On the Valuation of Performance Fees and Their Impact on Asset Managers’ Incentives

Abstract

This paper provides a robust and practical framework for assessing performance fees. The fee valuation uses standard option pricing models and therefore does not require any expected return or alpha estimate. These features make our framework easy to use, robust, and widely applicable to a variety of fee structures in practice. We discuss the incentive impact of performance fees and caution against the unintended consequences for manager behaviors. These implications are especially relevant today, as systematic investing is on the rise and asset owners are increasingly interested in the adoption of performance fees across a broader range of investment styles.

Keywords: performance fees, option pricing models, manager incentives, compensation, fee structure

JEL Classification: G23, J33, L14