'New Profits Calculation Example"

A substantial portion of the compensation our firm receives for our money management services is linked to the “new profits” our clients earn.

In our industry, fees that are linked to the continued profitability of a client account is known as an “incentive fee”.  The incentive fee is calculated as a percentage of the new profits in the account (typically 20% or 25% of the new profits).  Here’s an example of how it works....

Assume an account is opened with a starting value of $100,000. and the incentive fee for the account is 20% of new profits.  During the first month, say the account earns a profit of 5% or $5,000.  In this case, the incentive fee is $1,000 (the $5,000 profit multiplied by 20%.  Thus, the net profit for the month (after deducting the incentive fee) is $4,000.  To start the second month, the value of the account is $104,000.

In the second month, we’ll assume the account sustains a loss of 2% or -$2,080.  Since there is a loss during the second month, there are not any new profits in the account for this month.   At the start of the third month, the total value of the account is $101,920.

For month three, let’s assume a profit of 8% is earned.  In dollars, that’s a profit of approximately $8,150.   As has been noted, incentive fees are only charged on NEW profits earned for the account.  Thus, the account must recover all of its previous losses before any new incentive fee is assessed. 

Looking again at the performance for the third month, a profit of  $8,150 was earned for the month.  However, the account must recoup the 2,080 loss from the second month before any new incentive fees are assessed. After deducting the previous loss amount (the loss was $2,080) the third month generated new profits of $6,070 (the $8,150 profit in month three, minus the $2,080 loss from month two).   After the adjustment for prior losses is made, the incentive fee for the third month is $1,214 (the $6,070 of new profits multiplied by 20%). 

As you can see in the example, incentive fees are only assessed on the amount of NEW profits in the account. Typically, the balance of new profits in the account is called a “high water mark”.  Incentive fees are only assessed when a “new” high water mark has been reached.  This type of fee is truly “incentive” based.  It links the compensation our firm receives to the amount of new profits that our clients earn.