Case 074Asset management business and productsCore
A portfolio management service charges 1% a year plus 15% of returns above a 10% hurdle, with a high-water mark. A Rs 1 crore client earns plus 30%, minus 20% and plus 25% before fees. Work out the fees each year and compare the client's outcome with a flat 2% fee.
1The situation
A client invests Rs 1 crore with Vajrayudh PMS, a portfolio management service. The fee is 1% a year of the portfolio value plus 15% of returns above a 10% hurdle, subject to a high-water mark. The portfolio returns +30%, -20% and +25% before fees over three years.
Use these conventions from the client agreement. The management fee is 1% of the year-end value. The performance fee is 15% of the year-end value, after the management fee, above a threshold equal to the high-water mark grown by the 10% hurdle. The high-water mark starts at the Rs 1 crore invested and resets to the year-end value whenever a performance fee is paid. The alternative product charges a flat 2% of year-end value. Ignore GST on fees and tax for the comparison.
2Your task
What does the client pay each year under the 1% plus 15% structure, what does the client end with under each fee, and what work does the high-water mark do?
Quick check
In year three the portfolio gains 25% before fees. How much performance fee does the client pay that year?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
Fees are Rs 4,10,500 in year one, Rs 1,00,716 in year two and Rs 1,24,636 in year three, Rs 6,35,852 in all, leaving the client Rs 1,23,38,969. The 25% gain in year three earns no performance fee because it ends below the high-water mark of Rs 1,25,89,500. A flat 2% would have cost Rs 7,13,544 and left Rs 1,22,35,496. Without the mark, the client would have ended with Rs 1,21,33,319.
Step 1What does the client pay in year one?
Think of a tuition teacher paid a small monthly fee plus a bonus for every mark above 60, but only on marks above the student's best previous score. Year one works the same way. The portfolio grows 30% to Rs 1,30,00,000, the 1% management fee takes Rs 1,30,000, and the remaining Rs 1,28,70,000 exceeds the Rs 1,10,00,000 threshold by Rs 18,70,000, so the performance fee is 15% of that, Rs 2,80,500. The client ends year one with Rs 1,25,89,500, and that becomes the new high-water mark.
| F | performance fee for the year, Rs lakh |
| V | year-end value after the 1% management fee |
| HWM | high-water mark: the highest year-end value on which a performance fee was last paid, starting at the capital invested |
Step 2Why is there no performance fee in years two and three?
Year two is a 20% fall. The portfolio drops to Rs 1,00,71,600, the management fee still takes Rs 1,00,716, and the client ends at Rs 99,70,884. There is no performance fee. Year three is the interesting one. A 25% gain lifts the portfolio to Rs 1,24,63,605 and, after Rs 1,24,636 of management fee, to Rs 1,23,38,969. That is still below the high-water mark of Rs 1,25,89,500, so the 25% gain earns the manager no performance fee: the client already paid for that ground in year one.
| Year | Return | Value before fees, Rs | Management fee, Rs | Threshold, Rs | Performance fee, Rs | Value after fees, Rs |
|---|---|---|---|---|---|---|
| 1 | +30% | 1,30,00,000 | 1,30,000 | 1,10,00,000 | 2,80,500 | 1,25,89,500 |
| 2 | -20% | 1,00,71,600 | 1,00,716 | 1,38,48,450 | 0 | 99,70,884 |
| 3 | +25% | 1,24,63,605 | 1,24,636 | 1,38,48,450 | 0 | 1,23,38,969 |
| Total | 3,55,352 | 2,80,500 | 1,23,38,969 |
Step 3How does the outcome compare with a flat 2% fee?
Run the same returns through a flat 2% of year-end value: fees of Rs 2,60,000, Rs 2,03,840 and Rs 2,49,704, Rs 7,13,544 in all, and an ending value of Rs 1,22,35,496. On this bumpy path the 1% plus 15% client ends Rs 1,03,473 better off, paying Rs 6,35,852 against Rs 7,13,544, and the high-water mark is the whole reason. Remove it, and year three's threshold becomes the start-of-year value plus 10%; the manager collects Rs 2,05,650 again and the client ends with Rs 1,21,33,319, worse than the flat fee. Before fees the portfolio would be Rs 1,30,00,000; after them the client compounds at 7.26% a year against 6.96% on the flat fee.
The ranking flips on a different path, which is the limitation of judging a fee on one history. In a steady market returning 20% a year, the 1% plus 15% structure charges a performance fee every year: Rs 8,95,849 over three years against Rs 8,54,154 for the flat 2%. A performance fee is cheap when returns are lumpy or modest and dearer when they are strong and steady, so compare the two structures across several return paths, not one. Also check the agreement's details: whether the hurdle compounds, whether fees are charged yearly or on exit, and how GST applies. SEBI's PMS rules govern how performance fees and high-water marks may be charged; confirm the current requirements before quoting them to a client.
Where candidates lose it
The common loss is charging the year-three performance fee on the gain above 10%, as if each year started fresh. That ignores the high-water mark and bills the client twice for the same ground, Rs 2,05,650 here.
The second is comparing headline rates, 1% against 2%, and calling the first cheaper. The performance fee can make it the dearer option in strong years; only a path-by-path comparison settles it.
What the interviewer asks next
- How would the fees change if the returns came in the order minus 20%, plus 30%, plus 25%?
- What is the difference between a hurdle and a high-water mark, and why have both?
- The client withdraws half the money after year two. What happens to the high-water mark?
- Why might a manager prefer a lower management fee and a higher performance fee?
Company names and figures are illustrative.