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In the realm of private investments, the concept of performance fee netting has long been considered a beneficial strategy for investors. However, recent research challenges this conventional wisdom, suggesting that the benefits of fee netting are not as clear-cut as previously thought. This article delves into the complexities of performance fee netting, highlighting key insights from a comprehensive study that examines its impact on investors.

Understanding Fee Netting
Performance fee netting involves offsetting the returns of multiple funds and paying fees on the netted return. Traditionally, it is believed that this approach allows underperforming funds to dilute the aggregate gross return, thereby reducing the total performance fee paid by investors. However, our research reveals that the presence of catch-up provisions can alter this dynamic significantly. When catch-up is steep, netting can inadvertently increase overall fees by lifting weaker performing funds into the catch-up zone, where performance fees accumulate more rapidly.

The Role of Catch-Up Provisions
We have developed a model to measure the impact of fee netting under various scenarios, demonstrating that catch-up provisions can create a concave region in the performance fee function. This means that netting can sometimes lead to higher fees, contrary to the expected reduction. The study emphasizes the importance of understanding the interplay between expected returns, volatility, and correlation between individual funds, as these factors significantly influence the outcomes of fee netting.

Implications for Investors
Investors must carefully consider the structure of their private investment portfolios and the specific fee arrangements in place. We suggest that while fee netting may offer benefits in certain contexts, it is not universally advantageous. Investors should evaluate the expected characteristics of their investments, including return distributions and the presence of catch-up provisions, to determine whether fee netting aligns with their financial goals.

In conclusion, this paper invites investors to reassess their assumptions about performance fee netting in private investments. By understanding the nuanced effects of catch-up provisions and other factors, investors can make more informed decisions about their investment strategies.

For a deeper exploration of these findings, please read the full-length insight here.

Portfolio Solutions Group

The Portfolio Solutions Group is a comprehensive multi-asset business, with activity across all asset strategies and types (traditional and alternative), through solutions that span fully liquid (public assets), comprehensive (public and private assets) and fully private portfolios. Offerings are delivered via a managed portfolio or model, in discretionary or advisory format.


Important Information:
Diversification does not eliminate the risk of loss.

The views and opinions are those of the author as of the date of publication and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. The views expressed do not reflect the opinions of all investment personnel at Morgan Stanley Investment Management (MSIM) and its subsidiaries and affiliates (collectively the Firm”), and may not be reflected in all the strategies and products that the Firm offers.

This material is for the benefit of persons whom the Firm reasonably believes it is permitted to communicate to and should not be forwarded to any other person without the consent of the Firm. It is not addressed to any other person and may not be used by them for any purpose whatsoever. It is the responsibility of every person reading this material to fully observe the laws of any relevant country, including obtaining any governmental or other consent which may be required or observing any other formality which needs to be observed in that country.

This material is a general communication, which is not impartial, is for informational and educational purposes only, not a recommendation to purchase or sell specific securities, or to adopt any particular investment strategy. Information does not address financial objectives, situation or specific needs of individual investors.

Any charts and graphs provided are for illustrative purposes only. Any performance quoted represents past performance. Past performance does not guarantee future results. All investments involve risks, including the possible loss of principal.

For the complete content and important disclosures, refer to the Article’s PDF.