PERFORMANCE FEE EQUALISATION




When setting up a fund, one of the first decisions a manager has to make is the choice of fund structure. Partnership structures are very common in US domestic funds because they offer tax transparency to investors. Accounting calculations for partnership structures are relatively straightforward. Individual capital accounts are maintained for each partner and performance fees are calculated at the capital account level per partner. Therefore, there are no equalization issues for managers to contend with.
 
In Europe, a combination of other fund structures is frequently used which requires calculations of per share/unit price.  In calculating performance fees in these structures, the overriding concern among managers has been in determining how to fairly reward the manager for positive performance while at the same time ensuring investors are treated equitably. Essentially, this is where the various forms of performance fee Equalisation come in. 


One of the most common methods of Equalisation - certainly among European managers - which we explore in this article is the ‘Equalisation Credit /Contingent Redemption’ approach. This form of Equalisation involves making certain adjustments on an investor’s account. 
 
An Equalisation credit is awarded to investors who subscribe in periods when the Gross Asset Value (GAV) per share is   greater than the fund High Water Mark (HWM). The amount of Equalisation awarded per share is the equivalent to the difference per share between the GAV and the Net Asset Value (NAV).  This is to ensure that investors in the fund do not pay a fee to the manager for performance they did not enjoy.  This Equalisation credit is invested with the other assets of the fund and may depreciate.

However, it will never appreciate above the maximum Equalisation credit i.e. that awarded on entry.  Assuming an investor has an Equalisation credit at a period-end, additional shares in the fund will be awarded to them to the value of the total equalization credit available at that point in time.  If the Equalisation credit is not applied in full at the first period-end, additional shares will continue to be allotted at each future period end until the Equalisation credit, allowing for subsequent appreciation or depreciation in the fund has been fully applied.


If an investor buys into a fund when the GAV/NAV per share is below the HWM, the investor will owe an additional performance fee relating to the fund growth from the share price at which it entered up to the HWM. This amount is referred to as the contingent redemption.
 
This calculation ensures that he investor does not benefit from a “free ride” up to the HWM. A contingent redemption will be applied at each period end until such a time as the GAV rises above the HWM. The investor will experience a reduction in their number of shares to the value of the contingent redemption. This redemption amount is paid directly to the manager by the fund, by way of a fee.

We provide further explanation below of this Equalisation Credit / Contingent Redemption approach by way of example scenarios.

Example Scenarios

Consider a fund with the following criteria:

Offer Price: $100
Performance Period: Yearly
Performance Fee Rate: 20%
NAV Frequency: Quarterly
 
There are four dealing days in the period, on which the deals listed in Table 1 are placed. An account of the adjustments and fees on each investor’s account based on the year-end NAV of the fund is summarised in Table 2 and 3. 


Table 1: Shareholder Dealing
 

DATE

Deal

Investor

Amount

GAV

Shares Issued

Jan 1st

Subscription

A

$10,000,000

$100

100,000

April 1st

Subscription

B

$10,500,000

$105

100,000

July 1st

Subscription

C

$12,000,000

$120

100,000

Oct 1st

Subscription

D

$9,000,000

$90

100,000







FUND DATA

GAV

110

HWM

100

NAV

108










Note: True value per share = NAV per share+ (Equalisation Credit issued- Equalisation Credit Lost) - Contingent Redemption
Table 3: Summary


Investor

Shares

NAV

Equalisation

Credit

Account Values

Shares to Adjusted

A

100,000

108

Zero

$10,800,000

0.00

B

100,000

108

$100,000

$10,900,000

925.93

C

100,000

108

$200,000

$11,000,000

1851.85

D

100,000

108

($200,000)

$10,600,000

(1851.85)


  

Year-to-date this investor has enjoyed a return of $5 per share on their investment and so “owes” the manager a fee of $100,000.  At year-end the NAV quoted is $108, thus not a true reflection of the market value on their account.  As such, the fund crystallizes the $1 per share Equalisation factor issued on entry.  As of January 1st in the new period, investor B will receive an additional $100,000 worth of shares in the fund.  This ensures that the investor’s threshold will equal the fund HWM of $108 for the new period, meaning that this investment lot will never again be subjected to an Equalisation adjustment.

Investor C: this investor paid $120 per share on entry.  Inclusive in this price was a fee accrual of $4 per share payable to the manager for the positive performance over the previous two quarters. As this investor did not participate in this performance they are issued with an Equalisation credit of $4 per share as compensation.  The NAV of the fund on entry of $116 means that the investor’s account is valued at $11,600,000 ($116 *100,000 shares).   The difference of $400,000 Equalisation ($4 * 100,000 shares) brings the value of the account up to the investment amount of $12,000,000.

 A loss of $10 per share is incurred on this investment at year-end.  Although the NAV reported is $108, this investor should not have to pay the manager a “performance” fee of $2 per share.  As such, the fund will compensate investor D by crystallising $2 per share Equalisation.  Thus, this investor will receive $200,000 worth of additional shares on January 1st in the new period.  Note that there is still an additional $2 per share equalization on this investment that is lost as of December 31st.   This is to ensure that the investor will never be compensated for any performance fee charged on their investment below the price at which they entered the fund. 

Investor D: having enjoyed an increase in the value of their investment of $20 per share, investor D can expect to pay the manager a fee of 20% of this gain.  However, the NAV of the fund is $108, thus the manager is only earning a fee of 10% of the increase in the value of this investor’s account.  To ensure that investor D doesn’t get a “free ride” between the price they subscribed ($90) and the fund HWM ($100), the manager receives a fee of 20% of this difference in the form of a Contingent Redemption.

Essentially this means that $200,000 (i.e. $2 per share) worth of shares will be redeemed from their account at crystallisation.  The proceeds will be paid to the manager and the investor’s threshold will increase to equal that of the fund HWM.  This is a one-time adjustment on this investment that ensures the performance of these shares will move in line with the performance of the fund.

Crystallisation

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Note: shares issued/redeemed on crystallisation are calculated by dividing the Equalisation adjustment by the NAV per share at year-end.  Although shares have been issued and redeemed from respective investor accounts, the total account value for each investor has not changed, as the equalization adjustment amount after crystallisation will then be zero.Advantages/Disadvantages
The Equalisation Credit /Contingent Redemption approach has both advantages and disadvantages.

 Advantages
 
1. Only shares that have appreciated in value pay a performance fee.
2. All investors have the same amount at risk per share in the fund.
3. Every share in the fund has the same NAV per share.
4. The manager is rewarded fairly for the positive performance of all shares.

Disadvantages

1. Complex calculations may cause confusion among investors.
2. Published NAV per share may not be reflective of the actual value on an investor’s account, as only investors’ statements will reflect the Equalisation adjustment.

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