Understanding hurdle rates and catch-up provisions is essential for both portfolio managers and investors. This article provides a detailed mathematical explanation of how these concepts work in PMS performance fee calculations.
What is a Hurdle Rate?
Definition
A hurdle rate is the minimum amount of return that a client requires before the portfolio manager can charge a performance fee. Profit sharing/performance related fees are usually charged by portfolio managers upon exceeding a hurdle rate as specified in the agreement.
Purpose
The hurdle rate ensures that the portfolio manager only earns performance fees after the client has achieved a minimum level of return. This aligns the interests of the manager with the client's expectation of a baseline return.
Typical Hurdle Rate
Hurdle rates are typically set at:
- A fixed percentage (e.g., 10% per annum)
- A benchmark rate (e.g., Nifty 50 return)
- A risk-free rate (e.g., bank FD rate)
How Hurdle Rate Works
Basic Calculation
If a scheme has a 10% hurdle rate and delivers a 19% gross return in a year, the performance fee would apply only to the 9% return above the hurdle, not the entire 19%.
Example:
- Portfolio value: ₹10,00,000
- Hurdle rate: 10%
- Actual return: 19% (₹1,90,000)
- Return above hurdle: 9% (₹90,000)
- Performance fee (20% of excess): ₹18,000
High Water Mark Interaction
The high-water mark would then reset to the new NAV peak. This means the hurdle rate applies to the high water mark, not just the initial investment.
What is Catch-Up?
Definition
Catch-up provision allows the portfolio manager, once the hurdle return is reached, to receive all distributions until he has received performance fee on the total annualized return.
How Catch-Up Works
Without Catch-Up: Performance fee is applicable only on the returns generated in excess of the hurdle rate and not on the total returns.
With Catch-Up: Once the hurdle is achieved, the manager "catches up" by receiving a larger share of the next layer of profits until the manager's total share equals the agreed performance fee percentage on all profits.
Catch-Up Illustration
Assumptions:
- Investment: ₹10,00,000
- Hurdle rate: 10%
- Performance fee: 20%
- Gross return: 25% (₹2,50,000)
Without Catch-Up:
- Return above hurdle: 15% (₹1,50,000)
- Performance fee (20%): ₹30,000
- Manager's share: 12% of total profit
With Catch-Up (assuming 100% catch-up):
- First 10% (₹1,00,000): Goes to client (hurdle)
- Next layer (₹1,50,000): Manager receives 100% until catch-up is complete
- After catch-up: Manager receives 20% of remaining profits
Regulatory Considerations
SEBI's Position
SEBI has specified that performance fees could be paid every quarter and based only on the increase in portfolio value in excess of the previously achieved high water mark.
Hurdle Rate in Practice
Currently, performance-related fees are usually charged by portfolio managers when returns exceed a certain level (known as 'hurdle rate' in industry parlance) as specified in the client agreement.
Catch-Up Policies
Some portfolio managers follow a "No catch-up" policy, where the performance fee is applicable only on the returns generated in excess of the hurdle rate and not on the total returns.
Disclosure Requirements
Fee Structure Disclosure
Portfolio managers must disclose:
- The hurdle rate in the agreement
- How performance fees are calculated
- Whether catch-up provisions apply
- How the high water mark interacts with the hurdle rate
Fee Calculation Tool
Portfolio managers shall provide a fee calculation tool to all clients that highlights various fee options with multi-year fee calculations.
Expert Legal Guidance
Anuj Desai & Associates provides expert legal advisory services on PMS fee structuring, including hurdle rates and catch-up provisions. Our securities law experts help portfolio managers design compliant fee structures and ensure proper disclosure to clients. Contact us for guidance on performance fee calculations and other regulatory matters.