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A hedge fund with $98 million of initial capital charges a management fee of 2% and an incentive fee of 20%. The management fee is based on assets under management at year end and the incentive fee is calculated independently from the management fee. The fee structure has a high-water mark provision. The fund value is $112 million at the end of Year 1, $100 million at the end of Year, and $116 million at the end of Year 3. The net-of-fees return earned by the fund in Year 3 is closest to:A.11.87%.B.12.33%.C.14.15%.

Question

A hedge fund with 98millionofinitialcapitalchargesamanagementfeeof298 million of initial capital charges a management fee of 2% and an incentive fee of 20%. The management fee is based on assets under management at year end and the incentive fee is calculated independently from the management fee. The fee structure has a high-water mark provision. The fund value is 112 million at the end of Year 1, 100millionattheendofYear,and100 million at the end of Year, and 116 million at the end of Year 3. The net-of-fees return earned by the fund in Year 3 is closest to:A.11.87%.B.12.33%.C.14.15%.

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Solution

To calculate the net-of-fees return earned by the fund in Year 3, we first need to calculate the management and incentive fees for each year.

Year 1:

  • Management fee = 2% of 112million=112 million = 2.24 million
  • Incentive fee = 20% of (112million−112 million - 98 million) = $2.8 million
  • Total fees = 2.24million+2.24 million + 2.8 million = $5.04 million
  • Fund value after fees = 112million−112 million - 5.04 million = $106.96 million

Year 2:

  • Management fee = 2% of 100million=100 million = 2 million
  • There is no incentive fee because the fund value is less than the high-water mark of $106.96 million.
  • Total fees = $2 million
  • Fund value after fees = 100million−100 million - 2 million = $98 million

Year 3:

  • Management fee = 2% of 116million=116 million = 2.32 million
  • Incentive fee = 20% of (116million−116 million - 106.96 million) = $1.808 million
  • Total fees = 2.32million+2.32 million + 1.808 million = $4.128 million
  • Fund value after fees = 116million−116 million - 4.128 million = $111.872 million

The net-of-fees return for Year 3 is then calculated as the percentage change in fund value from the end of Year 2 to the end of Year 3:

((Fund value at end of Year 3 - Fund value at end of Year 2) / Fund value at end of Year 2) * 100%

= ((111.872million−111.872 million - 98 million) / $98 million) * 100%

= 14.15%

So, the answer is C. 14.15%.

This problem has been solved

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