Authored By: Scott Siemens and Michael C. Aronstein, Antiquity

In our, “Understanding Fees: Beyond the Headlines and into the Footnotes” article, we gave an overview and checklist of the various fees and expenses that are typical in Evergreen funds. In this article we will focus on Performance Fees.

Performance fees are where the alignment of interests between investors and managers either shines or falters. At first glance, the concept seems straightforward: managers earn a share of profits, typically around 20%, as a reward for generating returns. But in Evergreen funds, where there's no fixed end date and no predetermined wind-down, the mechanics become far more intricate. The real questions lie beneath the surface: What exactly counts as "profit"? When do managers get paid? And most critically, what safeguards exist to protect investors from paying fees on temporary gains that later evaporate?

This article explores the layers of complexity in Evergreen fund performance fees, from the distinction between realized and unrealized gains, to the nuances of waterfall structures that determine distribution sequencing, to the protective mechanisms like hurdle rates, high watermarks, and clawbacks that can make or break the investor experience. Understanding these elements is essential for evaluating whether a fund's incentive structure truly aligns with long-term value creation or simply rewards managers for riding market cycles at your expense.

Realized Gains vs. Unrealized Gains: The Mechanism of Paper Profits

Realized gains serve as the traditional trigger for performance fees in closed-end funds, where managers earn "carry," or a portion of profits from actual asset sales, distributed alongside investor returns. By contrast, unrealized gains denote appreciations in asset value derived from appraisals, without any underlying transaction. In many Evergreen funds, performance fees extend to these unrealized gains, prompting immediate fee payouts based on recurring valuations – typically conducted quarterly – using market-based estimates and manager appraisals. Investors are often taken aback to learn that managers can withdraw actual dollar amounts tied to these "paper" profits, which are inherently vulnerable to market reversals. Nevertheless, in perpetually structured funds without a predetermined wind-down, this approach seeks to align incentives amid open-ended timelines. Investors should carefully weigh the risks of paying fees on temporary appreciations against mitigating protections, such as clawbacks or high watermarks, to ensure proper safeguards on long-term net returns.

Waterfall Structures: Distribution Protocols 

“Waterfall” structures define the sequential distribution of profits to the investor and to the manager, with key variations that merit attention. American waterfalls enable payouts on a deal-by-deal basis, which may allow early manager compensation even when the broader portfolio experiences losses. European waterfalls, by contrast, postpone fees until the entire fund achieves profitability, offering stronger safeguards for investors. A critical nuance in perpetual evergreen structures: Without a fixed termination, how is "whole-fund" profitability determined and timed? This important nuance walks back many of the protections that a European waterfall provides. Without termination, there's no final "crystallization" – instead, the assessment is dynamic and iterative, relying on fund accounting to verify thresholds at various moments.

Make-Whole Provisions

Make-whole provisions are part of the waterfall structure, and guarantee that investors recover their full invested capital, plus any applicable hurdle rate, before managers receive performance fees. These are particularly vital in semi-liquid Evergreen funds with redemption features, where partial withdrawals could otherwise create imbalances. Weaker provisions might only address basic principal recovery, leaving gaps in protection, while comprehensive ones include adjustments for redemptions and ensure equitable treatment across investors, mitigating risks in perpetual structures without defined exits.

Hurdle Rates 

Hurdle rates set a minimum return threshold – typically 6-8% – that must be met before performance fees can be charged, giving investors first claim on initial profits to protect their baseline returns. Several details deserve scrutiny: Is the rate fixed at a set percentage, or floating and tied to market benchmarks like SOFR for better adjustment to economic shifts? Lower hurdles can trigger fees even on modest gains, which may weaken investor safeguards by allowing managers to earn incentives too easily. Higher hurdles, on the other hand, demand stronger overall performance to unlock fees.

High Watermark Provisions

High watermarks act as a safeguard, preventing performance fees on recoveries from losses until the fund's net asset value (NAV) surpasses its previous peak. This ensures managers are rewarded only for generating new value rather than recouping prior declines. In the absence of a high watermark – or with watermark provisions that reset periodically, such as annually – fees could apply to mere rebounds, potentially leading to repeated charges on the same capital during market cycles.

Clawbacks

Clawbacks are retrospective corrections. They require managers to repay excess performance fees if subsequent losses erase prior gains. In Evergreen funds lacking a fixed endpoint, their effectiveness hinges on structured enforcement, such as through annual performance reviews, escrow accounts, or personal guarantees from managers. Without clawbacks or with weakly implemented ones, investors face heightened exposure to unrecoverable payouts; strong versions, however, reinforce alignment by holding managers accountable over multi-year periods.

Checklist Guidance: Investors assessing performance fees in Evergreen funds should scrutinize key elements for alignment: check if fees apply to realized or unrealized "paper" gains; prefer European waterfalls for whole-fund protections over American deal-by-deal models, clarifying period-of-time assessments in perpetual structures; ensure make-whole provisions cover full capital plus hurdles with redemption adjustments; evaluate hurdle rates (aim for 6-8%, floating if possible) and equitable catch-ups; require perpetual high watermarks (no resets) to prevent fees on recoveries; and mandate enforceable clawbacks via escrows for overpayment recovery – simulate market scenarios to gauge fee drag and benchmark against peers for sound decisions.

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