Q33 – Can an RIA charge performance fees?

Also available as podcast (Episode #33)

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Can an RIA charge performance fees?

A meaningful benefit of the Registered Investment Advisor (“RIA”) model is the range of options and flexibility you have to charge clients for advisory services. One of those available options is to charge performance fees.  While technically possible to do, charging such fees comes with a plethora of additional variables and disclosure requirements that should be understood and considered before attempting to implement them as part of your service offering.

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Full Transcript:

Can an RIA charge performance fees? That is today’s question on the Transition To RIA video series. It is question #33.

Hi, I’m Brad Wales with Transition To RIA where I help advisors like you understand everything there is to know about why and how to transition to the RIA model.

In today’s question, we’re going to talk about….“if I were to make that transition to the RIA model, can I charge performance fees?” What I mean by performance fees is – there could be different ways to structure it – a typical way is think of the hedge fund world. The “2 and 20” that basically says there’s a flat amount based on the assets in the account – on the 2 and 20 example of the hedge fund world, they might charge 2% on assets regardless – and then they will also take a 20% – that’s the 20 part – of any profits on the way up.

Sometimes it’s 20% of any profits above a particular benchmark. There’s some nuances in that….every time you do that, you have a new high watermark. If the account value comes back down, they don’t start getting performance fees again until it exceeds the high watermark.

The idea is that there are potential ways to structure that. As an RIA, you can do performance fees. While you might not be 2 and 20 – that’s more in the hedge fund world – maybe you charge a more typical, the proverbial 1% asset-based rate for the client’s account, and maybe you have an arrangement where you get X% of the profits above a particular benchmark. So the short answer is as an RIA, performance-based fees are allowed.

The longer answer, and I’m going to get into that here – this was the whole reason I made this video – is while it is allowed, there are absolutely challenges of doing this. It is not a simple undertaking. There are a lot of things you would want to be aware of before you even consider doing it.

I’m not trying to suggest you shouldn’t, but I think it’s important that you fully understand exactly how this works and fully understanding exactly what the expectations would be before you even consider maybe….”if I go ahead and transition to the RIA model, that is something I would want to do.”

Before I dive into it, I would tell you these challenges, it does result in the overwhelming majority of RIAs out there do not charge performance fees.

You might say….”Brad, how do know that?” And the reason I know, at least from my experience, is I’ve read hundreds of ADVs of RIAs out there. In an ADV, every single ADV there is, in Part 2, there is a specific section that asks and has to address….”Do you charge performance fees?” You obviously provide the answer. I would tell you that out of hundreds and hundreds of ADVs I’ve read over the years – I’m going off of memory here – I venture it’s a single-digit number of them had performance fees or charged performance fees.

It is very rare, but it is doable. I do want to make sure that’s clear. In the RIA world, it is doable. But on this video, I want to walk you through some of these challenges so you can understand why a lot of your peers have decided not to implement that into their practice.

First challenge, only certain “qualified” investors can even enter into that arrangement with you. There are specific standards on net worth and income and things like that. Just because you want to offer performance fees, and because a particular client might be open to it, from a regulatory standpoint, that client has to qualify to even enter into that sort of arrangement. So that adds some complexity to it because obviously, you cannot run afoul of that.

You will absolutely have challenges or problems if the regulators find out you have not met that specific definition and only those clients are the ones you’ve entered into this performance fee arrangement for. So number one is only certain clients even qualify to enter into that arrangement.

The next one – and this is certainly prevalent in the hedge fund world with their 2 and 20 – but there is an argument out there that if you’re getting performance fees, you might have an incentive to take higher risks with managing the assets to try to grow those assets because that’s where you’re maybe going to make the bulk of your money is in that performance fee.

Do you take a more aggressive, riskier approach to managing the assets than you would have had you not had that performance fee? I know that can be entirely unfair to accuse a hedge fund manager of that, or accuse a financial advisor of that. But just because we’d say it’s unfair – and it very well might be unfair – that doesn’t mean, for instance, an opposing counsel of a client that has taken issue with you and now wants to sue you, might not try to use it and say….”clearly advisor, you clearly were only interested in taking risks so you could drive up your performance-based fee that you were going to receive.”

That could be an entirely unfair argument to target you with but that doesn’t mean someone won’t try to paint you with that brush no matter how unfair it is. So just something to be aware of that it is a potential conflict of interest that could potentially be used against you.

The next challenge is it’s harder to calculate for starters. If you have a more typical arrangement without performance fees, and let’s say you charge (for example) 1% to the client and the way you facilitate that, it’s on a quarterly cycle so….”Mr. and Mrs. Client, we take the end value on the last day of the quarter, and that’s what we assess the fee against.” That’s very simple math. It is what it is. What’s the account value. What’s the prorated amount of 1% on an annualized basis. That’s our math.

When you start getting into performance-based fees though, it’s significantly harder to calculate. There are some standards out there. You might’ve heard of GIPS compliant before. It’s Global Investment Performance Standards. That’s the de facto go-to of how you calculate performance in these sorts of capacities.

You might be thinking….”well, how hard could it be?” There’s a couple of variables there – you might have that high watermark situation. You need to keep in mind of where that high watermark is because maybe you achieved it, maybe you fell below it, then you went back above it a little bit so it raised higher, and now it’s gone back down. That’s a complication.

Then it can be complicated by a client either putting more money into the account or taking money out of the account. If they put in another $200,000 into the account, that’s going to increase the account value but it shouldn’t be counted arguably for your performance solely because they put $200,000 more in the account.

Now, after the $200,000 was in there, if you grew the assets by investing it, clearly that could be included in the calculation. But you can see how that starts to make it very complicated to calculate. It’s doable. There are firms you can hire that do this GIPS compliant calculation. So it is doable but know it is significantly more complicated.

The last challenge I’ll point out – not an exhaustive list here, but some challenges – I did a separate video. I’ve actually done two videos on regulatory exams. If you have your own RIA, you will get examined by your regulator. It could be the SEC or state. It depends on your size. I did one video on the frequency you can expect of how often that will occur, and then the other video on what you can expect to occur during the examination process. If you haven’t looked at those, I encourage you to go out and look at them.

A note I make on the frequency….there’s no hard and fast rule that says a regulator will come out to see you every 36 months or every 24 months or 48 months or whatever the case is. There are a whole host of variables of why they might come more frequently, less frequently, or whatnot. But there’s no doubt that the regulators – as well-intended as they are – they only have a certain amount of capacity. A certain amount of resources to get out and examine RIAs. That’s why you’re generally not examined every single year. There’s not the capacity to do that.

Part of what the examiners do is….”who should we go out and examine more frequently than others?” A typical example could be if one RIA has a billion dollars in client assets, and one has $100 million in client assets, arguably because they have limited resources they should probably go out and examine the billion-dollar one more frequently than the $100 million one.

Now, the $100 million one might be stirring up trouble. It’s not to say they’re immune from it. But if either of them are going to stir up trouble, unfortunately the one with $1 billion is going to have a bigger impact on the investing public. That doesn’t mean they won’t come out and see the $100 million RIA, but maybe they’ll put a higher risk profile on the billion-dollar one. You get what I’m saying there.

My point with that is, if you charge performance fees, that is most likely going to be factored into the regulators score of your RIA from a risk perspective. I’m not the one at the regulatory body setting those standards or whatnot, but it’s very conceivable that as they attempt to identify which RIAs they should examine more frequently than others, if you are charging performance-based fees – because of all the challenges with are the clients qualified, are you calculating it correctly, are you explaining it correctly – it’s quite conceivable that they will score you on a higher risk level and hence you will be susceptible to more frequent exams as a result of that.

Now, all that said, you might have a very good reason to want to charge performance-based fees and it might be well worth all of these additional challenges. When I talked about earlier, that most RIAs do not charge them, I didn’t say all RIAs do not charge them. There are some out there that charge and they’ve decided with their particular circumstances that it makes sense to work through this list of challenges and to make sure they can manage that appropriately.

Bottom line, it is doable. Number two, I do caution you to really consider all of these challenges before you take that step. I think it is – every situation is different, ultimately, the RIA needs to make their own decision – but it is a challenging environment to provide that service.

The third one is if you are going to charge such fees, the compliance consultant that you use will help you through all this. They will help make sure things are documented correctly. I wouldn’t be surprised though if they give you the same reaction I’m giving you. If you come to them and say….”I want to do performance-based fees,” they might indeed ultimately help walk you through that, but they probably will caution you with some of the same challenges I’ve pointed out as well.

The final thought I’ll leave you with is keep in mind if you like the idea of….”if I can help the client grow their assets better, if I can get paid more for that, that seems fair. I’m helping the client grow and I get paid more. So maybe I like the idea of this performance-based fee.”

Keep in mind – let’s put the performance-based fee aside – if you charge as a percent of assets – so the proverbial 1% of assets – in a way, not by the true regulatory definition, but in a way that is a performance-based fee on its own. If you can help grow that client’s assets, your 1% on the math will increase to higher compensation for you.

You are incentivized already if you’re using that pricing structure to grow the assets and for that, you will get rewarded. You can have the benefits of that without necessarily crossing that bridge into formal performance-based fees and all the challenges we talked about here. Some food for thought on that. No perfect answer. Every situation is different but something to be aware of.

With that, like I said, I’m Brad Wales with Transition To RIA where I help advisors understand everything there is to know about why and how to transition to the RIA model.

Today’s topic, a perfect example, if you were looking at the model, maybe you did hear about performance-based fees as an option. Or if I’m walking you through all the different ways you can charge clients, that generally comes up because I try to advise you about all the options you’d have.

Diving into this topic is the exact sort of thing I do with advisors. I’m more than happy to have that conversation with you. Whether you’d like to learn more about this specific topic or anything else to do with the RIA model, I’m happy to help.

If you’re not already there, if you head on over to TransitionToRIA.com, you can see plenty more videos that I’ve made. I have some economic whitepapers. The easiest thing to do is there’s a contact link right at the top. Click on that, you can instantly and easily schedule a specific date and time that we can have a conversation just like this.

Whether you have a question about today’s video or anything else about the RIA model, or you want to begin that macro conversation of….“Here’s my current situation. Here’s my current affiliation model. Here’s the current firm I’m with. Here’s my current client base. What might it look like if I were to transition to the RIA model, from an economic standpoint, to a flexibility standpoint, to a freedom and control standpoint, and responsibility standpoint as well?” I’m happy to have that conversation with you.

I hope you found value in today’s video, and I’ll see you on the next one.

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