Refundable Performance-Fee Reserve
Reward only durable alpha and return fees after subsequent underperformance
- Difficulty
- Expert
- Time to result
- ~ongoing to results
- Steps
- 7
- Confidence
- 99%
The refundable reserve replaces a conventional fee with a symmetrical, client-specific mechanism. When a portfolio generates alpha, the agreed manager share accrues first in a reserve account rather than immediately becoming firm revenue. The reserve is invested in the fund, grows before distributions begin, and flows to the manager only gradually above a threshold. If performance later falls below the benchmark, the same sharing ratio credits money from the reserve back into the client's net asset value. This makes compensation depend on durable value rather than one favorable period. It also changes client behavior: refundable fees soften relative losses and give clients an asset they would forfeit by redeeming, helping the manager retain patient capital and lean into attractive positions during drawdowns.
Origin
Extracted from Masters in Business. Orbis introduced its refundable fee structure in 2004 as an extension of founder Alan Gray's emphasis on alignment.
Core principles
- 01Clients should pay primarily for value added
- 02Manager and client should share both upside and downside
- 03Fees should reflect each client's own experience
- 04Deferred fees create protection against later underperformance
- 05Better incentives can reduce destructive investor behavior
How to run it
- 1
Define value added
Choose the relevant benchmark and calculate each client's alpha from their own inception date. Keep the fee experience bespoke even when assets sit in a pooled vehicle.
Pro tip Document transaction and valuation rules before onboarding clients.
Watch out Pool-level accounting can misalign fees with an individual client's actual experience.
- 2
Set symmetrical sharing
Agree how alpha is divided between the client and manager and apply the same ratio when refunding fees after underperformance.
Pro tip Make both favorable and unfavorable scenarios visible in client materials.
Watch out An upside-only performance fee does not create full alignment.
- 3
Accrue fees in reserve
Place the manager's earned share into a reserve account instead of recognizing all of it immediately. Reinvest that reserve in the underlying fund.
Pro tip Keep reserve balances clearly attributable to each client.
Watch out Operational errors can become material when calculations are frequent and bespoke.
- 4
Build a protective buffer
Require the reserve to exceed a defined percentage of net asset value before the manager receives distributions.
Pro tip Size the threshold against plausible periods of relative underperformance.
Watch out A small buffer may fail to provide meaningful downside symmetry.
- 5
Release fees gradually
Once the threshold is exceeded, distribute only a limited amount annually. Preserve most of the reserve as protection against future underperformance.
Pro tip Stress-test the release rate across multiple market cycles.
Watch out Rapid release recreates the short-term incentives the reserve is meant to remove.
- 6
Refund underperformance
When the manager underperforms, credit the client's net asset value from the reserve using the agreed sharing ratio.
Pro tip Show the refund explicitly so clients understand its behavioral and economic value.
Watch out Do not describe the structure as a guarantee of future alpha.
- 7
Finance the operating volatility
Build firm-level capital reserves and infrastructure to withstand uneven fee income. Monitor both investment performance and the returns clients actually realize.
Pro tip Reserve firm earnings during strong periods before scaling the structure.
Watch out The model can destabilize a manager that depends on smooth annual revenue.
In the wild
An institutional client above the stated size threshold pays no base fee. When Orbis produces alpha, two-thirds belongs to the client and one-third accrues to the fee reserve. Nothing flows to the manager until the reserve exceeds the specified percentage of net asset value, after which distributions are limited. Later underperformance is credited back to the client's net asset value.
→ The client pays for durable alpha while maintaining a funded claim against future relative losses.
During a period of relative underperformance, refundable fees dampen the client's loss and remain visible in the reserve. Redeeming would crystallize the decision and surrender the future benefit of that balance, so the client has an incentive to stay. The manager consequently faces fewer forced sales and can add to positions when prices are most attractive.
→ Fee design reduces the behavioral penalty and supports contrarian portfolio management.
Common mistakes
Paying fees out immediately
Immediate payment rewards temporary alpha and leaves nothing available to offset subsequent underperformance.
Underestimating operational complexity
Bespoke fee histories, transaction-triggered calculations, and reserve accounting require substantial infrastructure and capital.
Ignoring firm-level volatility
Symmetrical fees create volatile earnings, so the manager must retain sufficient capital to survive weak periods.
Is it for you?
Best for
It is best for established asset managers serving sophisticated clients and able to support bespoke accounting.
Not ideal for
It is not ideal for small firms without operational infrastructure, financial reserves, or tolerance for volatile earnings.
From the transcript
“all of our fees of performance based fully metrical and we refund the fees when we underperform”
“We don't survive unless we generate alpha and add value UM.”
“that underperformance at the same sharing ratio in this case is credited back to the nav of the client.”
From the episode
Adam Karr on Contrarian Investing