March 2, 2010 CPO/CTA Regulatory Seminar. Common Errors in Break-Even Analysis

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1 March 2, 2010 CPO/CTA Regulatory Seminar Common Errors in Break-Even Analysis Written by Kaitlan Chi In order to ensure customers are aware of the impact fees and expenses have on the potential profitability of their investments, CPOs are required to disclose in a tabular presentation a calculation of the pool s break-even point. This break-even point is the amount of trading income required for the pool s net asset value (NAV) per unit at the end of one year to equal the selling price per unit. In other words, it is the amount of income the pool must make in order to offset all commissions and fees and avoid a loss for the year. The break-even point must be expressed as both a dollar amount and a percentage of the minimum unit of initial investment. In order to calculate the break-even point, the CPO must determine the amount of all fees and expenses, inclusive of incentive fees, that are anticipated to be incurred by the pool during the first year of the investment. Incentive Fees The incentive fee will be zero when it is not charged until the pool generates enough income sufficient to offset all other pool expenses. However, in some situations the incentive fee amount in the break-even analysis will not be zero because certain expenses are not deducted when computing the In such situations, the CPO will need to determine the additional trading profit that would be necessary to overcome any incentive fees to be incurred. Such situations will arise when a CTA/investee pool charges an incentive fee without deducting all of the expenses the pool incurs (e.g. upfront syndication costs, general partner's (the GP ) management fee, accounting and legal fees). Below is an example of some pool expenses: Sample Pool Expenses General Partner's Management Fee Pool Operating Expenses Trading Advisor's Management Fee Brokerage Commissions and Trading Fees In the above example, if the CTA charges a 20% incentive fee, then from the CTA's perspective, the CTA will not earn an incentive fee until it generates a trading profit greater than $1,000 (enough to cover its management fee and the brokerage commissions and trading fees). However, the pool also has other expenses (i.e. the GP's management fee of $500 and Pool Operating Expenses of $200) that need to be overcome before the pool can break-even. This means the CTA will need to generate additional profits so it can provide the pool with sufficient funds for it to break-even. In this example, this means the CTA will need to generate additional trading profits so it can provide the pool with an additional $700 (net of Page 1 of 5

2 the CTAs incentive fee) before the pool can break-even. Since the CTA will charge an incentive fee on this additional profit, the CTA will actually need to generate more than $700 in trading profits since it will charge a 20% incentive fee on the $700 earned. To determine the incentive fee amount the CTA will charge on the additional trading profits it generates, the CPO will need to calculate the additional trading profit necessary to overcome the CTA's The additional trading profit necessary to overcome the incentive fee, is determined by taking the pool expenses or income not accounted for when computing the incentive fee and dividing it by (1-incentive fee rate). For example, if the incentive fee is 20 percent, the denominator would be (1.20), or.80. In the above scenario, this would mean the additional trading profit necessary to overcome the CTA's incentive fee would be: $700/.80 = $875. After determining the additional trading profit needed, you multiply this value by the incentive fee rate of.20 to arrive at the incentive fee amount the CTA will charge on the additional trading profit it earns: $875*.20 = $175. In this scenario the break-even analysis will need to include $175 as the CTA's Basis of the Break-Even Analysis The Disclosure Document should include what the break-even point would be if the minimum proceeds needed to commence trading were raised. However, if the break-even point is expected to vary significantly based upon the size of the offering (as in the case of fixed expenses), then a second breakeven point can be calculated based upon an assumed amount of total funds raised. Redemption Fees If there are redemption fees, they must be clearly shown and considered a part of the total cost and reflected in the break-even analysis. Interest Income If pool participants receive some or all of the interest income generated by the pool, the expected interest income should be deducted from the expenses which must be covered by trading profits to return the customer to the level of his initial investment. The estimate of that interest income must include the assumed interest rate, which must reflect current cash market information. If any interest income is to be paid to the pool operator, or to anyone other than the pool participants, that fact and an estimate of the amount must also be clearly disclosed. Page 2 of 5

3 A More Comprehensive Example of a Break-Even Analysis: Minimum Subscription Amount (1) $100, Upfront Syndication and Selling Expense (1) $5, General Partner's Management Fee (2) Pool Operating Expenses (3) 1, Trading Advisor's Management Fee (4) 1, Trading Advisor's Incentive Fees on Trading Profits (5) 2, The General Partner s Incentive Fee on Trading Profits (6) 0 Brokerage Commissions and Trading Fees (7) 3, Less Interest Income (8) (475.00) Amount of Trading Income Required for the Pool's Net Asset Value per Unit (Redemption Value) at the End of One Year to Equal the Selling Price per Unit $ 14, Percentage of Initial Selling Price per Unit 14.90% Explanatory Notes: (1) Investors will initially invest $100,000. After the commencement of trading, units will be purchased at the pool's month-end Net Asset Value per unit. A 5% upfront syndication and selling charge will be deducted from each subscription to reimburse the pool, the General Partner and/or the Clearing Broker for the syndication and selling expenses incurred on behalf of the pool. (2) Except as set forth in these explanatory notes, the illustration is predicated on the specific rates or fees contracted by the pool with the General Partner, the Trading Advisor, and the Clearing Broker as described in "Fees, Compensation and Expenses." The pool's General Partner will be paid a monthly management fee of 1/12 of 1% of Allocated Net Assets. The annual figure of 1% is used for the purpose of this calculation. Note also that the basis for this and subsequent calculations is $95,000 [$100,000 - $5,000] it is calculated after deducting the upfront syndication and selling expense. (3) The pool's actual accounting, auditing, legal and other operating expenses will be borne by the pool. These expenses are expected to amount to approximately 1.50% of the pool's Net Asset Value. (4) The pool's Trading Advisor will be paid a monthly management fee of 1/12 of 2% of Allocated Net Assets. (5) The Trading Advisor will charge 25% on the net trading profits it generates on behalf of the pool. For example, the pool estimates that profits of approximately $6, must be retained in order Page 3 of 5

4 to pay for the Upfront Syndication and Selling Expenses, General Partner's Management Fee, and Pool Operating Expenses less the pool's Interest Income [See calculations on page 5]. Therefore, the pool estimates that the CTA will need to earn $9, ($6, divided by 1 minus the incentive fee rate of 25% charged by the trading advisor) in net profits for the pool to have $6, available after the incentive fee is paid. Specifically, $9,200 times the 25% CTA incentive fee equals $2,300.00, the CTA After the $2, CTA incentive fee is paid, the pool will have $6, to pay the aforementioned expenses. (6) In the above example, no incentive fee for the General Partner is included in the calculation. The General Partner also makes the trading decisions for the pool and charges a quarterly incentive fee based upon New Net High Profits. New Net High Profits is the net of all management fees, brokerage commissions, trading advisor fees, upfront fees and operating expenses and as such, the General Partner does not receive an incentive fee until the pool generates trading income sufficient to offset such expenses. Based on the above analysis, the General Partner would need to earn more than $14, of trading income per unit before it would be entitled to an In other words, no incentive fee is charged by the GP until after the pool breaks even. (7) Brokerage commissions (including any spread on forex transactions) and trading fees are estimated at 4% of Net Asset Value. (8) The pool will earn interest on margin deposits with its Clearing Broker. Based on a current assumed interest rate of 1.5% paid on ⅓ of the pool s assets, interest income is estimated at 0.5% of Net Asset Value. Page 4 of 5

5 How to determine the incentive fee amount in the More Comprehensive Example of a Break-Even Analysis above: 1. Sum all the expenses and income not accounted for in the CTA's incentive fee calculation. Upfront Syndication and Selling Expense $5, General Partner's Management Fee $ Pool Operating Expenses $1, The General Partner s Incentive Fee on Trading Profits 0 Less Interest Income ($475.00) Sum of pool expenses which would not be deducted from the CTA's net performance in calculating the CTA's $6, Determine the additional trading profit necessary to overcome the expenses not accounted for in the CTA's incentive fee calculation above. Sum of pool expenses which would not be deducted from the CTA's net performance in calculating the CTA's $6, Divided by (1-incentive fee rate) (1-.25) The additional trading profit necessary to overcome the CTA's incentive fee $9, Determine the incentive fee amount the CTA will charge before the pool breaks-even. The additional trading profit necessary to overcome the CTA's incentive fee $9, Multiplied by the incentive fee rate.25 The incentive fee the CTA will charge on the additional trading profit it earns, which will need to be included in the break-even analysis. $2, Page 5 of 5