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
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.
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
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.
The Equalisation Credit
/Contingent Redemption approach has both advantages and disadvantages.
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.
