PERFORMANCE FEE EQUALIZATION USING EQUALIZATION SHARES

APPROACH - Hrishikesh Herekar

Introduction

Performance fee is a reward for the hedge fund manager for demonstrating a
positive performance. However since investors can enter the hedge fund at different
times, it becomes imperative that the investors are charged only for the returns that
they receive. If no fee equalization is used, problems such as the following occur:

1. Unfair Claw-back: Say the fund value drops down since the starting of the
performance period. The accrued performance fee will have to be reversed in
this case. If an investor enters the fund at the end of the period, and no
equalization is used, he will also have his fee reversed even though he never
had to suffer the cost of the accrued performance fee.

2. Free-Ride: If an investor enters a fund when the fund value is less than the
High Water Mark (HWM), the investor will not be charged any performance
fee if no equalization is used even if the NAV of the fund grew after the
purchase as long as the fund value is below the HWM.

There are various methods of equalization such as the Equalization Shares Approach,
Equalization Factor / Depreciation Deposit Approach and the Equalization Adjustment
Approach. This article explains the process of the Equalization Shares Approach.

The Equalization Shares Approach Calculations

The process can be explained using the following example. Consider a hedge fund
having a High Water Mark (HWM) level of 100, a performance fee rate of 20% and
an annual performance period. We consider four investors A, B, C & D who enter the
fund at the dates as shown in the table with the mentioned amounts. The initial
Gross Asset Value (GAV) and Net Asset Value (NAV) of the fund are both 100.

Accrued Shares
Date Investor Amount GAV Fee/ Share NAV Issued
Jan 1st A 10,000,000.00 100 0 100 100,000.00
April 1st B 10,500,000.00 105 1 104 100,000.00
July 1st C 12,000,000.00 120 4 116 100,000.00
Oct 1st D 9,000,000.00 90 (2.00) 92 100,000.00
Dec 31st 110 2 108
Table 1: Sample data for four Investors

The performance fee of the fund accrues throughout the period as the GAV grows.
On Jan 1st, the fee is 0 and hence the GAV and NAV of the fund are equal. Investor A
gets shares at $100 and so 100,000 shares are issued to A. In April, the GAV is
$105. So the fee accrued till date is 20% of (105-100) which is $1 per share.

Investor B enters the fund at this point and gets 100,000 shares at $105 each. The
NAV here is $104 since $1 out of the GAV goes towards the fee accrual.

Similarly for investor C, on July 1st, the GAV was $120. So the accrued fee till date
will be 20% of (120-100) which is $4 per share. Thus the NAV is $4 less than the
GAV. C gets 100,000 shares at $120 each.

After this the GAV of the fund falls to $90 by Oct 1st. So investor D gets 100,000
shares at $90 each. The accrued fee to date at this point is 20% of (90-100) which is
-2$ per share.
At the end of the year, the GAV rises to $110. Thus the final fee payable by all is
20% of (110-100) which is $2 per share. The final NAV is $108 which is $2 less than
$110. Hence all of the investors pay $2 per share. This would have been simple if all
the investors would have entered the fund on Jan 1st. But investors B, C and D
entered the fund when some fee had already accrued before their entry which was
$1, $4 and -2$ which needs to be removed since the investors did not benefit from
the performance of the fund before they entered. This is done by giving them credit
as shown in the Equalization Credit Issued column in table 2.

Adjusted
Unadjusted Fee
Fee payable Equalization payable Shares Issued
Investor / Share Credit Issued / Share (Redeemed)
A 2 0 2 0.00
B 2 1 1 925.93
C 2 2 0 1851.85
D 2 (2.00) 4 (1851.85)
Table 2: Equalization Credit Calculations

Investor A will not get any credit as no fee had accrued when he entered the fund.
Investor B will get a credit of $1 as the accrued fee was $1/share on April 1st when
he entered the fund. Investor C will get only $2 as credit and not $4 as the fund GAV
fell in value at the end and hence the accrued fee of $2 was reversed at the end.
Investor D needs to pay $2 above the unadjusted fee of $2. This is represented by
the -2$ credit issued. A negative Equalization Credit is also known as Contingent
Redemption.

Thus the adjusted fees to be actually paid by the investors are found by subtracting
the credit issued from the unadjusted fee of $2. The column Adjusted Fee shows this
calculation.

Now since all the investors pay $2 as the performance fee, they need to be
compensated to realize the equalization credit issued to them. This is done by issuing
the investors new shares. The number of shares issued is calculated by multiplying
the credit with the number of shares owned by the investors and then dividing by the
final NAV of the fund. For example investor B will get (1 * 100,000)/108 which is
925.93 new shares. Investor D will have to lose 1851.85 shares as the fees that he
needs to pay is more than the unadjusted $2. These calculations are shown in
column Shares Issued in table 2. This process of issuing shares is called
Crystallization.

Thus at the beginning of the next year, all of these investors are at the same level
and no effects of equalization credit carry over to the next performance period.

Conclusion

The Equalization Shares Approach remedies the unfair claw-back and the free-ride
issues as seen above. It however has both advantages and disadvantages. One
advantage is that no separate balances are needed to be tracked and report. Another
advantage is that there is only one NAV for the entire fund rather than for individual
investors. The disadvantage is that the calculations are fairly complex which may
confuse investors. Also issuance of new shares dilutes the ownership interest in the
fund. This approach is widely used for performance fee allocation especially in
Europe.
Reference:

1. AIMA Guide to Sound Practices for Hedge Fund Administrators

2. http://www.aima.org
3. http://www.hedgefundnews.com
4. http://www.customhousegroup.com

Hrishikesh is a business analyst with the Securities and Capital Markets Practice at
Wipro Technologies.