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Nick, great post.

With regard to performance based fees, a recent IRS ruling provides elegant considerations for each of your observations. The ruling allows managers to leave their performance fee in the fund on a pre tax basis under certain conditions. This means that managers and their institutional investors can agree to divide the pre tax profits of the fund whenever they wish and in the proportion they wish on a multi-year basis. For long term investors this is the alignment of interests they have always sought.

For hedge fund investors this represents a sea change in the incentive fee model. Using the stock appreciation rights (FARs) as per the ruling, incentive fee institutional investors can secure a full pre tax claw back of the incentive fee for as long as the duration of the investment. No more tax distributions, no more annual fee crystallization. As compared to the annual crystallization incentive fee model, FARs increase investors' returns. Depending on the design Investors can be better off in up years and down, or no worse off in up years and better of in down (thanks to the clawback). A big win for institutional investors.

Don't feel sorry for the manager. It has left its fee in the fund on a pre tax basis in the form of the appreciation rights (FARs) to compound tax deferred. By receiving FARs, performing managers will accumulate substantially greater wealth as compared to the annual (taxed) crystallization. A big win for the managers.

FARs can be built with hurdle rates by simply adding the desired hurdle to the strike price of the right. FARs reward investor longevity because the longer the investor remains the more incentive fee is captured as FAR spread. That spread becomes a larger and larger pool of capital, "insurance", to be clawed back during a drawdown. FARs can be designed to split the profit on the original allocation cumulatively, split the profit on the profit thereafter or anytime the investor and manager agree.

Look forward to hearing more about FARs in the near future. You were spot on to ask if there may not be a better way to structure feee between institutional investor and manager, there certainly is when it comes to a performance fee.