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Good article. Point of reference for those institutions allocating to offshore funds advised by US hedge fund management companies: US tax law requires that US hedge funds recognize all fees (mgt and incentive) each year and pay the taxes due lest face a 20% tax penalty. This fact makes creating a multiyear performance fee problematic, but not impossible thanks to a recent IRS tax ruling.

If a US manager receives options on their own fund shares in lieu of an annual cash fee then the value of the option spread is not taxable until the manager exercises its option. Think corporate stock options awarded to executives to align interests with shareholders for long term price (NAV) appreciation.

Since the manager owes no taxes on its incentive fee at the end of the year it may leave its incentive fee pre tax in its own fund side by side the investor, and by agreement for a period longer than a year, subject to the same performance (clawback).

Further, the option's strike price can change to create a hurdle before an incentive fee begins to accrue. The hurdle can be an index, or any agreed upon figure.

Finally, unlike every other fee proposal that act to lower a manager's net income and potentially hurt the business model, options create the opportunity for the manager, through good performance compounding its pre tax fee on a tax deferred basis to more than make up in net after tax wealth for any other fee consession.