs the reader nothing. A rate applied to Rs 100.00/- scales to any total the reader wants to put behind it.

Rebuild the first row yourself. Rs 100.00/- rises 9.00 per cent to Rs 109.00/-. The reference of plus 4.00 per cent for the period puts the bar at Rs 104.00/-. The value clears it by 5.00 percentage pointsThe unit for a difference between two percentages, kept separate from the words per cent so a gap is never read as a rate., so the excess is Rs 5.00/-, one fifth of which is Rs 1.00/-. Add the charge on size of Rs 0.55/- and the two together are Rs 1.55/-.

Now the second row, and it is the one that catches people. Plus 24.00 per cent is not quite three times as good as plus 9.00 per cent. The charge on the outcome goes from Rs 1.00/- to Rs 4.00/-, a rise of four times. The reference is taken off before the share is applied, so the excess grows faster than the outcome does and the charge grows faster still. An outcome up by a factor of 2.67 produced a charge up by a factor of 4.00, and no rate anywhere changed to do it.

And the third row, the quietest and the most important. The charge on size is exactly the same rupee amount in the worst period shown as in the best one. Rs 0.55/- at plus 24.00 per cent. Rs 0.55/- at minus 5.00 per cent. The investor who lost 5.00 per cent of the value paid the same charge on size as the one who gained 24.00 per cent, and the only line that moved between those two people was the one that went to nothing.

What does a charge on the outcome do to the manager's own revenue line?

Seen from behind the manager's desk, this whole sequence opened on one uncomfortable fact: a manager paid on the size of the money has revenue that moves with a market it does not control. Vaidehi Asset Managers Limited earns Rs 990 crore for the year because the rate of 0.55 per cent met assets under management of Rs 1,80,000 crore, and if that base had been higher on the last day of the year for reasons nobody at the manager caused, the revenue would have been higher for reasons nobody at the manager caused. The operating marginOperating profit set against revenue, so it reads as the share of what came in that survives being spent on keeping the place open. is therefore the number to watch at a manager, and the revenue line is not.

Now add a charge on the outcome to that picture. Revenue no longer moves only with the value; it moves with the value and with the gap between the value and a reference, and the second part can be nothing for years at a stretch. Meanwhile the costs do not move at all. Vaidehi Asset Managers Limited's costs of Rs 594 crore for the year are 60.0 per cent of its Rs 990 crore of revenue, and the same cost line measured against assets under management of Rs 1,80,000 crore is 0.33 per cent. Both of those are true. The two figures are struck on different bases, and that is why they differ, and why the base belongs in the same sentence as the figure every time. Neither figure gets any less certain because a charge on the outcome was added to the revenue side.

Shifting a charge from the size of the money onto the outcome makes the manager's revenue less certain and its costs no less certain, and that is the same trade the investor is being offered from the other side. The investor gets a smaller certain payment and a larger uncertain one; so does the manager. Which of them should prefer that depends on the reference, the share, the period and the outcome, and three of those four are settled before anybody knows anything.

Can the same rise be charged for twice?

Here is the shape, and it is worth reading slowly because nothing in it is a trick. A period runs plus 9.00 per cent, the value goes from Rs 100.00/- to Rs 109.00/-, and a charge of Rs 1.00/- is taken on the excess. The next period falls back over exactly the same ground, ending at Rs 100.00/-. Nothing is charged on the outcome that period, though the charge on size of Rs 0.55/- is paid as usual. The period after that runs plus 9.00 per cent again, and the value climbs to Rs 109.00/-, where it already was two periods ago.

Read that third period on its own and it looks exactly like the first one, so a charge worked out on that period alone takes another Rs 1.00/-. Two charges of Rs 1.00/- have now been taken, and the value is standing precisely where it stood at the end of period one. Nothing was earned the second time. The ground was covered twice.

The shape of the answer is a recorded mark: the highest value already charged on is written down, and the charge on the outcome does not resume until the value gets back above it. Under a recorded mark set at Rs 109.00/-, the third period's climb produces nothing. The value ended level with the mark rather than above it. Whether such a mark is required at all, and what form it has to take, is set by SEBI at sebi.gov.in.

What does neither charge reveal about the outcome?

A comparison of charges usually goes soft at this point. Neither charge is evidence about the outcome, and reading either one as a signal of quality is the mistake the whole comparison has been circling.

A charge on size is paid on money that lost value and on money that gained it, in identical rupees, as the third row of the worked table shows. The charge says what the arrangement costs to be in. The charge says nothing whatever about what being in it produced.

A charge on the outcome looks more informative and is not, for a reason that sits in the fine print. The charge is paid on a period that cleared a reference somebody chose. Choose an easier reference and the same period produces the same charge for a worse result. Choose a harder one and a genuinely strong period produces nothing. The charge is a fact about the arrangement's terms first and a fact about the period second, and the terms were set before anybody knew anything about the period.

There is a further reason, covered separately: a rise in the value is not by itself evidence of anything the manager did. The value moved for two reasons at once, what the market did and what the manager did, and a charge struck on the movement cannot separate them any better than the reader can. Which charge an investor is better off under depends on the reference, the share, the period and the outcome, and three of those four are set before anybody knows anything.