Excelsior Management Co., a prominent hedge fund manager pursuing an event-driven

strategy, charges a management fee of 1.5% per annum and an incentive fee of 15% on any

"net new profits" (i.e., above the previous high water mark) earned by its fund after deducting

this management fee. All fees are charged and collected at the end of each year.

Over the past three years, the Fund generated the following gross returns (i.e., prior to any

fees being charged):

Year 1 +20%

Year 2 -10%

Year 3 +5%

After the technology stock bubble burst in 2000, some hedge fund managers attempted to

convince their investors to accept a "modified" incentive fee arrangement whereby they

would charge an incentive fee at half the rate of the full incentive fee on profits earned by

the Fund in any year in which it failed to surpass its previous high water mark, but that

lower incentive fee would stay in force until the Fund earned enough to return investors to

the point at which they would have been had the original arrangement been in place.

These managers argued they needed some incentive fee during these "catch-up" years in

order to have cash on hand to pay employees' bonuses and cover other ongoing expenses.

If Excelsior charged this modified incentive fee formula, what would have been the

effective annualized net return of its fund over this three-year period?

Answer rating: 100% (QA)

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