What are the typical fee structures associated with Alternatives?
Alternative Investments typically involve specific fee structures that may reflect the complexity required to manage these opportunities. Understanding how they work can help you evaluate potential investments and determine how they fit within your overall portfolio strategy.
Published by the Investment Solutions Group | Alternative Investments Team
Key takeaways
- Alternative Investment fees typically reflect the specialized management, sourcing and operational demands of these strategies.
- Many funds charge both management and performance fees to align manager compensation with investor outcomes.
- Funds that invest in other funds usually involve layered or pass-through fees.
- Fee structures tend to vary by strategy and investment vehicle, making it important to review a fund's offering documents for specific fee details.
Note: The fees outlined here are intended to provide an overview and may not be completely exhaustive of all fees a client could experience.
How do Alternative Investment fee structures work?
NOTE
Alts fees help support the specialized expertise, active management and resources required to source, evaluate and manage these types of investments.
Funds can charge several types of fees, which are outlined in detail in a fund's offering or disclosure documents. These documents explain how fees are calculated, when they are charged and how they affect returns.
While structures vary, most fees fall into a few broad categories.
Common types of fees
Management fees
Management fees are ongoing charges paid to the fund manager for operating and overseeing the investment strategy. They are typically calculated as a percentage of committed capital or invested capital, depending on the fund.
These fees generally cover:
- Identification and evaluation of investment opportunities
- Execution and monitoring of investments
- Portfolio management and risk oversight
- Fund administration and operational expenses
When fees are based on committed capital, investors pay management fees on their full commitment before all capital calls have been made. As a result, effective cost relative to invested dollars can be higher in the fund's early years, before declining as more capital is deployed. This structure reflects the manager's responsibility to source, evaluate and prepare investments throughout the fund's investment period, even before all committed capital has been deployed.
Performance (incentive) fees
In addition to management fees, many strategies charge performance fees, also known as incentive fees. These fees are usually calculated as a percentage of profits earned above a set return threshold called a hurdle rate. This structure is intended to align the manager's incentives with investor performance.
Many funds also use a high water mark, which means the manager must recover any prior losses before earning additional performance fees. This helps prevent investors from paying incentive fees on gains that merely offset earlier declines.
Hypothetical scenario with a $1M investment, 5% hurdle and a high water mark in place
For illustrative purposes only. Not representative of all strategies.
The "1.5 and 20" fee model
One commonly referenced structure is the "1.5 and 20" model, which combines:
- A 1.5% management fee to cover ongoing fund operations, and
- A 20% performance fee on profits above the hurdle rate
While actual fee levels vary by strategy and market conditions, this framework illustrates how management and performance fees can work together to support active oversight while linking compensation to results. The “1.5 and 20” reference today often reflects fee levels that have moved below the historical “2 and 20” in many strategies.
Placement and upfront fees
Some funds may assess placement fees or upfront charges, often calculated based on an investor's full capital commitment. These fees may apply before capital is invested and can help compensate intermediaries for sourcing, structuring or distributing the offering.
When applicable, these fees are clearly disclosed in offering documents.
Fees that may apply when exiting an investment
Unlike traditional investments, Alts strategies generally do not charge standard transaction fees when investors redeem or transfer their investment. However, funds that offer periodic liquidity with restrictions may charge an early-repurchase fee (typically around 1% to 2%) or impose a soft lock-up penalty for redeeming before a specified holding period ends. These provisions reflect the longer-term nature of these investments and help to protect remaining investors from short-term redemption activity that could disrupt the fund's strategy. Secondary market sales for Alts funds may occur at a discount to NAV, reflecting market conditions and limited liquidity, rather than a fee.
Fund structures that invest in other funds
NOTE
Some funds offer actively managed portfolios of multiple underlying funds or other pooled vehicles, providing investors with broader diversification and professional oversight.
These structures often involve fees charged at multiple levels (layered fees), meaning investors may pay fees at the main fund level and also indirectly through the underlying funds (pass-through fees). While most common in fund-of-funds and multi-manager funds, some evergreen funds, such as interval funds, may also use this approach, depending on their investment strategy.
Hypothetical scenario: How fees can layer in fund-of-funds and multi-manager funds
Investor invests $1,000,000
- Upfront placement fee (if applicable). A fee may be deducted before capital is invested.
- Remaining capital invested in strategy
Underlying funds level
- Provide exposure to a diversified group of managers and strategies
- Each underlying fund may charge management fees, performance fees and fund expenses
- These costs generally reduce the returns reported to the main fund
Main fund level
- Provide underlying fund sourcing/due diligence, portfolio construction, ongoing oversight and consolidated reporting/administration
- May provide access to strategies with higher investment minimums
- Management fee (typically 1.5%)
- Performance fee (typically 20% of profits above a specified hurdle)
- Applicable fund expenses
For illustrative purposes only. Not representative of all strategies.
How do fees tend to vary across strategies?
Fee structures often depend on both the fund vehicle and the assets or strategies involved. The table below offers an at-a-glance overview of common approaches, though investors should always consult a fund's offering documents for details. In the table below, “Rare,” “Sometimes” and “Common” indicate how frequently each fee type applies.
While individual offerings differ, the following general patterns are common:
How are fees applied?
Direct fund fees
Management and performance fees are generally deducted directly from the fund, rather than billed separately to investors. As a result, they typically do not appear as individual line items on investor statements. Fund performance is also usually reported net of these fees.
Layered and pass through fees
For fund structures that invest in underlying funds, each underlying fund may charge management fees, performance fees and expenses.
These amounts generally reduce returns reported to the primary fund, which also deducts its own direct fees. Investors should review disclosure documents to confirm whether performance is shown gross or net of each fee layer and to understand any estimated all-in fee.
Initial investment fees
When upfront or placement fees apply, they are typically applied in addition to the amount of capital initially invested. This can affect early performance calculations and make initial returns appear lower.
Audit holdbacks
One item investors sometimes mistake for a fee is an audit holdback. Audit holdbacks are temporary portions of a distribution that are held back, not a charge to investors. In these cases, a fund withholds part of a distribution until its annual audit is completed. Any remaining amounts are typically paid to investors once the audit is complete.
This practice is common in evergreen funds and helps ensure redemptions and fees are based on finalized, audited results.
What this means for you
Alts fees often differ from those associated with traditional investments, but they generally follow clear, consistent structures based on fund type and strategy. Understanding how these fees work, and how they are reflected in performance, can help investors make more informed decisions. Investors should compare the estimated all-in fee with the strategy’s expected net return, portfolio role, liquidity and access. Your Merrill advisor can help assess whether the overall value proposition supports your investment objectives.
Alternative Investments are speculative and involve a high degree of risk.
Alternative Investments are intended for qualified investors only. Alternative Investments such as derivatives, hedge funds, private market offerings, and funds of funds can result in higher return potential but also higher loss potential. Changes in economic conditions or other circumstances may adversely affect your investments. Before you invest in Alternative Investments, you should consider your overall financial situation, how much money you have to invest, your need for liquidity, and your tolerance for risk.
When considering the appropriateness of mutual funds or Alternative Investments, please be aware that there are significant differences between these investments which will cause their investment portfolios, performance, tax treatment and other factors to differ. These differences include the types, availability and diversity of securities that can be purchased, economies of scale, regulations and other factors applicable to their management.
