Equalization accounting
Equalization
accounting
Historically,
hedge funds typically provide for some form of performance-based compensation
to the investment manager of the hedge fund (as set out above under section
3). This has generally been a
percentage of the increase in the gross assets over the prior high water
mark. For example, if the prior
performance fee period had a net asset value of 100 and the following period's
net asset value was 120 then the further performance fee for the period will be
paid on the amount of that increase which is 20 and the high water mark for
this following period would be set at 120. Thereafter if the net asset value
fell below 120, no performance fee would be payable. Although relatively simple to understand,
there were certain situations where individual shareholders would suffer a fee
not in line with performance and, consequently, the investment manager would
receive either too large or too small a
fee relative to the individual shareholder's performance. This inequity arose because the performance
fee is calculated at the fund level and distortions occur when the subscription
cycle differs from that used for calculating the performance fee.
In
order to counter the inequality of this performance fee calculation, most hedge
funds will track and calculate performance fees using a range of equalization
methods to try to ensure that each shareholder pays a performance fee which
equates to the performance of their investment.
There are two common methods
used to achieve
'equalization' within a
hedge fund; these
are series accounting
and consolidation method and 'traditional equalization'. Traditional equalization, in turn, can be
broken down into different types – for the purposes of this guide we have set
out one of the more common, being the use of an equalization adjustment
approach. The suitability of either
method being adopted for a hedge fund will ultimately depend on a number of
factors including the proposed fee structure being charged, operational issues
with the hedge fund's service providers and investor familiarity and acceptance
of the proposed method. As a general
rule, the series accounting method (discussed below) is more commonly used with
US asset managers, whilst traditional equalization is more commonly used with
European asset managers.
Series accounting
This
is probably the simplest equalization method available to a hedge fund such
that it is comparatively easy to implement and explain. The multi-series method uses the following
approach: a separate series of shares is created each time there is a
subscription opening and the performance fee period with respect to that series
begins from the date of such subscription. The result is that the performance
fee is calculated separately for each series, ensuring that the performance fee
is charged equitably with each shareholder having the same amount of capital
per share at risk.
Generally,
when the performance fee is payable (at the end of the performance period), the
various series' issued throughout the performance period are converted to the
initial series of shares at the relevant net asset value of such initial share
series. However, this conversion is only
performed if an individual series is above the initial series' relevant high water
mark. This process is known as a 'series roll-up'.
The
Performance Period for Series 1 runs from January to December. During this period the net asset value of
Series 1 reaches 100. After January
Series 2 is issued, the net asset value of Series 2 falls and at the end of
December is 80. As the net asset value
of Series 2 at the end of December is 80 and is below the net high water mark
of Series 1 of 100, Series 2 will not be 'rolled-up' into Series 1. Series 3 and Series 4, however, have each
exceeded the Series 1 high water mark of 100 at the end of December so this
Series will be 'rolled up' into Series 1.
As a result, following the first performance period, the only series
outstanding will be Series 1 and Series 2.
Although comparatively easy to implement and understand, there are some
disadvantages with this approach, namely:
1.
it
makes it difficult to manage and publish net asset value per share information
at external service providers such as Bloombergs and Telekurs;
2.
if
investors are institutional they may invest at multiple times during the year
and end up with many different series, making it difficult to manage the
overall custody relationship; and
3.
if
a fund loses money in a given year, it is possible that you do not have any
series consolidation at year end, so you could end up with a large number of
series outstanding.
Equalisation
The
other method for countering the inequality of performance fee calculations is
the traditional Equalisation method.
Rather than issuing separate series on respective subscription dates and
then rolling such series up as described above, the Equalisation method seeks
to address any inequalities in the calculation of performance fees by adjusting
the price at which shares are issued and/or adjusting the holdings of investors
in the company, as appropriate. This is achieved by calculating a per share fee
at the fund level and then compensating each investor by adopting an Equalisation
mechanism for the portion of this fee which should not have been charged or by
charging an additional amount for the extra portion that should be paid to the
manager. Using the Equalisation share
adjustment, shares are allocated to investors at the gross asset value per
share (that is, before deduction of any performance fees) and shares are
redeemed at the net asset value (that is, after deduction of any performance
fees).
If a
shareholder invests during
a period of
positive performance, the
shareholder is allocated
an Equalisation credit equal to the current performance fee per
share. This equalisation credit is at
risk in the fund and will appreciate or depreciate based on future performance
of the fund subsequent to the investment.
The total value of the shareholder's investment is the number of shares
allocated (valued at their net asset value) plus the value of the equalisation
credit.
If
a shareholder invests during a period of negative performance, the gross and
net asset value will be the same as there is no performance fee per share. As the net asset value per share increases
up to the previous highest net asset value per share, no performance fee is
charged at the fund level. As the value
of the shareholder's holding has increased, the shareholder will be required to
pay a performance fee which is affected by the redemption of that number of
shares, the value of which reflects the performance fee owed to the
manager. The total value of the
shareholder's investment is the number of shares allocated (valued at their net
asset value).
An
advantage of this sort of equalization is that the fund only has one NAV per
share and there is only one group of shares outstanding at any one point in
time which overcomes some of the issues set out above with respect to series
accounting. That said, Equalisation in
this manner can result in very complicated accounting, and can be difficult to
explain to investors. Furthermore,
investors have to track their own Equalisation credits etc. to determine their
true exposure to a fund at any given point in time. Equalisation is generally
not as common as the series accounting method and the precise manner of
calculation will typically depend upon the approach of the administrator.
Indeed,
no equalization method is completely perfect, but all methods try to result in
a fair and equal allocation of performance fees.
