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EQUALIZATION

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EQUALIZATION

  1. 1. EQUALIZATIONEQUALIZATION Nidhish SinghNidhish Singh
  2. 2. What is Equalization ?What is Equalization ? Any open ended fund or hedge funds thatAny open ended fund or hedge funds that pays incentive or performance fees – thepays incentive or performance fees – the term "Equalization" refers to an accountingterm "Equalization" refers to an accounting methodology, designed to ensure that notmethodology, designed to ensure that not only the investment manager is paid theonly the investment manager is paid the correct incentive, performance or profitcorrect incentive, performance or profit sharing fee, but also that the incentive fees aresharing fee, but also that the incentive fees are fairly allocated between each investor in the fund.fairly allocated between each investor in the fund.
  3. 3. Why is equalization important?Why is equalization important? When there is active subscription andWhen there is active subscription and redemption activity in a fund, equalization isredemption activity in a fund, equalization is necessary to apportion the performance feenecessary to apportion the performance fee fairly amongst shareholders and ensuring thatfairly amongst shareholders and ensuring that inequities do not occur between shareholdersinequities do not occur between shareholders when a performance fees is levied.when a performance fees is levied.
  4. 4. TERMS OFTEN USED IN EQUALISATIONTERMS OFTEN USED IN EQUALISATION High Water Mark (HWM)High Water Mark (HWM) The highest peak in value that an investment fund/account hasThe highest peak in value that an investment fund/account has reached. This term is often used in the context of fund managerreached. This term is often used in the context of fund manager compensation, which is performance based.compensation, which is performance based. 0 5 10 15 20 25 30 35 40 Apr-06 May- 06 Jun- 06 Jul-06
  5. 5. Incentive Fee / Performance FeeIncentive Fee / Performance Fee A fee paid by the fund house to the fund manager for hisA fee paid by the fund house to the fund manager for his better performance (i.e. could be higher than the agreedbetter performance (i.e. could be higher than the agreed bench mark)bench mark) Performance fees can be a fair and useful tool to align thePerformance fees can be a fair and useful tool to align the interests of a manager with those of the clients, a way forinterests of a manager with those of the clients, a way for clients to cut their overall fee burden, or a way for anclients to cut their overall fee burden, or a way for an investment manager to expropriate large chunks of clientinvestment manager to expropriate large chunks of client wealth.wealth.
  6. 6. What is a Hurdle Rate?What is a Hurdle Rate? The required rate of return in aThe required rate of return in a discounteddiscounted cash flow analysis, above which ancash flow analysis, above which an investment makes sense and below which it does not. Often, this is based oninvestment makes sense and below which it does not. Often, this is based on the firm's cost of capital or weighted average cost of capital, plus or minus athe firm's cost of capital or weighted average cost of capital, plus or minus a risk premium to reflect the project's specific risk characteristics.risk premium to reflect the project's specific risk characteristics. On 1.4.2005 ,an investment is of Rs.10Crores and the minimum assured returnOn 1.4.2005 ,an investment is of Rs.10Crores and the minimum assured return a person would get say 8% pa (Government Bonds)a person would get say 8% pa (Government Bonds) Hence the interest return after one year would be 8 lacs.Hence the interest return after one year would be 8 lacs. At the end of one year, if the manager makes a profit of more than 8 lacs thenAt the end of one year, if the manager makes a profit of more than 8 lacs then the manager is eligible to get the performance fees, on the difference betweenthe manager is eligible to get the performance fees, on the difference between the actual return earned (-) minimum assured return i.e. 8lacsthe actual return earned (-) minimum assured return i.e. 8lacs
  7. 7. ii Investor A buys one Share at US$100Investor A buys one Share at US$100 iiii End of first quarter Gross NAV per Share has risen toEnd of first quarter Gross NAV per Share has risen to US$110US$110 iiiiii NAV per share published at US$108 - (US$110 - US$2NAV per share published at US$108 - (US$110 - US$2 incentive fee)incentive fee) iviv New High Watermark - US$110New High Watermark - US$110 vv At end of the following month, the NAV per Share falls toAt end of the following month, the NAV per Share falls to US$100US$100 vivi Investor B buys one Share at US$100Investor B buys one Share at US$100 viivii High watermark still US$110High watermark still US$110 viiiviii If NAV per Share rises to US$110 again, Investor B will haveIf NAV per Share rises to US$110 again, Investor B will have a US$2 (20% of US$10 profit) "Free Ride"a US$2 (20% of US$10 profit) "Free Ride" THE FREE RIDETHE FREE RIDE A free ride is a person who pays less for a good than her or hisA free ride is a person who pays less for a good than her or his true marginal willingnessto pay; that is, a person whotrue marginal willingnessto pay; that is, a person who underpays relative to the benefits he receives.underpays relative to the benefits he receives.
  8. 8. The Rising Share PriceThe Rising Share Price i)i) Investor A buys one Share at US$100Investor A buys one Share at US$100 ii)ii) NAV per share rises in the second month to US$110NAV per share rises in the second month to US$110 iii)iii) NAV per Share published at US$108, net of 20% incentive fee accrualNAV per Share published at US$108, net of 20% incentive fee accrual iv)iv) Investor B buys one share at US$108Investor B buys one share at US$108 v)v) At quarter-end, the Gross NAV per Share has risen to US$120At quarter-end, the Gross NAV per Share has risen to US$120 vi)vi) Gross profit is US$32, calculated as follows:Gross profit is US$32, calculated as follows: a) Investor A invested: US$100a) Investor A invested: US$100 b) Investor B invested: US$108b) Investor B invested: US$108 Total invested: US$208Total invested: US$208 c) Gross NAV at end Qt: US$240c) Gross NAV at end Qt: US$240 Gross Profit: US$ 32Gross Profit: US$ 32 vii)vii) Incentive fee at 20% of US$32 = US$6.4 Gross, or US$3.2 per ShareIncentive fee at 20% of US$32 = US$6.4 Gross, or US$3.2 per Share viii)viii) NAV per Share = (US$240 2) = (US$ 120 - US$3.2 incentive fee) = US$116.8 per ShareNAV per Share = (US$240 2) = (US$ 120 - US$3.2 incentive fee) = US$116.8 per Share ix)ix) Therefore:Therefore: a) Investor A effectively pays US$3.2 incentive fee on a profit of US$20, which equals 16.4% of the profit made bya) Investor A effectively pays US$3.2 incentive fee on a profit of US$20, which equals 16.4% of the profit made by Investor A; whereas,Investor A; whereas, b) Investor B effectively pays US$3.2 incentive fee on a profit of US$12, which equals 26.66% of the profit made byb) Investor B effectively pays US$3.2 incentive fee on a profit of US$12, which equals 26.66% of the profit made by Investor BInvestor B
  9. 9. The Claw Back SyndromeThe Claw Back Syndrome i)i) Investor A buys one Share at US$100 per share at launch.Investor A buys one Share at US$100 per share at launch. ii)ii) At the end of the second month the gross NAV per share has risen to US$110, i.e. US$108 net of incentive fee accrual.At the end of the second month the gross NAV per share has risen to US$110, i.e. US$108 net of incentive fee accrual. iii)iii) Investor B now buys one share at US$108Investor B now buys one share at US$108 iv)iv) The NAV of the fund is now US$218 excluding incentive fee accrualThe NAV of the fund is now US$218 excluding incentive fee accrual v)v) The fund loses US$26 in month three. The Gross NAV falls down to US$192 or US$96 per share.The fund loses US$26 in month three. The Gross NAV falls down to US$192 or US$96 per share. vi)vi) The loss per share should be US$26 2, which equals US$13 per share.The loss per share should be US$26 2, which equals US$13 per share. vii)vii) Given that the fund lost US$13 per share, the fair value of Investor A's investment should be US$97 (US$110 - US$13)Given that the fund lost US$13 per share, the fair value of Investor A's investment should be US$97 (US$110 - US$13) whereas the fair value for investor B would be US$95 (US$108 less US$13).whereas the fair value for investor B would be US$95 (US$108 less US$13). viii)viii) The actual loss to Investor A is US$14 (US$110 less US$96), whereas the loss to Investor B is actually US$12 (US$108The actual loss to Investor A is US$14 (US$110 less US$96), whereas the loss to Investor B is actually US$12 (US$108 invested less US$96).invested less US$96).
  10. 10. Series of shares & consolidated methodSeries of shares & consolidated method It requires the fund to issue a new Series of Shares each time there is aIt requires the fund to issue a new Series of Shares each time there is a subscription. Every month, when calculating the NAV per Share, the correctsubscription. Every month, when calculating the NAV per Share, the correct incentive fee accruals, if any, are applied to each of the Series separately. Theincentive fee accruals, if any, are applied to each of the Series separately. The first Series of Shares, which are issued when the fund is launched, is usuallyfirst Series of Shares, which are issued when the fund is launched, is usually known as the "Lead Series". The objective is to consolidate each of theknown as the "Lead Series". The objective is to consolidate each of the subsequent Series issued into the Lead Series, at the end of every accountingsubsequent Series issued into the Lead Series, at the end of every accounting period, providing an incentive fee has been paid for each of the Series,period, providing an incentive fee has been paid for each of the Series, including the Lead Series. This may be quarterly, half-yearly, or annually.including the Lead Series. This may be quarterly, half-yearly, or annually. The advantage of this system is that it is a relatively simple procedure and,The advantage of this system is that it is a relatively simple procedure and, investors can understand how it works and can see that it is fair to all parties.investors can understand how it works and can see that it is fair to all parties.
  11. 11. Series of shares & consolidated method –risingSeries of shares & consolidated method –rising marketmarket i)i) Investor A buys 1,000 Lead Series Shares at US$1,000 per ShareInvestor A buys 1,000 Lead Series Shares at US$1,000 per Share ii)ii) End of first month, GNAV per Share has risen 10% to US$1,100End of first month, GNAV per Share has risen 10% to US$1,100 iii)iii) NAV published at US$1,080 (US$1,100 less US$20 incentive fee)NAV published at US$1,080 (US$1,100 less US$20 incentive fee) iv)iv) Investor B now buys 1,000 Series II Shares at US$1,000 per ShareInvestor B now buys 1,000 Series II Shares at US$1,000 per Share v)v) End of second month, value of fund has risen by further 10% so that:End of second month, value of fund has risen by further 10% so that: a) GNAV of Lead Series is now US$1,210 = NAV US$1,168; anda) GNAV of Lead Series is now US$1,210 = NAV US$1,168; and b) GNAV of Series II is now US$1,100 = NAV US$1,080b) GNAV of Series II is now US$1,100 = NAV US$1,080 vi)vi) Investor C buys 1,000 Series III Shares at US$1,000 per ShareInvestor C buys 1,000 Series III Shares at US$1,000 per Share vii)vii) End of third month, fund value has again risen by 10% so that:End of third month, fund value has again risen by 10% so that: (i) GNAV of Lead Series is now US$1,331 = NAV US$1,264.80;(i) GNAV of Lead Series is now US$1,331 = NAV US$1,264.80; (ii) GNAV of Series II is now US$1,210 = NAV US$1,168; and(ii) GNAV of Series II is now US$1,210 = NAV US$1,168; and (iii) GNAV of Series III is now US$1,080(iii) GNAV of Series III is now US$1,080 viii)viii) As it is the end of the quarter and new HWM has been achieved, the incentive fees are paidAs it is the end of the quarter and new HWM has been achieved, the incentive fees are paid ix)ix) Series II and Series III Shares are then consolidated into Lead SeriesSeries II and Series III Shares are then consolidated into Lead Series x)x) Thus:Thus: a) Investor B exchanges 1,000 Series II Shares, now worth US$1,168,000 for 923.466 Lead Series Shares ata) Investor B exchanges 1,000 Series II Shares, now worth US$1,168,000 for 923.466 Lead Series Shares at US$1,264.80US$1,264.80 b) Investor C exchanges 1,000 Series III Shares, now worth US$1,080,000 for 853.890 Lead Series Sharesb) Investor C exchanges 1,000 Series III Shares, now worth US$1,080,000 for 853.890 Lead Series Shares
  12. 12. Series of shares & consolidated method –volatileSeries of shares & consolidated method –volatile marketmarket i)i) Investor A buys 1,000 Lead Series Shares at US1,000 per ShareInvestor A buys 1,000 Lead Series Shares at US1,000 per Share ii)ii) End of first month, GNAV per Share has risen 10% to US$1,100End of first month, GNAV per Share has risen 10% to US$1,100 iii)iii) NAV published at US$1,080 (US$1,100 less US$20 incentive fee)NAV published at US$1,080 (US$1,100 less US$20 incentive fee) iv)iv) Investor B now buys 1,000 Series II Shares at US$1,000 per ShareInvestor B now buys 1,000 Series II Shares at US$1,000 per Share v)v) End of second month, value of fund has risen by further 10% so that:End of second month, value of fund has risen by further 10% so that: a) GNAV of Lead Series is now US$1,210 = NAV US$1,168; anda) GNAV of Lead Series is now US$1,210 = NAV US$1,168; and b) GNAV of Series II is now US$1,100 = NAV US$1,080b) GNAV of Series II is now US$1,100 = NAV US$1,080 vi)vi) Investor C buys 1,000 Series III Shares at US$1,000 per ShareInvestor C buys 1,000 Series III Shares at US$1,000 per Share vii)vii) End of third month GNAV has declined by 4% so that:End of third month GNAV has declined by 4% so that: (a) GNAV of Lead Series is US$1,161.6 = NAV US$1,129.28(a) GNAV of Lead Series is US$1,161.6 = NAV US$1,129.28 (b) GNAV of Series II is US$1,056 = NAV US$1,044.8(b) GNAV of Series II is US$1,056 = NAV US$1,044.8 (c) GNAV of Series III is US$960 = NAV US$960(c) GNAV of Series III is US$960 = NAV US$960 viii)viii) At this time an incentive fee is paid on the Lead Series and Series II, but obviously not on Series IIIAt this time an incentive fee is paid on the Lead Series and Series II, but obviously not on Series III ix)ix) Therefore, Series II will be consolidated into the Lead Series = but Series III will have to wait until a new HWMTherefore, Series II will be consolidated into the Lead Series = but Series III will have to wait until a new HWM has been achievedhas been achieved
  13. 13. Disadvantage of Series MethodDisadvantage of Series Method • Many funds only pay incentive fees once a year and this means that the SeriesMany funds only pay incentive fees once a year and this means that the Series of Shares and Consolidation Method can be quite cumbersome, if a fund is aof Shares and Consolidation Method can be quite cumbersome, if a fund is a heavily traded, expanding fund, then by the end of the year it could haveheavily traded, expanding fund, then by the end of the year it could have twelve separate Series in issue. And of course, if it is a losing year, then it istwelve separate Series in issue. And of course, if it is a losing year, then it is possible that that could go up to twenty-four Series being issued, before thepossible that that could go up to twenty-four Series being issued, before the next accounting period is finished.next accounting period is finished. • It’s not possible to publish a single NAV per Share, because each Series hadIt’s not possible to publish a single NAV per Share, because each Series had its own NAV. There is no real problem in publishing several different NAVs,its own NAV. There is no real problem in publishing several different NAVs, but it could be confusing to some shareholders, particularly if they makebut it could be confusing to some shareholders, particularly if they make several investments into the fund over a period of time and so end up withseveral investments into the fund over a period of time and so end up with holdings that have different NAVs.holdings that have different NAVs. • Fund's whose Shares are listed on a Stock Exchange, will probably beFund's whose Shares are listed on a Stock Exchange, will probably be necessary to apply to list each Share in issue. This is administratively timenecessary to apply to list each Share in issue. This is administratively time consuming and therefore expensive and again there is the problem of havingconsuming and therefore expensive and again there is the problem of having to publish the full list of NAVs.to publish the full list of NAVs.
  14. 14. The Wish ListThe Wish List • Equitable allocation of incentive feesEquitable allocation of incentive fees • All investors have same capital risk per share.All investors have same capital risk per share. • Single NAV per share.Single NAV per share. • Published NAV accurately reflects the fundsPublished NAV accurately reflects the funds performance.performance. • Method used should be easily understood.Method used should be easily understood.
  15. 15. What is Simple Equalization?What is Simple Equalization? • Simple Equalization", the procedure is to calculate theSimple Equalization", the procedure is to calculate the performance fee and allocate it fairly between eachperformance fee and allocate it fairly between each investor, or group of investors at the end of eachinvestor, or group of investors at the end of each accounting period. As investors will have come in ataccounting period. As investors will have come in at different levels this will mean calculating differentdifferent levels this will mean calculating different NAVs per investor. However, in order to get aNAVs per investor. However, in order to get a common NAV for all Shares in the fund, the lowest ofcommon NAV for all Shares in the fund, the lowest of all the NAVs calculated, on an investor-by-investorall the NAVs calculated, on an investor-by-investor basis, is selected to become the NAV of the fund.basis, is selected to become the NAV of the fund.
  16. 16. Types of equalizationTypes of equalization • Simple equalization-rising market.Simple equalization-rising market. • Simple equalization-volatile market.Simple equalization-volatile market. • Simple equalization –falling market.Simple equalization –falling market. • Equalization factor / Depreciation depositEqualization factor / Depreciation deposit.. • Equalization adjustment approach.Equalization adjustment approach. • Equalization approach-Decline marketEqualization approach-Decline market • Investment Mgmt Agreement-Failure to adjustInvestment Mgmt Agreement-Failure to adjust for redemptionsfor redemptions
  17. 17. Simple equalization-rising marketSimple equalization-rising market Shareholders with a higher individual NAV perShareholders with a higher individual NAV per share are issued "Equalization Shares", so that theshare are issued "Equalization Shares", so that the total number of Shares issued to that investor (i.e.-total number of Shares issued to that investor (i.e.- the original Shares purchased plus anythe original Shares purchased plus any Equalization Shares) multiplied by the new NAV ofEqualization Shares) multiplied by the new NAV of the fund, which we know is the lowest NAVthe fund, which we know is the lowest NAV calculated, will now enable the investment forcalculated, will now enable the investment for those investors to be kept constant.those investors to be kept constant.
  18. 18. Simple equalization-rising marketSimple equalization-rising market i)i) Launch:Launch: Investor A buys 1,000 shares at US$100Investor A buys 1,000 shares at US$100 = US$100,000= US$100,000 ii)ii) End Month 1:End Month 1: GNAV = US$110GNAV = US$110 iii)iii) Investor A NAV = US$108 (US$110 minus US$2 incentive fee)Investor A NAV = US$108 (US$110 minus US$2 incentive fee) = US$108,000= US$108,000 iv)iv) Investor B buys 1,000 shares at US$108.Investor B buys 1,000 shares at US$108. = US$108,000= US$108,000 v)v) Total NAV of the fundTotal NAV of the fund = US$216,000= US$216,000 vi)vi) End Month 2:End Month 2: GNAV = US$120GNAV = US$120 vii)vii) Investor A NAV = US$116 (US$120 minus US$4 incentive feeInvestor A NAV = US$116 (US$120 minus US$4 incentive fee = US$116,000= US$116,000 viii)viii) Investor B NAV = US$1176 (US$120 minus US$2.4 incentive feeInvestor B NAV = US$1176 (US$120 minus US$2.4 incentive fee = US$117,600= US$117,600 ix)ix) Published NAVPublished NAV = US$116= US$116 a) Investor B has 1,000 shares @ US$116a) Investor B has 1,000 shares @ US$116 = US$116,000= US$116,000 b) Investor B allocated 13.793 shares @ US$116b) Investor B allocated 13.793 shares @ US$116 = US$1,600= US$1,600 Total ValueTotal Value = US$117,600= US$117,600
  19. 19. Simple equalization-volatile marketSimple equalization-volatile market i)i) End Month 3: GNAV = US$105End Month 3: GNAV = US$105 ii)ii) Investor A NAV = US$104 (US$105 minus US$1 incentive fee)Investor A NAV = US$104 (US$105 minus US$1 incentive fee) iii)iii) Investor B NAV = US$105 (No incentive fee)Investor B NAV = US$105 (No incentive fee) iv)iv) Published NAV = US$104Published NAV = US$104 a) Investor B has 1,000 shares @ US$104 = US$104,000a) Investor B has 1,000 shares @ US$104 = US$104,000 b) Investor B allocated 9.6154 shares @ US$104 = US$ 1,000b) Investor B allocated 9.6154 shares @ US$104 = US$ 1,000 Total Value = US$105,000Total Value = US$105,000 Simple equalization-falling marketSimple equalization-falling market i)i) End Month 4End Month 4:: GNAV = US$98GNAV = US$98 ii)ii) Investor A NAV = US$98 - no incentive feeInvestor A NAV = US$98 - no incentive fee iii)iii) Investor B NAV = US$98 - no incentive feeInvestor B NAV = US$98 - no incentive fee iv)iv) No Equalization shares issued because NAVs are equalNo Equalization shares issued because NAVs are equal
  20. 20. Equalization Factor / Depreciation DepositEqualization Factor / Depreciation Deposit • In this case each investor invests at the NAV, plus either theIn this case each investor invests at the NAV, plus either the Equalization Factor or the Depreciation Deposit, dependingEqualization Factor or the Depreciation Deposit, depending upon whether the NAV of the Fund has increased or declinedupon whether the NAV of the Fund has increased or declined from the last high water-mark.from the last high water-mark. • If the NAV has risen during the period, then a new subscriberIf the NAV has risen during the period, then a new subscriber would invest the equivalent of the GNAV, to place the samewould invest the equivalent of the GNAV, to place the same amount of money at risk as the existing shareholders, theamount of money at risk as the existing shareholders, the difference between the NAV and the GNAV being thedifference between the NAV and the GNAV being the Equalization Factor. If the fund maintains its performance, theEqualization Factor. If the fund maintains its performance, the Equalization Factor paid will be refunded in Shares, at the end ofEqualization Factor paid will be refunded in Shares, at the end of the incentive fee calculation period. If, however, the fundthe incentive fee calculation period. If, however, the fund subsequently loses value the Equalization will be lost for thatsubsequently loses value the Equalization will be lost for that period, but is refundable, in the future, if the fund recovers. Thisperiod, but is refundable, in the future, if the fund recovers. This avoids the claw-back syndrome.avoids the claw-back syndrome.
  21. 21. If, on the other hand, the fund's NAV is at a discountIf, on the other hand, the fund's NAV is at a discount to the high water-mark at the time that an investorto the high water-mark at the time that an investor makes a subscription, then the investor will be requiredmakes a subscription, then the investor will be required to pay a Depreciation Deposit equal to the incentive feeto pay a Depreciation Deposit equal to the incentive fee that would be payable if his shares rose to the HWM. Ifthat would be payable if his shares rose to the HWM. If the fund starts to improve and recoup its losses, thenthe fund starts to improve and recoup its losses, then the Depreciation Deposit becomes payable to thethe Depreciation Deposit becomes payable to the Investment Advisor as a performance fee. This avoidsInvestment Advisor as a performance fee. This avoids the 'free ride' syndrome.the 'free ride' syndrome. If the NAV declines, then the Deposit is paid back toIf the NAV declines, then the Deposit is paid back to the investor upon a redemption.the investor upon a redemption. Equalization Factor / Depreciation DepositEqualization Factor / Depreciation Deposit
  22. 22. Equalization Adjustment ApproachEqualization Adjustment Approach • The Equalization Adjustment Approach, the investor willThe Equalization Adjustment Approach, the investor will subscribe at the GNAV, but if the NAV, at the time ofsubscribe at the GNAV, but if the NAV, at the time of subscription, is above the previous high watermark, then thesubscription, is above the previous high watermark, then the investor will receive an Equalization Credit for that portion ofinvestor will receive an Equalization Credit for that portion of the NAV which represents the incentive fee accrual, (which thethe NAV which represents the incentive fee accrual, (which the investor has paid within the GNAV). Like the Equalizationinvestor has paid within the GNAV). Like the Equalization Factor, if, at the end of the accounting period the NAV is stillFactor, if, at the end of the accounting period the NAV is still showing a profit, or an increased profit, the investor will be paidshowing a profit, or an increased profit, the investor will be paid his Equalization Credit by way of an allocation of additionalhis Equalization Credit by way of an allocation of additional Shares in the fund. If, however, the fund's NAV declines beforeShares in the fund. If, however, the fund's NAV declines before the accounting period ends, then the Equalization Credit willthe accounting period ends, then the Equalization Credit will decline pro rata, but is recoupable, if the NAV rises again.decline pro rata, but is recoupable, if the NAV rises again.
  23. 23. Equalization Adjustment ApproachEqualization Adjustment Approach i)i) Launch at US$100 per shareLaunch at US$100 per share ii)ii) Investor A buys 1,000 shares @ US$100 Cost = US$100,000Investor A buys 1,000 shares @ US$100 Cost = US$100,000 iii)iii) End Month 1: GNAV = US$120End Month 1: GNAV = US$120 iv)iv) Investor A NAV (US$120 minus US$4 incentive) = US$116 NAV = US$116,000Investor A NAV (US$120 minus US$4 incentive) = US$116 NAV = US$116,000 v)v) Investor B subscribes GNAV (US$120) for 1,000 shares Cost = US$120,000Investor B subscribes GNAV (US$120) for 1,000 shares Cost = US$120,000 vi)vi) This comprises:This comprises: 1,000 shares @ US$116 NAV = US$116,0001,000 shares @ US$116 NAV = US$116,000 Equalization credit = (incentive fee) = US$ 4,000Equalization credit = (incentive fee) = US$ 4,000 Total subscribed = US$120,000Total subscribed = US$120,000 vii)vii) End Month 2: GNAV = US$130End Month 2: GNAV = US$130 viii)viii) Investor A NAV = US$124 (US$130 - US$6 incentive fee) NAV = US$124,000Investor A NAV = US$124 (US$130 - US$6 incentive fee) NAV = US$124,000 ix)ix) Investor B NAV = US$128 (US$130 - US$2 incentive fee) Total = US$128,000Investor B NAV = US$128 (US$130 - US$2 incentive fee) Total = US$128,000 x)x) This will be comprised of:This will be comprised of: Investor B = 1,000 shares @ US$124 = US$124,000Investor B = 1,000 shares @ US$124 = US$124,000 Equalization credit = US$ 4,000Equalization credit = US$ 4,000 Total = US$ 128,000 US$128,000Total = US$ 128,000 US$128,000 xi)xi) Total Fund NAV = US$252,000Total Fund NAV = US$252,000 xii)xii) Cross check:Cross check: a) GNAV (2,000 x US$130 = US$260,000a) GNAV (2,000 x US$130 = US$260,000 b)Total Subscribed: Investor A = US$100,000b)Total Subscribed: Investor A = US$100,000 Investor B = US$120,000Investor B = US$120,000 Total subscribed = US$220,000 US$220,000Total subscribed = US$220,000 US$220,000 ADD Gross Profit = US$ 40,000ADD Gross Profit = US$ 40,000 GNAV = US$260,000GNAV = US$260,000 DEDUCT Incentive 20% = US$ 8,000DEDUCT Incentive 20% = US$ 8,000 Thus Net Profit = US$32,000Thus Net Profit = US$32,000 xiii)xiii) Add net profit to sum subscribed NAV = US$252,000Add net profit to sum subscribed NAV = US$252,000
  24. 24. • If the investor subscribes during a loss, period, he willIf the investor subscribes during a loss, period, he will still pay the GNAV (which, in this case, will be thestill pay the GNAV (which, in this case, will be the same as the NAV), so that he has the same amount ofsame as the NAV), so that he has the same amount of capital risk as existing shareholders, but he will alsocapital risk as existing shareholders, but he will also receive what is described as an "Equalization Deficit".receive what is described as an "Equalization Deficit". If the fund subsequently increases in value by the endIf the fund subsequently increases in value by the end of the calculation period, a certain number of theof the calculation period, a certain number of the investor's Shares will be redeemed to equate to theinvestor's Shares will be redeemed to equate to the Equalization Deficit, (or that part of it that isEqualization Deficit, (or that part of it that is applicable) and the proceeds paid to the Investmentapplicable) and the proceeds paid to the Investment Manager.Manager. Equalization approach-Decline marketEqualization approach-Decline market
  25. 25. Equalization approach-Decline marketEqualization approach-Decline market i)i) Investor A buys 1,000 shares @ US$100Investor A buys 1,000 shares @ US$100 ii)ii) Investor B buys 1,000 shares @ US$120, inclusive of US$4 Equalization Credit as beforeInvestor B buys 1,000 shares @ US$120, inclusive of US$4 Equalization Credit as before iii)iii) End Month 2:GNAV = US$105End Month 2:GNAV = US$105 iv)iv) Investor A NAV = US$104 (US$105 US$1 incentiveInvestor A NAV = US$104 (US$105 US$1 incentive v)v) Investor B = US$105Investor B = US$105 Comprised of NAV: US$104Comprised of NAV: US$104 Equalization Credit: US$ 1Equalization Credit: US$ 1 Total Value US$105Total Value US$105 vi)vi) End Month 3: GNAV = US$98End Month 3: GNAV = US$98 vii)vii) Investor A NAV = US$98 (no incentive fee)Investor A NAV = US$98 (no incentive fee) viii)viii) Investor B NAV = US$98 (no Equalization credit)Investor B NAV = US$98 (no Equalization credit)
  26. 26. Investment Mgmt Agreement-Failure to adjust forInvestment Mgmt Agreement-Failure to adjust for redemptionsredemptions It is essential to ensure that the Equalization method chosenIt is essential to ensure that the Equalization method chosen complies with the Investment Management Agreement. Manycomplies with the Investment Management Agreement. Many Investment Management Agreements state that the InvestmentInvestment Management Agreements state that the Investment Manager will be paid an incentive fee of 20% of profits. Thus, ifManager will be paid an incentive fee of 20% of profits. Thus, if a loss occurs, the Investment Manager has to recoup the totala loss occurs, the Investment Manager has to recoup the total loss before any further incentive fees can be paid. What must beloss before any further incentive fees can be paid. What must be made clear is that, if an investor redeems during a draw downmade clear is that, if an investor redeems during a draw down period and thereby accepts a portion of the loss, the amount ofperiod and thereby accepts a portion of the loss, the amount of loss that the Investment Manager has to recoup will be reducedloss that the Investment Manager has to recoup will be reduced pro ratapro rata
  27. 27. Investment Mgmt Agreement-Failure to adjust forInvestment Mgmt Agreement-Failure to adjust for redemptionsredemptions i)i) 4 Investors subscribe US$1 million each.4 Investors subscribe US$1 million each. Total NAV = US$4,000,000Total NAV = US$4,000,000 ii)ii) NAV declines by 20%.NAV declines by 20%. Loss = (US$ 800,000)Loss = (US$ 800,000) iii)iii) Thus, Total NAVThus, Total NAV = US$3,200,000= US$3,200,000 iv)iv) One Investor redeems his holdingOne Investor redeems his holding =(=(US$ 800,000US$ 800,000)) Remaining NAVRemaining NAV = US$2,400,000= US$2,400,000 v)v) If Investment Manager has to recoup full lossIf Investment Manager has to recoup full loss == US$800,000US$800,000 Total NAV will beTotal NAV will be = US$3,200,000= US$3,200,000 vi)vi) Therefore, 3 remaining shareholders will have made US$200,000 "free ride" between themTherefore, 3 remaining shareholders will have made US$200,000 "free ride" between them
  28. 28. THANK YOUTHANK YOU

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