An Investment Memorandum (IM) for an infrastructure fund passed over my desk a few weeks ago. Most people find these things a boring read. I don’t. I love them. I always find interesting things in them and sometimes I even find things that you would not expect. As they say, ‘the devil is in the detail’ and getting down in the weeds and understanding the detail is what I do for my clients.

In this case, I had already attended the webinar and on the surface, the investment had potential. The manager was reputable with size and success in the sector. The lead portfolio manager of the fund presented well, and their experience was impressive. The size and depth of talent in the team, was encouraging.

All of the above was enough to pique my interest and warrant a further exploration of the investment and a deep dive into all the details of the investment documents. At the outset, I had some concerns about this type of infrastructure, and I was wondering if the stated objective of 9-11% returns was enough given the risk-free returns that could be generated from the likes of term deposits.

However, as soon as I hit the page that explained their fees, any chance that this could be a potential investment for my clients went out the window when I was confronted by a wordy, complicated performance fee structure that included the following characteristics:

• It’s a 10% performance fee on the net realised and unrealised appreciation of the Fund’s NAV (Net Asset Value) after management fees. I wasn’t worried about this. Sounded reasonable to me. The fund is unlisted, so accountants decide the value of the assets. It is important to understand the methodology of how this is done, but it is not unusual for this type of fund.
• A hurdle rate of 6% applies – which means they must make you a 6% return (hopefully net of management fees but this was not specified) before they can charge the performance fee. Again, sounds fine to me, given the type of fund.
• Calculated and paid annually – that sounds fine enough, definitely better than calculated and paid semi-annually or monthly.
• And now here comes the clanger: 50% of outperformance can be held back each year to offset underperformance in the next year. Excuse me? So, they could make you stellar returns one year, bank some of that performance, charge you a performance fee in year 1 then potentially charge you a performance fee in year 2 even if they have terrible performance? This means you could end up paying a performance fee – for essentially what is no performance!!! Are you kidding me??? I have never heard of this before!!! I found this completely outrageous.
• Also missing from this wordy performance fee structure is a high water mark. A high water mark is important as it means that investment managers cannot charge performance fees unless they are generating new returns which are greater than what you had previously earned. For example, if they make you 10% in Year 1, they can charge their performance fee above 6% in this context, but if in Year 2 they lose you 20% they cannot charge you any fees until they get you back to where you were at the end of Year 1. The way this fee structure is written, the 6% return hurdle is applied each year and resets. This means that even if they have lost you 50% of your money in the previous year as long as they make 6% in the next year, they can charge a performance fee. A performance fee structure without a high water mark, with a hurdle that resets each year, is a hard no for me.

This fee structure was enough for me to tell my clients not to invest in this product. But this is a great example of why it pays to read the details before you invest and how something that looks fine on the surface can have hidden catches once you dig into the details. If you want to know how I think a performance fee should be structured, please click here.

I believe it always pays to take the time to understand all the details of every investment you make. You should always understand the risks you are taking, and how an investment fits into a portfolio and helps you to achieve your goals. You need to make sure your investments really do what they say on the tin.

Have a great week!

Kind regards,

Shelley Marsh
Outsourced Chief Investment Officer (OCIO) & Founder
Wealth Differently

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