Level III Core · Investment Manager Selection

Manager Fees, Contracts and the Investment Management Agreement

Updated 9 October 2026 · Fact-checked

Manager fees are either ad valorem (a percentage of assets under management) or performance-based (a share of returns above a hurdle or high water mark), often combined. The investment management agreement sets scope, fees, guidelines and termination. To solve questions, compute the fee, then judge incentives, cost and alignment with the client's objectives.

Understand Fees, Contracts and Investment Management Agreement

A manager is paid for running money. The fee structure decides who carries the risk and what behaviour the manager is rewarded for. You must be able to compute a fee and then judge whether the structure suits the client.

Ad valorem fee is a fixed percentage of assets under management (AUM), such as 0.60% a year. It is simple and predictable. The manager earns more as AUM grows, whether or not performance is good. This rewards asset gathering, not skill. Fees are often tiered, so the rate falls as AUM rises (breakpoints).

Performance-based fee pays the manager when returns are good. It is often paired with a smaller base fee. A hurdle rate is the minimum return the manager must beat before earning a performance fee. A hard hurdle pays the incentive only on the excess above the hurdle. A soft hurdle pays the incentive on the whole gain once the hurdle is cleared. A high water mark (HWM) is the highest previous net asset value on which a performance fee was paid. No new fee is earned until value exceeds it, so the client does not pay twice for recovering earlier losses. A clawback returns part of earlier fees if later results fall short. This is common in private equity.

Performance fees are asymmetric. The manager shares in gains but not in losses. This can encourage extra risk taking, like holding a call option on the portfolio. Reduce this with a hurdle, an HWM, a fee cap, a long measurement period, or a symmetric (fulcrum) fee where the manager also gives back fee for underperformance.

The investment management agreement (IMA) is the contract between client and manager. It should reflect the client's investment policy statement. Typical terms: scope of services and authority, investment objectives and guidelines, benchmark, permitted and prohibited assets, risk limits, fee schedule and how fees are calculated and paid, valuation and reporting, liquidity and withdrawal terms, conflicts and soft-dollar policies, liability and indemnification, and termination and notice terms. In negotiation, clients can seek lower fees, most favoured nation clauses, fee breaks for size, HWM and hurdle terms, and clear termination rights. Compare fees on a net-of-fee basis against the benchmark.

Key rules to remember

Ad valorem fee: Fee = fee rate × AUM; Use average or end-of-period AUM exactly as the contract states. Tiered schedules apply each rate only to its own band.
Performance fee with hard hurdle: Incentive fee = incentive rate × max(0, return − hurdle) × AUM; Only the excess over the hurdle is shared.
Performance fee with soft hurdle: Incentive fee = incentive rate × total gain, if return > hurdle; otherwise 0; The whole gain is shared once the hurdle is cleared.
Performance fee with high water mark: Incentive fee = incentive rate × max(0, ending NAV − max(HWM, hurdle-adjusted starting NAV)); Read the contract for how the hurdle and HWM combine. Fee is zero if NAV is at or below the HWM.
Net return: Net return = gross return − (fees ÷ beginning AUM); Equivalent form: Net return = (ending value net of fees − beginning value) ÷ beginning value. Compare net return with the benchmark, not gross return.

How to solve Fees, Contracts and Investment Management Agreement questions

Use this method for any fee or IMA question. Read the command word first, then follow the steps.

1Identify the fee type: ad valorem, performance-based, or both, and any hurdle type, HWM or clawback.
2Write down the base amounts: starting AUM, ending value, gains, hurdle, HWM and rates.
3Compute the base fee first, then the incentive fee. Apply tier bands, hurdle and HWM exactly as defined.
4Show each calculation line, then state the total fee and, if asked, the net return.
5Judge the structure against the client's objectives and constraints: cost, alignment, risk taking and fee certainty.
6If the question is about the IMA, match each clause to the IPS and name the risk it controls.
7Answer with the command word: calculate gives a number, justify gives a reason, recommend gives a choice plus one reason.

Quickest way: Fee check in four lines

When to use it: Use when a fee calculation appears inside an item set and time is short.

Compute the base fee on AUM.
Find the excess return over the hurdle and over the HWM, whichever the contract requires.
Multiply the qualifying gain by the incentive rate.
Add the two fees and divide by starting AUM for the cost as a percentage. Eliminate options that ignore the HWM or confuse hard and soft hurdles.

Common mistakes in Fees, Contracts and Investment Management Agreement

Treating a soft hurdle like a hard hurdle.
Both use the word hurdle, so students subtract it every time.
Fix: Hard: fee on the excess only. Soft: fee on the whole gain once the hurdle is beaten.
Paying a performance fee on a recovery of earlier losses.
Students compare with the prior year only and skip the HWM.
Fix: Compare ending NAV with the HWM. No fee until NAV exceeds it.
Saying performance fees always align the manager with the client.
The idea sounds logical.
Fix: Explain the asymmetry. The manager shares gains but not losses, which can raise risk taking unless a hurdle, HWM, cap or clawback limits it.
Applying one tiered rate to all assets.
Students use the rate for the final band.
Fix: Apply each rate to its own band of AUM, then add.
Writing a generic IMA list that ignores the client.
Students memorise clauses without linking them to the IPS.
Fix: Tie each clause to the client's objectives, constraints and benchmark, such as liquidity terms for a client needing cash.
Comparing gross returns to the benchmark.
Fees feel separate from performance.
Fix: Deduct all fees first and compare net return.

Worked examples

Example 1

A client invests ₹10,00,00,000 with a manager. The fee is 0.50% of beginning AUM plus 20% of the return above a hard hurdle of 6%, with no HWM issue. The portfolio earns 14% before fees. Calculate the total fee and the net return.

Show the solution

Base fee = 0.50% × ₹10,00,00,000 = ₹5,00,000.
Excess over hurdle = 14% − 6% = 8%, which is ₹80,00,000.
Incentive fee = 20% × ₹80,00,000 = ₹16,00,000.
Total fee = ₹5,00,000 + ₹16,00,000 = ₹21,00,000, which is 2.10% of AUM.
Net return = 14.00% − 2.10% = 11.90%.

Answer: Total fee is ₹21,00,000 and net return is 11.90%.

Example 2

A fund has a 20% performance fee with a high water mark and no hurdle. NAV was 100 at the start of year 1 and the HWM is 100. The fee is paid at the end of each year out of the fund, so each year starts from the NAV left after any fee. Year 1 ends at 120 before fee. Year 2 ends at 110. Year 3 ends at 130 before fee. Calculate the performance fee in each year, per 100 of NAV at the start of year 1, ignoring the base fee.

Show the solution

Year 1: NAV before fee 120 exceeds HWM 100. Fee = 20% × (120 − 100) = 4. NAV after fee = 120 − 4 = 116. The HWM becomes 116.
Year 2: the year starts at 116 and ends at 110, which is below HWM 116. Fee = 0. The year ends at 110, so the HWM stays at 116.
Year 3: the year starts at 110 and ends at 130 before fee, which exceeds HWM 116. Fee = 20% × (130 − 116) = 2.8. NAV after fee = 130 − 2.8 = 127.2 and the HWM becomes 127.2.
The client does not pay a fee on the rise from 110 to 116, because that only recovers the earlier loss.

Answer: Year 1 fee is 4, year 2 fee is 0, year 3 fee is 2.8.

Exam tips

Read whether the hurdle is hard or soft before you calculate. The difference changes the fee, so check it before calculating.
For a calculation item, a correct number typed on its own earns full credit; show working only if time allows and it helps you avoid errors.
For a justify question, link the fee feature to the client's objective in one sentence, for example HWM protects the client from paying twice.
For IMA questions, name the clause and the risk it controls. Only give the number of clauses requested, in the order asked.
Use net-of-fee returns whenever a question compares managers or a benchmark.

Fees, Contracts and Investment Management Agreement in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Fees, Contracts and Investment Management Agreement: frequently asked questions

What is the difference between ad valorem and performance-based fees?

An ad valorem fee is a set percentage of assets under management and is paid whatever the result. A performance-based fee depends on returns, usually above a hurdle or high water mark. Many managers charge both.

What does a high water mark do?

It is the highest NAV on which a performance fee was last paid. The manager earns no new performance fee until NAV exceeds it. This stops the client paying twice for the same gains.

What is the difference between a hard and soft hurdle?

With a hard hurdle, the manager earns the incentive only on returns above the hurdle. With a soft hurdle, once the hurdle is cleared, the incentive applies to the entire return.

What should an investment management agreement include?

It should cover scope and authority, objectives, guidelines, benchmark, risk limits, fees, reporting, valuation, liquidity terms, conflicts, liability and termination. Each term should match the client's investment policy statement.