Understanding Fee Netting; Does It Always Pay Off?

In the realm of private investments, the concept of performance fee netting has long been considered a beneficial strategy for investors. However, recent research challenges this conventional wisdom, suggesting that the benefits of fee netting are not as clear-cut as previously thought. This article delves into the complexities of performance fee netting, highlighting key insights from a comprehensive study that examines its impact on investors.

Understanding Fee Netting
Performance fee netting involves offsetting the returns of multiple funds and paying fees on the netted return. Traditionally, it is believed that this approach allows underperforming funds to dilute the aggregate gross return, thereby reducing the total performance fee paid by investors. However, our research reveals that the presence of catch-up provisions can alter this dynamic significantly. When catch-up is steep, netting can inadvertently increase overall fees by lifting weaker performing funds into the catch-up zone, where performance fees accumulate more rapidly.

The Role of Catch-Up Provisions
We have developed a model to measure the impact of fee netting under various scenarios, demonstrating that catch-up provisions can create a concave region in the performance fee function. This means that netting can sometimes lead to higher fees, contrary to the expected reduction. The study emphasizes the importance of understanding the interplay between expected returns, volatility, and correlation between individual funds, as these factors significantly influence the outcomes of fee netting.

Implications for Investors
Investors must carefully consider the structure of their private investment portfolios and the specific fee arrangements in place. We suggest that while fee netting may offer benefits in certain contexts, it is not universally advantageous. Investors should evaluate the expected characteristics of their investments, including return distributions and the presence of catch-up provisions, to determine whether fee netting aligns with their financial goals.

In conclusion, this paper invites investors to reassess their assumptions about performance fee netting in private investments. By understanding the nuanced effects of catch-up provisions and other factors, investors can make more informed decisions about their investment strategies.

For a deeper exploration of these findings, please read the full-length insight here.