Performance fees: hedge funds

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Performance fees: hedge funds

Hedge fund managers’ remuneration is a combination of fixed and variable fees. Performance determines the variable fee element. However, the traditional 2/20 model is no longer industry standard due volatile markets and investor pressure. New arrangements are emerging. We deliver the alternative arrangements and deliver you the full picture.

This industry has its trends, although these trends are not inflexible. We also create bespoke alternatives that better suit your fund’s objectives.

Hedge fund LLP agreements

The LLP agreement regulates the relationship between the individuals who act as the funds’ managers. Funds are often located offshore, e.g. in the Caymans or British Virgin Islands. Different rules apply to funds located in Ireland or Luxembourg.

We ensure manager’s activities in the UK do not bring the fund within HMRC’s remit. The definition of “permanent establishment” requires consideration before we confirm whether or not the fund and its investors are affected.

LLP agreement: key issues

The individuals seek to split the entitlement to income and capital to reflect intentions. For example, the founder usually has a greater entitlement to capital than an incoming member.

LLPs can have corporate members. However, since the Finance Act 2014, a corporate member may pay income tax, not the lower corporation tax rate. This reduced the number of corporate LLP members. Restructures are common.

Incorporation considerations

Every fund is different. Usually, key considerations for a hedge fund LLP agreement include:

  • Each LLP members’ entitlement to income/capital;
  • Each members’ responsibilities, e.g. management of a designated fund;
  • What happens on exit, e.g.
    • Must the other members buy-out the exiting member;
  • What if the LLP relocates the fund. UCITS regulations permit relocation subject to certain requirements,  so
    •  Must all members agree, or
    • Will an expert make the decision.

Performance provisions

Agreements between hedge fund managers include performance entitlements. Although guided by legal and tax advice, the managers often negotiate this issue.

Points entitlement calculation

Each member’s entitlement to income points at the end of each financial year mainly depends on the:

  • Fund’s assets under management;
  • Fees agreed with investors;
  • Market forces.

Most LLP members are treated as self-employed. Hence we often navigate disguised remuneration rules.

Side letters

A new manager might negotiate an increased performance entitlement, subject to the fund having certain assets under management at any given time. We often draft side letters to enable such arrangements.

Equity interest related performance agreements

Performance fees directly paid from the fund to a UK LLP, or to individual members,  may be a disguised investment management fee (DIMF).

Drafting equity interests

DIMF operates to tax the performance fee as employment income. However, DIMF rules do not apply if the performance fee relates to:

  1. Repayment or a return on a co-investment; or
  2. “Carried interest”.

The second is the likelier exemption. “Carried interest” is broadly an equity return based on the performance of the assets within the investment scheme. We often determine whether a performance fee is actually a “carried interest”. It depends on the structure and the fee paid.

Bonus and carry issues

For fund managers, carried interest is their primary income source. The small management fee is often dwarfed by the performance fees.

These days, investors seek to limit performance fees paid to managers. Often, managers must meet conditions before accruing entitlement to carry. Hurdles are common.

Common issues with carry

Carry can be clawed back. For example, a manager may have a hurdle of assets under management over a three year period. Carry is calculated at the end of each financial year. So:

  1. End of year one: the hurdle is on course. So, carry is paid.
  2. End of year three: Assets under management not met. So the carry is clawed back.

We draft provisions to cater for this arrangement.

Usually, HMRC taxes carry as capital, not income. However, since April 2016, HMRC might regard carried interest as an employment related security. If so, a different tax treatment applies, that also includes National Insurance.

Bespoke bonus provisions

Sometimes, individual LLP members have their own bonus schemes, in addition to the above entitlements. There are no regulatory issues.

The issue depends on the members’ views. We often draft bespoke bonus entitlements to address interests. Of course, bonuses depend on performance.

Performance fee tax issues

For tax purposes, ignore the LLP. The LLP does not pay corporation tax on performance and management fees. The tax liability falls on the individual members.

Individual members tax

For individual LLP members their profits are taxed:

  • At the normal rate of up to 45%, for additional rate taxpayers; and
  • To class 2 and class 4 (NICs).

A host of anti-avoidance provisions affect funds and their UK managers or advisers.  If these provisions apply, we address them.

Track record: performance fee arrangements

Recent instructions include:

  • Equity performance related agreement for a UK LLP manager and a British Virgin Islands fund.
  • Resolved transfer pricing issues in an equity performance related agreement between a UK LLP manager and a Cayman Islands fund.
  • Improved income points arrangement in an LP agreement for a UK based, asset management entity.
  • Created a tax efficient exit for a UK LLP’s lead manager, with $500m assets under management. We
    • Enabled entitlement in the current financial year, by addressing the bonus and carry provisions.

Summary

Your hedge fund’s structure requires detailed, and experienced consideration.  Once you’ve chosen your structure , we prepare the documentation to meet your requirements. Investors interests are crucial and hedge funds compete on performance fees. We offer the expertise that ensures your interests are met.