Why Equalization? Bachelor Thesis

Why Equalization? Bachelor Thesis Dagmar Poelman 0042986 University of Amsterdam Business Studies, Finance December 2005 Vossiusstraat 19-2 1071AD Amsterdam dagmarpoelman@hotmail.com 06-53556545 La Joya Villas 5 Girouette, Curaçao +5999-5296633

CONTENTS Preface 4 CHAPTER 1 6 Hedge Funds 1.1 A Brief History 6 1.2 Hedge Funds vs. Mutual Funds 7 1.3 Structures, Characteristics and Regulations 8 1.4 Parties to a Fund 10 1.5 Strategies and Risk 11 CHAPTER 2 12 Fee Structure 2.1 Fees and High Water Marks 12 2.2 Net Asset Value Calculation 13 CHAPTER 3 14 Calculation Methods 3.1 The Onshore Hedge Fund 14 3.2 The Offshore Hedge Fund 15 3.2.1 No equalization 15 3.2.2 Equalization 16 3.2.2.1 Multi series 16 3.2.2.2 Equalization / Depreciation Deposit 19 3.2.2.3 Equalization / Forced Redemptions 21 3.3 Comparison of Structures and Methods 21 CHAPTER 4 23 Empirical Data 2

CHAPTER 5 25 Conclusion Appendix 26 Bibliography 36 3

PREFACE An internship with Citco Fund Services (Curacao) N.V. offers the opportunity to see and experience how academic theory and principles are applied in practice. The internship experience as a whole, combined with the necessary theoretic research, will serve as the basis of my chosen topic for my bachelor thesis. Citco is the global leader in custody and administration services for the alternative investment fund industry and is widely considered within the industry to be the leading expert in concepts unique to hedge funds such as equalization and multi-series calculations. A hedge fund is generally defined as a privately organized, unregulated investment vehicle, which is available to wealthy, financially sophisticated investors and certain other entities as a means of investing for the most part in publicly traded securities and derivatives. The administering of hedge funds is a challenging and complex task, which requires the application of a number of procedures and methodologies to ensure the proper calculation of a fund s net asset value. One of the issues involved in this process is the calculation and allocation of incentive fees. Incentive fees are payable to the investment manager and are determined based on a percentage of the profit earned by the fund. Many hedge funds adopt various methodologies to determine the applicable fees across the pool of investors. Multi-series and equalization are examples of such methodologies used to allocate incentive fees across investors. As Martin Luther King once said: I have a dream that one day this nation will rise up and live out the true meaning of its creed: We hold these truths to be self-evident, that all men are created equal. Should this apply for the allocation of incentive fees attributable to investors also? By constitution everyone is treated equal, can we assume that hedge fund investors are also treated equally when it comes to the calculation and allocation of incentive fees? As an intern at Citco, I wonder: Why equalization? And if so, which of the currently available methods is the most equitable? 4

To answer the question I will first provide a short introduction into hedge funds taking into account all information needed for understanding the implication of incentive fees and equalization. I will then give a description of three different equalization methods and their influence. Finally, I will use Citco s share registration database, to examine trends and preferences over time as regards incentive fee allocation. 5

CHAPTER 1 Hedge Funds A hedge fund is generally defined as a privately organized, unregulated investment vehicle, which is available to wealthy, financially sophisticated investors and certain other entities as a means of investing for the most part in publicly traded securities and derivatives. This chapter provides an introduction to hedge funds. It will give some historical background of the emergence and development of hedge funds and will explain the differences between hedge funds and mutual funds explaining hedge fund characteristics, regulations, and legal and organizational structures. It will outline the different parties involved with a fund and conclude by taking a brief look at hedge fund strategies and risk. 1.1 A Brief History In 1949 the first hedge fund was established by Alfred Jones. Jones launched a limited partnership (under certain conditions these are exempt from the regulatory requirements of the Investment Company Act of 1940 and the Securities and Exchange Commission 1 ). By incorporating two investment tools into his strategy short selling and leverage, Jones was able to achieve an element of market risk hedging. Jones charged an incentive fee of 20% of profits and he kept most of his own personal money in the fund. In the mid 1950's a number of other funds followed and started engaging in the short-selling of shares, although for the majority of these funds the hedging of market risk was not central to their investment strategy. For years the Jones Hedge Fund went unnoticed until a 1966 Fortune Magazine article outlined the strategy and highlighted that Jones had outperformed mutual funds by 87% over the previous ten years. The first rush into hedge funds followed and the number of hedge funds increased severely and by 1968, approximately 200 hedge funds were in existence. During the equity market downturn of 1969, the number of hedge funds and the value of assets managed by them declined as investors withdrew their investments due to the incurring of losses which led to the collapse of 1 see further chapter 1; Structures, Characteristics and Regulations 6

many of the funds which were managed by less experienced fund managers. As a consequence, hedge funds suffered from a drop in their popularity. The following years were relatively quiet for the industry until the successes of Julian Robertson with his Tiger Fund in the early 1980s which grew from $8million to $3billion and the success of George Soros with his Quantum Fund. The Quantum Fund traded in the currency markets by buying and selling various currencies and most notably made over $1 billion betting against the British pound. This high performance helped boost the formation of new hedge funds and sparked an explosive growth of the industry. More recently, hedge funds have begun to receive many negative headlines in newspapers. During the liquidity crisis of 1998 and the equity market downturn in 2000 many hedge funds closed down or liquidated. However, the value of assets under management has grown from $170 billion a decade ago to almost $1 trillion today with an estimated growth to $2.4 trillion by 2008. Approximately 8,000 hedge funds are currently active across the globe. 1.2 Hedge Funds vs. Mutual Funds Hedge funds are exempt from many of the rules and regulations which govern mutual funds. A hedge fund is an investment vehicle that is allowed to use aggressive strategies to a much greater extent then mutual funds, such as short selling, borrowing money through leverage, swaps, arbitrage and derivatives. Mutual funds advertise heavily. They are available to all investors, offering minimum investment sizes that can be as low as $1,000. Hedge funds are not widely available to the public and therefore are not publicly marketed. They usually only accept investments from wealthy, sophisticated individuals and institutions. The managers of a hedge fund are typically the general partners in a limited partnership and put much of their own capital at risk in the fund. It is also possible for the fund to be established as a traditional corporation if the fund is organized in an offshore country. As with traditional mutual funds, investors in hedge funds pay a management fee; however, hedge fund managers in addition charge a performance fee based on a percentage of the profits. Investing money with a hedge fund manager is thus not comparable to investing in a mutual fund. 7

1.3 Structures, Characteristics and Regulations A hedge fund can be domiciled onshore or offshore. An onshore hedge fund is subject to all onshore legislation and regulation. The term onshore mainly refers to funds based in the United States. Most onshore funds are set-up as limited partnerships, with the hedge fund manager as the general partner and the investors as the limited partners. The general partner is responsible for the management of the partnership and liable for the debts and obligations of the partnership. The exposure to loss for the limited partners is limited to the amount of capital they invested in the partnership. The onshore fund is generally organized as a limited partnership because a partnership itself is not subject to tax. Rather, any income or loss will flow directly through to the individual investors and be taxable in their hands. Offshore hedge funds are domiciled in offshore jurisdictions and designed to permit investment in a fund without exposing the fund to onshore taxation. Offshore funds are more loosely regulated and are generally set up as corporations. The development of offshore investment vehicles dates back to the late 1960 s. At that time the jurisdiction of choice was the Netherlands Antilles, as the Netherlands had a comparatively favorable tax treaty with the United States. The treaty benefits applied only if the fund was set up as a corporation. Nowadays hedge funds continue to be set up as corporations as most European investors are more comfortable with this structure and feel more at home with having a holding in the form of shares in a fund than a partnership interest. In addition to the Netherlands Antilles, other widely used offshore jurisdictions for hedge funds are the British Virgin Islands, Bermuda, Cayman Islands, the Bahamas, Jersey and Luxembourg. Hedge funds are generally unregulated investment vehicles. This is true for hedge funds domiciled in the above mentioned offshore jurisdictions or located in the United States. In the most European countries, including the Netherlands, hedge funds are subject to the same regulation as traditional investment funds. Therefore European investors invest mainly in funds which are domiciled outside of Europe or in low-tax jurisdictions within Europe. For onshore investment funds the Securities and Exchange Commission (SEC) requires that subject to certain exemptions all securities must be registered with the SEC and that a prospectus be provided to all 8

investors. The SEC proscribes detailed disclosure requirements which govern the contents of such prospectus. Securities that are not registered are called private placements. Typical private placements include unregistered stocks and bond investments as well as investments in hedge funds. Onshore hedge funds escape the SEC registration requirement through an exemption in U.S. securities law. In order to qualify for this exemption, hedge funds must not advertise to the general public and may accept subscriptions from accredited investors only. In order to be an accredited investor an individual must have investment capital in excess of $1 million or an annual income greater than $200,000. The Investment Company Act limits the type of trading and leverage funds can employ and requires that the funds activities be disclosed to investors in a prospectus before their investments can be accepted. Hedge funds can make use of an exemption from the Investment Company Act by allowing no more than 99 accredited investors. The National Securities Market Improvement Act provides a further exemption which increases the number of investors to 500 if the investors are qualified purchasers. A qualified purchaser is a natural person with assets over $5 million or an institution (such as a pension fund) with over $25 million of assets. Thus hedge funds typically set extremely high minimum investment levels, ranging from $250,000 to over $1 million. The regulatory requirements faced by offshore funds vary by jurisdiction, but in general they are quite similar to U.S. regulations. Depending on the jurisdiction, offshore funds typically do not accept investments of taxable U.S. investors. The reasoning for this has to do with their own business conditions, desire to avoid additional provisions in the offering documentation and to avoid additional annual taxation work. As such, hedge fund asset management firms usually include both a domestic hedge fund and an offshore hedge fund with similar or identical investment strategies. This allows hedge fund managers to attract capital from all over the world. Hedge funds can have different organizational structures. The master-feeder fund structure is a combined and integrated structure that utilizes both onshore and offshore entities. Typically, a hedge fund investment manager will set up one offshore entity as a master fund to hold all of the underlying investments of the fund and one or more feeder funds to accept subscriptions from 9

investors. In most cases there will be both an onshore feeder fund, typically set-up as a limited partnership, and an offshore fund, typically set up as a corporation. The feeder funds will generally invest all of their assets in the master fund and by doing so the assets of the master fund are allocated to the feeder funds. This structure enables both domestic and offshore investors to participate in the same investment pool. The umbrella fund structure is a structure whereby a number of separate sub-funds or classes are each representing a separate group of investors and assets. It is typically set-up when the fund offers different strategies or fee structures. A fund of funds invests the assets of the fund in a portfolio of other underlying funds for diversification purposes. There are several legal documents which a fund requires. The most important one of these is the offering document which states the funds investment objective and policy risks, terms for investors to subscribe and redeem, the net asset value calculation method and the management and performance fee calculation and method. 1.4 Parties to a Fund The board of directors or general partners usually act in a non-executive capacity and the investment manager manages the assets of the fund. The investment manager will use one or more prime brokers to make the investments of the fund and for processing cash and settlement transactions. The custodian is responsible for the safekeeping of the assets and securities. A legal counsel provides legal advice. A fund can have both an onshore and an offshore legal counsel. An onshore legal counsel is used to ensure the fund complies with all applicable legislation. Independent auditors are appointed to audit the financial statements on an annual basis and give an independent audit opinion thereon. Hedge fund administrators offer accounting, administration, shareholder and corporate services to hedge funds. They can also provide custodial services. The added value for the investors of an independent administrator is the independent valuation of assets and liabilities, independent reconciliation of broker and bank accounts and independent calculation of management and performance fees. The added value for the hedge fund manager lies in the administrative and operational support and centralized expertise which independent administrators provide, thus enabling the manager to focus on the core activities. 10

1.5 Strategy and Risk The preliminary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive absolute 2 returns under all market conditions. There can be tremendous differences between hedge fund strategies; each of them having specific risk and return characteristics. Despite these differences they can be classified into three broad strategies: Relative Value, Event-Driven and Market Directional. Relative value strategies use equities and capital structure arbitrage. Such funds look for market inefficiencies to achieve performance. This strategy tries to eliminate market risk and is to a large extent market-neutral. Event-Driven strategies aim to achieve performance through specific events, such as mergers and corporate distress. Market directional strategies focus on interest and currencies and are the most commonly used and risky strategies. In addition to market and factor risk, there are several other types of risks that are faced by hedge funds. These can be broadly classified into four main types: systematic, structure, trading and organizational risk. Systematic risk includes market risk, common factor risk by taking large positions and the exposure for derivatives to interest rate and volatility changes. Structure risk stems from the freedom to leverage, from the performance fee reward which may result in increased risk taking and from the length of the lockup period which may lead to a forced unwinding of a profitable long run trading strategy. Trading risks such as specific risk are normally small, but can be exacerbated by the use of leverage. Trading risk further includes borrowing risk, counterparty credit risk, capacity risk (caused by limited market opportunities), illiquid assets, stale pricing risk (valuation of positions without recent market trades), herding risk (when the same opportunities are exploited by multiple managers at the same time) and position risk. Organizational risk incorporates errors in analyzing, trading, or recording positions, shift style risk (occurs when a fund manager with only a few or on expertise area decides to shift style), fraud and people risk (when losing key people with essential knowledge). 2 The return that an asset achieves over a period of time and does not compare it to any other measure 11

CHAPTER 2 Fee Structure This chapter considers the unique fee structure of hedge funds and the procedure for calculating the net asset value of a hedge fund. 2.1 Fees and High Water Marks When compared to traditional asset managers, the fees of hedge funds are much higher and considerably more complicated. Hedge fund managers typically receive two forms of compensation: an incentive fee and a management fee. The management fee is calculated as a fixed percentage of total assets under management, usually 1 to 2%, which should cover the expenses of operating a hedge fund. The performance fee is in general 20% of the profits generated by the hedge fund, though rates of 10%-25% are also not uncommon. Such fees are generally paid to the manager on a quarterly or annual basis. The fee structure creates a serious incentive for portfolio managers to generate positive returns. Fund managers typically invest a substantial amount of their own money in the fund also to ensure that their incentives and those of the investors are aligned. With many hedge funds, there is also a "high water mark." So that if an investor has any prior net losses allocated to him from a previous year, the manager will not receive an incentive fee from that investor until the net profits allocated to them exceeds the prior net losses. Thus no incentive fee is assessed until the net asset value exceeds the highest net asset value used for incentive fee calculations. This level of appreciation that the fund must achieve before the manager can receive the incentive fee is known as the high water mark. This protects an investor from being charged an incentive fee when their total cumulative return in the fund is negative. Subsequently hedge fund managers are only rewarded for performance. If they make money they do well, if they are flat or lose money they will receive only the management fee. Sometimes hedge funds also have a hurdle rate which the fund must perform above the high watermark before any incentive fee is payable. 12

2.2 Net Asset Value Calculation Due to the strategies hedge funds use and the fee structures they adopt, the calculation of a hedge funds net asset value is a complex procedure. The process of calculating the net asset value of a fund starts with the manager s trades. These listings are matched to corporate action data supplied by various vendors to a central securities database to price portfolios and determine accrued dividends and other corporate actions. Reconciliation matches the portfolio to the trades as fed from the manager or to portfolios produced by the bank or broker. Most net asset values are reported monthly. With this reporting goes a full set of financial statements, including assets and liabilities, a statement of operations, a statement of changes in net assets, and a portfolio. The offering document typically outlines the net asset value calculation procedure and which method of calculating and allocating the incentive fee on performance across the pool of investors will be utilized. Hedge funds investors appreciate an independent third-party verification of their funds results by a hedge fund administrator. 13

CHAPTER 3 Calculation Methods Given the fee structure of hedge funds the impact of the performance fee on the net asset value can be significant. There are different methodologies for allocating the incentive fee across investors. For investors it is important that the fee structure is equit able and transparent. The following chapter will outline various calculation methods available to onshore and offshore hedge funds for determining the net asset value, assuming a performance fee of 20% for all examples. This chapter will also aim to discuss the advantages and disadvantages of the various calculations. 3.1 The Onshore Hedge Fund As mentioned in the previous chapter onshore hedge funds are typically structured as limited partnerships, where the hedge fund manager is the general partner and the investors are the limited partners. The following section presents an example of an onshore partnership. See table 1 for an overview. Suppose investor A invests $1,000,000. After three months the fund grows to $1,500,000, at which time investor B invests $1,500,000. The fund reduces from a $3,000,000 pool to $1,000,000 six months later. At that point investor C decides to invest $500,000. The manager then turns what is now a $1,500,000 pool into $6,000,000 at year-end. Given the net asset value of the fund at the time of subscription of each investor and their subscription amount, each investor holds 33% of the funds total gross asset value 3. The incentive fee charged will be 20% of the profit. Therefore the manager will earn $600,000 of incentive fees and each investor s net asset value will be $1,800,000 for investor A, $1,900,000 for investor B and $1,700,000 for investor C. 3 Gross asset value is effectively the net asset value of the fund before deduction of performance fees paid to the fund manager 14

Thus, the performance of an onshore hedge fund set up as a limited partnership is allocated to each investor in proportion to their investment from the date of subscription to year-end (or at each withdrawal date), hence receiving individually portions of gains and losses. The incentive fees are calculated for each investor on his individual gains and so each investor pays an incentive fee only on the performance of his investment and therefore each investor is treated fair and equal. 3.2 The Offshore Hedge Fund For offshore funds which are structured as corporations the allocation of incentive fees across the pool of investors becomes quite complex. The difficulty rises from the fact that investors are offered shares, of which a number has to be issued each time an investor invests, and the value per share is traditionally used as a measure of the fund s performance. The timing of subscriptions and redemptions and the calculation method adopted can potentially impact the level of performance fees paid quite significantly. This paragraph illustrates and discusses no equalization and three of the most often used methods of equa lization for the offshore corporation. 3.2.1 No equalization The next examples are provided to illustrate what occurs to offshore hedge funds when no method of equalization is used. Table 2 presents an outline. Assume a hedge fund with a high water mark of 100. Investor A subscribes on January the 1 st 1 share for $100. Subsequently the share rises to $150, at which time shareholder B invests 1 share for $150. Then at year end the shares further rise to a gross asset value of $200. The incentive fee that the fund charges is $20 per share. The manager will be entitled to $20 times 2 shares. However investor B made a profit of only $50 and therefore should only pay $10 incentive fee. Investor B is over charged for $10 and the fund manager benefits unfairly. If the gross asset value at year-end would be $130 investor B should not be paying incentive fee, however in this 15

second situation he is charged $6 incentive fee. If the gross asset value would fall below high water mark at the end of the year, no incentive fee is charged. Now suppose shareholder A subscribes 1 share at $100 on January the 1 st and on June 30 th the gross asset value falls to $80, at which time shareholder B subscribes for 1 share at $80. At December the 31 st the fund moves up to $120. The incentive fee charged by the fund is $4 per share. The manager receives $4 times 2 shares. Since investor B made a profit of $40 per share, he should pay an incentive fee of $8. Investor B gets a free ride of $4 and the manager is not rightfully compensated. Unless the gross asset value at year end would drop below the subscription amount of investor B, the investor will be enjoying a free ride. As such, it is clear that if investors purchase shares at different times with different net asset values and no equalization method is adopted investors may be treated differently. Some shareholders will pay a proportionately lower or no incentive fee, and conversely, others will pay a higher incentive fee than they should. Thus, some shareholders are subsidizing other shareholders, to their own disadvantage. Further, the investment manager can be losing out on performance fee which he is rightfully entitled to. If investors understand this, they can adopt strategic behavior in the timing of subscribing and redee ming which results in reduced alignment of interest between the hedge fund manager and investors, which is unfavorable to overall fund performance. This is obviously unfair, so an adjustment should be required. 3.2.2 Equalization Many hedge funds adopt one of the various methodologies to allocate the performance fees across the pool of investors fairly, this process is called equalization. The three most widely used methods will be discussed with the use of examples. While there are many more methods the focus will be on these three as they are the most widely used within the offshore hedge fund industry and many of the other methods are based on of these three. 3.2.2.1 Multi series The multi-series method utilizes multiple net asset values. The shares are divided into series 16

which are usually tied to the calendar month (depending on the offering document) and the subscriptions of that month, each with a different high water mark. The following example demonstrates the multi-series method. Table 3a provides an overview of the following. At the end of January the fund manager turns a subscription of $1,000,000 from the beginning of the month into $2,000,000, which implies a profit of $1,000,000 for series I. The net asset value is $1,800,000 and the accrued fee $200,000. At the beginning of February there is a subscription of $1,000,000. The total gross asset value of the fund is now $3,000,000. Of this $3,000,000 one third belongs to series I and two third to series II. At the end of February there is a profit of $1,500,000, which is allocated proportionally to the initial investment against the total value of the fund at time of subscription. Thus the profit for series I is $1,000,000 and for series II $500,000. The gross asset value minus the initial investment multiplied by 20% gives the performance fee. Subsequently the accrued incentive fee in February for series I is $400,000 and for series II $100,000. In March there is a subscription for series III of $1,000,000 and a loss of $550,000 is incurred. In proportion to the initial subscription and total value of the fund the loss is divided in 55% for series I, 27% for series II and 18% for series III, respectively $300,000, $150,000 and $100,000. The gross asset value at the end of March is $2,700,000 for series I, $1,350,000 for series II and $900,000 for series III. The incentive fee for series I is $340,000 and for series II $70,000. No performance fee is charged for series III as the gross asset value is below the amount subscribed. The month end net asset value for series I is $2,360,000, for series II $1,280,000 and for series III $900,000. This example illustrates the impact on a total net asset value per series. Taking a look at the net asset value per series on a share level, suppose that the high water mark is set at 100, then the subscription of $1,000,000 divided by the high water mark of 100 gives 10,000 shares in series I. See table 3b for the overview. Each shareholder in series I at the end of January has $1,800,000 divided by 10,000 shares which is $180 per share. For series II the high water mark is set at 180, the last available net asset value per share of series I. With a subscription of $1,000,000 in February, there are 5,556 shares in series II, each with a net asset value of $1,400,000 divided by 5,556 shares which is $252 per share. For the investors in series I the net asset value per share at the end of February is $260. For series III the high water mark is 17

thus set at 260. The net asset value per share is $234 at month end for series III, which is below high water mark, thus, if incentive fees are paid quarterly, no performance fee is payable for series III. However, the net asset value for series I and II are above high water mark, hence these investors pay an incentive fees of $34 per share for series I and $12.60 per share for series II. When the incentive fee period ends all series that are above high water mark and therefore where a performance fee applies are rolled up into series I. The reason for this is to minimize the number of series and thus the number of net asset values. Hence the total net asset value of series II is added to series I. Series II will obtain the last net asset value of series I, which will also be the new high water mark. The number of shares of series II divided by the net asset value per share of series I plus the number of shares already in series I make up for a total of 15,424 shares in series I for the new incentive fee period. The loss of series III is carried forward to the next incentive period, the reason for this is that investors in series III otherwise would get the high water mark of series I, which would not be fair, because then series II could be charged an incentive fee that would not be appropriate. The fund first must recoup the loss before it can roll up series III into series I. The multi-series method mirrors the onshore limited partnership, as every series reflects a limited partner. Because it resembles a limited partnership many US investment managers and investors are familiar with this structure. It is also simple to explain for managers, lawyers and administrators. Another advantage is that every investor is treated on an individual basis, receiving individually portions of gains and losses and paying an incentive fee only on the performance of his investment. Some hedge funds divide the shares into several classes. A common reason for this being segregate to new issues 4 from non new issues is because some investors are not entitled to receive new issue income due to various restrictions. Each class encloses their own group of series. Due to the multiplicity of share classes on offer and the additional work involved in keeping track of such the method loses some of its appeal. In addition losses carried forward can lead to an unwieldy number of series of shares. The same investor who invests at different dates can have multiple net asset values, which might be confusing. It is also imaginable that large investors who are using nominee accounts might refuse 4 Stock, often an initial public offering, which is in great demand 18

to invest in hedge funds using multi-series because of the need to track the equalization account reporting they receive from the administrators all the way back to their (many) underlying client accounts. 3.2.2.2 Equalization / Depreciation Deposit The equalization depreciation deposit method reports one net asset value to all investors. This method utilizes an equalization capital when subscribing above high watermark and a depreciation deposit when subscribing below high water mark. Three examples of a subscription above high water mark and three examples of subscription below high water mark will be given for an offshore hedge fund with a high water mark of 100. Table 4 provides an overview of the examples. For the first three scenarios figure 1 shows an outline. Assume that shareholder A subscribes for 1 share at $100 on January 1 st and at June 30 th, when the gross asset value is $150, shareholder B then subscribes for 1 share at $150. The net asset value at that time is $140 and the unrealized incentive fee for investor A $10. The fund will record an equalization capital due of $10 for investor B, which represent the $10 unrealized incentive fee. This equalization capital due will be used to compensate the investor if necessary at the end of the performance fee period. In the first situation the gross asset value at year-end is $200 per share. The incentive fee per share is $20 and the net asset value therefore $180. However, for the allocation of the incentive fee among the investors shareholder B should only pay $10 per share, as his profit is $50. The manager will reimburse the equalization capital due and therefore investor B pays only $10, whereas investor A pays $20. The equalization capital will be returned in the form of shares. Investor B receives 10 divided by 180 which is 0.0556 shares, thus as a result shareholder B paid an incentive fee of $10. If investor B decides to redeem, the net asset value of his share will be $190. Presume for the second situation a gross asset value of $130 at the end of the year. As the fund treats each investor as if they stepped in at high water mark the incentive fee is $6 per share and so the net asset value $124 per share. However, investor B should not pay an incentive fee, because he made no profit and should be compensated for the $6. The difference will be paid by returning part of his equalization capital paid, in the form of shares, 6 divided by 124 which are 0.04839 shares. In the third situation suppose at year-end a gross asset value of $90 per share. No 19

incentive fee will be paid and no equalization capital is returned, because investor B does not need to be compensated. Figure 2 illustrates the next three examples of subscription below high water mark. Assume for all situations that shareholder A subscribes for 1 share at $100 on January 1 st and on June 30 th, when the gross asset value is $80, shareholder B subscribes for 1 share at $84. The net asset value is $80 per share. The fund charges investor B a depreciation deposit of $4, which represents the incentive fee that would be paid if the net asset value reaches the level of high water mark again. The fund will only invest the depreciation deposit in relatively safe assets, such as T-bills, thus the depreciation deposit will always be returnable. Suppose for the first situation at year-end a gross asset value of $120. The incentive fee is $4 per share, hence the net asset value is $116. The incentive fee for investor B should be $8. As a result of his depreciation deposit investor B prepaid the remaining $4 incentive fee, thus the depreciation deposit will not be refunded, but rather becomes payable to the manager. If the investor decides to redeem his share is worth $116. In the second situation the gross and net asset value on December 31 st is $95. Investor A does not pay an incentive fee, while the incentive fee for investor B is $3, thus $1 depreciation deposit will be returned. If the investor decides to redeem, the value of his share will be $96. For the final situation suppose a gross net asset value of 70 at the end of the year. Now investor A and investor B should not pay an incentive fee and thus investor B s prepaid depreciation deposit of $4 will be returned in full. Equalization depreciation deposit offers the benefit of an equitable allocation of incentive fee and the simplicity that one net asset value can be reported to all investors. Each investor pays the performance fee chargeable on the gain made on his investment only. Thus there is equality among investors, one shareholder does not effectively subsidize another and the manager gets paid the right amount. In addition equalization depreciation deposit offers the ease of reporting only one net asset value per share. This makes it easier for shareholders to track their performance. It is this combination which makes this approach attractive to investors and investment managers alike. However the disadvantage of this method is the prepaying of the depreciation deposit. Although, depending on the offering document in most cases this method comes short because of foregone interest. In addition the investor puts the money in a hedge 20

fund, while the depreciation deposit is not used for investing, which defies the purpose of the fund and investor. 3.2.2.3 Equalization / Forced Redemptions The equalization forced redemption method reports one net asset value to all shareholders. For subscriptions above the high water mark the equalization forced redemption method makes use of the equalization capital, similar to the equalization depreciation method, but for subscriptions below the high water mark this method redeems shares. Three examples for subscription below high water mark will be given for an offshore hedge fund with a high water mark of 100. See table 5 for an overview. Figures 1 and 2 illustrate these examples. Assume investor A subscribes for 1 share of $100 on January 1 st and on June 30 th, when the gross asset value is below high water mark at $80, shareholder B subscribes for 1 share at $80. The subscription net asset value for investor B is $80. Suppose in the first situation a gross asset value per share of $120 at year end. The net asset value is $116 and both investors pay an incentive fee of $4. However, investor B should pay $8 and does so by redeeming $4 divided by $116 which is 0.03448 shares. If investor B chooses to redeem, then share will be worth $112. In the second situation the gross asset value is $95 at the year end. Investor A pays no incentive fee. Investor B made a profit of $15 and pays the incentive fee of $3 to the fund manager by redeeming $3 divided by $95 totals 0.03158 shares. The value of his share becomes $92 if he decides to redeem. In the third situation the gross asset value is $70 at year end. Thus both investors do not have to pay an incentive fee and the redemption value stays the same. The beauty of equalization forced redemption is also one net asset value per share for all investors, whilst retaining the benefit of an equitable allocation of incentive fee. However, the disadvantage of this method for investors is that the redeeming of shares can be a taxable event. 3.3 Comparison of Structures and Methods For investors it is important that the fee structure is equitable and transparent. Onshore hedge fund investors are treated equal, while for offshore hedge fund investors problems arise because 21

of the involvement of shares. If investors purchase shares at different times with different net asset values, naïve calculations of incentive fees may treat the investors differently. This can have substantial impact on the performance for each investor. Therefore it can be argued that a method of equalization for allocating the performance fee across the pool of investors to ensure that investors are treated fair and equal is a necessity for most investors. The hedge fund manager will in all probability appreciate a method of equalization also, as without use of one he could be missing out on performance fees which he is entitled to. However, after looking at the calculation methods, which of the discussed is most equitable? The multi series method resembles the onshore structure and is thus a fair and even-handed method. On the other hand investors might find having multiple net asset values confusing. Both the depreciation deposit method as the forced redemption method treat all investors equal and benefit from the simplicity of one net asset value. Nevertheless the subscription price when entering below high water mark for the depreciation deposit method is higher then for the forced redemption method, as a fraction will be an on fore hand paid deposit which is not invested in the fund. If the redeeming of shares is not a taxable event then the forced redemption method is preferred given that the investor does not have to prepay the incentive fees. From the managers perspective it is not an issue since he will be fairly compensated with all equalization methods. 22

CHAPTER 4 Empirical Data The equalization methodologies for allocating performance fees across the pool of investors fairly is a relatively new concept. The equalization depreciation deposit method was only developed in the early nineties, multi-series was first introduced in 1994, and the equalization forced redemption started to be used around 1996. In this chapter a small empirical research will be made with the use of Citco s database to find out market trends and preferences as regards the adoption of approaches to incentive fee allocation. The market share of the main offshore hedge fund administrators is illustrated in figure 3. From this it can be seen that Citco is the clear global leader of offshore hedge fund administration services administering 27% of such funds world wide. The utilization of the various calculation methods by active offshore hedge funds worldwide in Citco s database is presented in figure 4. This shows that 53% of current offshore hedge funds use no equalization method and that there is a small preference for multi-series compared to other equalization methods. However, given that funds hardly ever switch calculation method once they are set-up, by dividing the funds and their calculation methods into time periods based on the start dates of a fund, this provides a timeline. The timeline, presented in figure 5, clearly shows an increase in the use of equalization methods. It also shows a considerable growth in use for the multi-series method, a steady growth for equalization forced redemption and a decline in use of the equalization depreciation deposit approach. Prior to 1995 few funds adopted equalization and many of the largest hedge funds within the industry do not use equalization. When many of these funds started, equalization as a concept was in its childhood and having already had a number of years of steady success behind them, the investment managers decided that if investors wanted in, then they could pay the entire package for the privilege. Further, as equalization was quite a new concept, neither investors nor managers where acquainted with the calculations involved or the necessity to use one method in the early days. In more recent years, with the arrival of the larger institutional investors (such as 23

pension funds) an attempt to eke out every last dime and dollar from an investment has become more and more customary. However, although the popularity of equalization is clearly growing, a lot of hedge funds still have not adopted a method of equalization. One reason for this, as mentioned before, hedge funds rarely switch from calculations method once set-up. There is not a big difference in the extent of the utilization of equalization forced redemption method and the multi-series method. However, in figure 5 it can be seen that the use of equalization forced redemption is growing slower, whereas the multi-series method is not only more widely used it has also grown more considerably. Based on Citco s database it looks like the hedge fund industry is moving towards multi-series as being the favorite method and seems to continue to grow in the future. 24

CHAPTER 5 Conclusion Looking at the different aspects of the hedge fund industry and the incentive fee calculations it can be clearly seen that equalization offers benefits to both investors and investment managers. The potential free ride when not using a form of equalization should be unacceptable to both investors and investment managers. The number of hedge funds using not adopting an equalization method is declining. Investors have definitely become more comfortable with the concept of equalization, but the majority of hedge funds are still not using an equalization method. While looking at the three equalization methods discussed, we cannot lose sight of the fact that the industry is based on personal preferences. At the present time the most widely adopted approach remains to be not to adopt any method. When comparing the depreciation deposit and forced redemption methods of equalization the examination of the calculation methods and review of the figures in Citco s database show that the benefit of avoiding a need to pay any upfront deposit makes the equalization forced redemption method the more favored method. However, an overall preference for multi-series is clearly shown and therefore it can be argued that reporting multiple net asset values is not as unpalatable as it may seem for investors. Based on the pro s and con s of the various methods and the figures from Citco s database, a move by the industry towards multi-series and equalization forced redemption will be beneficial for investors in the hedge fund industry. 25

APPENDIX Table 1: Limited Partnership 1-Jan 31-Mar 30-Sep 31-Dec P/L GAV P/L GAV P/L IF NAV Investor 500,000 (2,000,000) 6,000,000 A 1,000,000 500,000 1,500,000 (1,000,000) 500,000 2,000,000 200,000 1,800,000 B 1,500,000 (1,000,000) 500,000 2,000,000 100,000 1,900,000 C 500,000 2,000,000 300,000 1,700,000 totals 1,000,000 500,000 3,000,000 (2,000,000) 1,500,000 6,000,000 600,000 5,400,000 26

Table 2: No Equalization SUBSCRIPTION ABOVE HWM SUBSCRIPTION BELOW HWM Situation 1 Situation 1 Date Description Amount Date Description Amount 1-Jan HWM 100 1-Jan HWM 100 1-Jun SUB GAV 150 1-Jun SUB GAV 80 31-Dec GAV 200 31-Dec GAV 120 31-Dec Charged IF 20 31-Dec Charged IF 4 31-Dec NAV 180 31-Dec NAV 116 Correct IF Investor B 10 Correct IF Investor B 8 Over Charge 10 Free Ride 4 Situation 2 Situation 2 Date Description Amount Date Description Amount 1-Jan HWM 100 1-Jan HWM 100 1-Jun SUB GAV 150 1-Jun SUB GAV 80 31-Dec GAV 130 31-Dec GAV 95 31-Dec Charged IF 6 31-Dec Charged IF 0 31-Dec NAV 124 31-Dec NAV 95 Correct IF Investor B 0 Correct IF Investor B 3 Over Charge 6 Free Ride 3 Situation 3 Situation 3 Date Description Amount Date Description Amount 1-Jan HWM 100 1-Jan HWM 100 1-Jun SUB GAV 150 1-Jun SUB GAV 80 31-Dec GAV 90 31-Dec GAV 70 31-Dec Charged IF 0 31-Dec Charged IF 0 31-Dec NAV 90 31-Dec NAV 70 Correct IF Investor B 0 Correct IF Investor B 0 Over Charge 0 Free Ride 0 27

Table 3a: Mult-Series on a Fund Level All amounts * 1,000 1-Jan 31- Jan 28- Feb 31- Mar P/L GAV NAV IF P/L GAV NAV IF P/L GAV NAV IF Series NAV 1,000 1,500 (550) I 1,000 1,000 2,000 1,800 200 1,000 3,000 2,600 400 (300) 2,700 2,360 340 II 1,000 1,000-500 1,500 1,400 100 (150) 1,350 1,280 70 III 1,000 1,000 - (100) 900 900 - totals 1,000 1,000 3,000 2,800 200 1,500 5,500 5,000 500 (550) 4,950 4,540 410 Table 3b: Mult-Series on a Share Level Series Sub HWM #shares GAV NAV NAV per share 31-Jan I 1,000,000 100 10,000 2,000,000 1,800,000 180 II III 28-Feb I 100 10,000 3,000,000 2,600,000 260 II 1,000,000 180 5,556 1,500,000 1,400,000 252 III 31-Mar I 100 10,000 2,700,000 2,360,000 236 II 180 5,556 1,350,000 1,280,000 230 III 1,000,000 260 3,846 900,000 900,000 234 Roll-Up I 236 15,423.73 3,640,000 236 III 260 3,846 900,000 234 28

Table 4: Equalization Depreciation Deposit SUBSCRIPTION ABOVE HWM SUBSCRIPTION BELOW HWM Situation 1 Situation 1 Date Description Amount Date Description Amount 1-Jan HWM 100 1-JanHWM 100 1-Jun SUB GAV 150 1-JunSUB GAV 80 1-Jun SUB NAV 140 1-JunSUB NAV 80 1-Jun SUB equalization 10 1-JunSUB equalization 4 31-Dec GAV 200 31-Dec GAV 120 31-Dec NAV 180 31-Dec NAV 116 31-Dec EQ refund 100% 10 31-Dec EQ refund 100% 0 31-Dec Redemption/Market Value 190 31-Dec Redemption/Market Value 116 Situation 2 Situation 2 Date Description Amount Date Description Amount 1-Jan HWM 100 1-JanHWM 100 1-Jun SUB GAV 150 1-JunSUB GAV 80 1-Jun SUB NAV 140 1-JunSUB NAV 80 1-Jun SUB equalization 10 1-JunSUB equalization 4 31-Dec GAV 130 31-Dec GAV 95 31-Dec NAV 124 31-Dec NAV 95 31-Dec EQ refund 100% 6 31-Dec EQ refund 100% 1 31-Dec Redemption/Market Value 130 31-Dec Redemption/Market Value 96 Situation 3 Situation 3 Date Description Amount Date Description Amount 1-Jan HWM 100 1-JanHWM 100 1-Jun SUB GAV 150 1-JunSUB GAV 80 1-Jun SUB NAV 140 1-JunSUB NAV 80 1-Jun SUB equalization 10 1-JunSUB equalization 4 31-Dec GAV 90 31-Dec GAV 70 31-Dec NAV 90 31-Dec NAV 70 31-Dec EQ refund 100% 0 31-Dec EQ refund 100% 4 31-Dec Redemption/Market Value 90 31-Dec Redemption/Market Value 74 29

Table 5: Equalization Forced Redemptions SUBSCRIPTION ABOVE HWM SUBSCRIPTION BELOW HWM Situation 1 Situation 1 Date Description Amount Date Description Amount 1-Jan HWM 100 1-Jan HWM 100 1-Jun SUB GAV 150 1-Jun SUB GAV 80 1-Jun SUB NAV 140 1-Jun SUB NAV 80 1-Jun SUB equalization 10 1-Jun SUB equalization 0 31-Dec GAV 200 31-Dec GAV 120 31-Dec NAV 180 31-Dec NAV 116 31-Dec EQ refund 100% 10 31-Dec EQ refund 100% -4 31-Dec Redemption/Market Value 190 31-Dec Redemption/Market Value 112 Situation 2 Situation 2 Date Description Amount Date Description Amount 1-Jan HWM 100 1-Jan HWM 100 1-Jun SUB GAV 150 1-Jun SUB GAV 80 1-Jun SUB NAV 140 1-Jun SUB NAV 80 1-Jun SUB equalization 10 1-Jun SUB equalization 0 31-Dec GAV 130 31-Dec GAV 95 31-Dec NAV 124 31-Dec NAV 95 31-Dec EQ refund 100% 6 31-Dec EQ refund 100% -3 31-Dec Redemption/Market Value 130 31-Dec Redemption/Market Value 92 Situation 3 Situation 3 Date Description Amount Date Description Amount 1-Jan HWM 100 1-Jan HWM 100 1-Jun SUB GAV 150 1-Jun SUB GAV 80 1-Jun SUB NAV 140 1-Jun SUB NAV 80 1-Jun SUB equalization 10 1-Jun SUB equalization 0 31-Dec GAV 90 31-Dec GAV 70 31-Dec NAV 90 31-Dec NAV 70 31-Dec EQ refund 100% 0 31-Dec EQ refund 100% 0 31-Dec Redemption/Market Value 90 31-Dec Redemption/Market Value 70 30

Figure 1: Equalization Subscription Above HWM 31

Figure 2: Equalization Subscription Below HWM 32

Figure 3: Market Share Offshore Administrators Source: HFN proprietary research on over 2,000 offshore hedge funds with a total reported capital of $240 billion. 33

Figure 4: Calculation Methods Present 34

Figure 5: Timeline Calculation Methods 35

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