Perry Capital Pitches Novel High-Water Mark

Perry Capital is floating a plan to continue charging investors a performance fee, albeit at a reduced rate, even though its flagship fund remains well below its high-water mark.

Richard Perry's New York firm is giving investors in Perry Partners International a choice: stick with the traditional high-water mark provision, which means no performance fees until the fund returns to its peak level, or join a new share class with a more-complicated fee structure. Investors in the new class would pay a performance fee of 10% - half the usual rate - on any gains after Jan. 2, 2009, even if the fund remains below the high-water mark. The incentive for investors is that the discounted rate would remain in effect even after the high-water mark is reached, until 250% of the losses have been recouped.

The move is expected to be closely watched by investors and fund managers alike at a time when most funds remain far below their peak levels. For investors, the high-water mark is what sets hedge funds apart from other investment vehicles, ensuring that asset managers reap generous fees only when they generate positive returns.

Perry's flagship fund, which manages $6 billion of the firm's $8 billion of assets, posted a 26.8% loss in 2008, the first annual loss in the firm's 20-year history. Like most of its peers, Perry Capital stands to see its revenue decline now that performance fees have dried up and all that's left is the standard 2% management fee. Depending on the extent of the losses and the strength of the economy and financial markets going forward, it could take a hedge fund years to return to its high-water mark.

Perry laid out the alternative performance fee structure in a Jan. 22 letter to investors. The letter credited some investors for suggesting the idea. Here's how it would work: If an investor had $10 million of assets with Perry Partners International at the fund's peak, and those assets are now worth $8 million, the investor would pay a 10% fee on any gains, even if the fund remains below the high-water mark. But the discounted rate would remain in effect until the assets reached $13 million (recouping 250% of the $2 million of losses). Above that level, the performance fee would revert to the standard 20% rate. Investors have until Feb. 5 to decide whether to stick with the traditional high-water-mark provision or switch to the new share class.

Perry's proposal appears to be similar to a modified high-water-mark scheme adopted several years ago by a handful of elite fund shops, including Lone Pine Capital and Farallon Capital. The difference is that those fund managers convinced investors to go along during a bull market, when assets were steadily rising. If Perry succeeds in switching investors to the new share class, it is likely other fund managers would attempt a similar move.

Perry is seeking to adjust its fee structure at a time when the firm has been undergoing a sweeping reorganization, including job cuts. Perry has scaled back its equity investment operations in order to focus on opportunities in the beaten-down credit markets.

Separately, Perry is allowing investors to choose how much of their assets are allocated to "special situations" investments. Traditionally, fund managers have not given investors much of a say in investment strategy. But since the credit crisis, many investors have gotten burned when managers mixed conventional stock investments with less liquid holdings, such as private equity stakes. Now, Perry is allowing investors to decide whether they want 15%, 30% or none of their shares allocated to investments in "special situations."

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