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By Anthony Stocks, President, Tennyson Capital, a London based hedge fund consulting firm. This article appeared in the August 1994 issue of Fund News┐

The issues that accountants and lawyers have had to come to grips with in calculating incentive fees may become quite complex in setting up offshore funds in corporate form. The major obstacle to overcome is to mirror the partnership method of allocating gains where each investor’s capital account receives individually allocated portions of gains and losses. The difficulty stems from the fact that investors are usually offered a single class of shares, of which a fixed number has to be issued each time an investor invests, and which is traditionally used also as a measure of the fund’s performance. At year-end, a mid-year investor should pay an incentive fee only on his individual gains. If the fund has previously accrued an incentive fee which is later reversed, the high water mark of the fund, the point from which profits get charged 20%, may no longer be his individual high water mark. To compensate, adjustments are made either to the number of shares held by investors or to the net asset value per share. The losses incurred by the vast majority of hedge funds so far in 1994 have made the treatment of performance fees a burning issue. An added complication exists for the increasing number of managers who are registered under the Investment Advisers Act which prohibits the payment of an incentive fee for performance of less than twelve months.

Why are offshore hedge funds generally set up as corporations rather than partnerships? The offshore arm of the hedge fund industry dates from the late 1960’s. Then, the jurisdiction of choice was the Netherlands Antilles which had a favorable tax treaty with the U.S. The treaty benefits applied only if the fund was set up as a corporation. Through the late 1980’s and the 1990’s, when the benefits of the tax treaty no longer existed, hedge funds were also set up in the British Virgin Islands, Bermuda, Cayman Islands and elsewhere. Following the model of the 1960’s, they continued to be set up as corporations as the European investor was most comfortable with this structure.

Suppose that a volatile hedge fund manager starts a U.S. partnership with $1,000,000 from investor A, turns it into $1,500,000 gross after three months, then gets investor B to put in $1,500,000 and manages to turn this $3,000,000 pool into $1,000,000 by September 30. That $1,000,000 is then equally shared between A and B. At that point, investor C, a buy low type, decides to invest $500,000. Boosted by his confidence and improving markets, the manager turns what is now a $1,500,000 pool into $6,000,000 by year end, creating an aggregate profit of $3,000,000 on the investors’ total investment of $3,000,000. The 20% incentive fee would earn the manager $600,000. A, B and C’s year-end capital accounts would aggregate $5,400,000 divided into $1,800,000 for A, $1,900,000 for B and $1,700,000 for C, with each being charged 20% of their respective gain. The manager’s net performance for the year is reflected by A’s account which went up by 80%. The answers are not so simple if A, B and C are non-American and invested by buying shares in an offshore corporation managed exactly in the same way. There are five principal methods of dealing with incentive fee accounting, which are presented on the basis of the performance of our volatile hedge fund manager.

Simple high water mark

This method actually ignores the need for equalization and throws all shareholders into one pot. If the initial net asset value per share is $100, A receives 10,000 shares. At the end of the first quarter, the NAV is $140 and B’s $1,500,000 buys him 10,714 shares. Before C decides to invest, the fund has assets of

$1,000,000 or $48.28 for each of the 20,714 shares. For his $500,000 investment, C receives 10,357 shares. At year end, the NAV is $173.80 ($5,400,000 divided by 31,071 shares) with A: $1,737,955; B: $1,862,045 and C: $1,800,000. What has happened is that A and B have paid a performance fee on behalf of C and the performance fee has been allocated in proportion of the value of A, B and C’s holdings, not by their relative performance. Under this method, the manager can only earn an incentive fee if he returns to $100 and, for this reason, many managers will not take new money when their NAV is below a previous high. However, the popularity of this method is its simplicity and that the manager receives the correct fee, $600,000. But the $173.80 NAV reflects a performance of 73.8% rather than 80% for the U.S. partnership.

Equalization factor

This method attempts to correct the unfair results of the simple high water mark in its allocation of incentive fees among investors and in its measure of fund performance. But it is neither perfect nor simple. It allows every subscriber to subscribe at the gross net asset value (pre-incentive fee accrual). B’s $1,500,000 would get him 10,000 shares at a gross NAV of $150 and an equalization factor of $100,000 which represents the fact that should the fund continue to grow, he should have only paid $140 a share or $1,400,000. The $100,000 is put in a segregated capital account. If at year end the NAV is higher than at subscription, as in our example, B receives additional shares from the segregated account at the then NAV. For C to have $500,000 invested in the fund and get 10,000 shares at the $50 price, he has to pay an additional $100,000 for a depreciation deposit, equal to the performance fee that the manager would otherwise not be able to charge until he reaches the $100 high water mark again. It is normally kept in a segregated account and invested in money market instruments. At year-end, the NAV is $180 a share, and B’s equalization factor is generally used to buy him an additional shares ($100,000 divided by $180), bringing the total shares of the fund to 30,555. Each shareholder’s worth is as follows: A: $1,800,000. B: $1,899,900. C: $1,800,000 and each shareholder has paid his due performance fee. Note that C’s investment was $500,00 plus $100,000 which became payable directly to the manager at year-end. If the gross NAY of the fund had only increased $75 at year-end rather than $200, only $50,000 of C’s depreciation deposit would generally be paid to the manager and the balance would remain for his account against future performance. Also, B’s equalization reserve would be added to the capital of fund: the reversal reserve would be netted against it. Some funds allow this to be carried forward as with the depreciation deposit. In this method, each shareholder pays his due performance fee and the NAY starts the same for each. The $180 NAY reflects properly the performance of the fund. However, investors do not like the equalization factor. Was I fully invested? If! get more shares at year-end, where did the money come from? Because of the lack of simplicity in tracing segregated accounts, the equalization shares method was introduced in 1993.

Equalization shares

This method starts with the simplicity of the simple high water mark method in which B gets 10,714 shares at $140 and C gets 10,357 shares at $48.28. However, it offsets the shortcoming of the simple high water mark method by taking each investor’s high water mark into account rather than the fund’s $100 by distributing additional shares to A and B so that neither pays a portion of incentive fee that should be paid by C. When the incentive fee accrual ($150 to $140) is reversed at the time C invests, A gets an extra 2,071 shares ($100,000 divided by $48.28); that brings A’s high water mark down to $82.84 ($1,000,000 divided by 12,071). When the incentive fee becomes payable at year end, the gross NAY of the fund is $6,000,000 divided by 33,141 shares or $181.04. The NAV is calculated on the basis of C’s high water mark, $48.28, or $154.49 representing an incentive fee accrual of $26.55 per share. Since A’s high water mark is $82.84, not $48.28, 20% of that difference ($6.91 per share or $83,434) should be distributed to A in the form of shares or 540 shares at $154.49. Same for B ($140 high water mark) who gets 1,272 shares. Each shareholder’s worth is as follows: A: $1,948,286. B: $1,851,729. C: $1,600,063. The manager once again receives $600,000 and each shareholder pays exactly 20%. But the allocation to A, in the fourth quarter, of extra shares relating to an accrual in the first quarter has artificially inflated his account at the expense of B and C. Also, this method suffers from the fact that each shareholder has a different previous high and thus must be calculated separately, until the year ends on a new high. More importantly, the inconsistency in number of shares outstanding at any given month makes the $154.49 NAV meaningless as a performance measure.

Automatic redemption of shares

In this method, there is only one NAV, the gross NAV and each shareholder pays his portion of the performance fee at the end of the financial year by redeeming the number of shares which represents the amount owing, using the gross NAV as divisor. The end result is that the NAV of the fund is $200 with A having 9,000 shares, B: 9,500 shares and C: 8,500 shares. This method has only been used a couple of times, perhaps because shareholders do not like forced redemptions or perhaps because the performance fee

not reflected in the NAV.

Individual classes of shares

This method is used when the twelve month lock-up rule is being observed, or increasingly because it is the simplest to understand. It is applied in a variety of ways, either with a $100 opening with each subscription, or shareholder. This method most closely approximates the partnership method of accounting. The class can be rolled over each twelve months, but only in the case of positive performance, unless new shareholders were required to pay a depreciation deposit. In addition, while each class knows how it is doing, the long-term performance of the fund is undetermined unless one uses a pro-forma figure.

The most common method remains the simple high water mark, but the next common is the individual class of shares for each opening, with a new beginning NAV. This may be because of the entry of registered investment advisers into the hedge fund field, whether SEC registered or state registered. However, spare a thought for the administrator, who onshore deals with 99 partners reported to quarterly, and offshore deals with between 300 to 1,000, monthly. Spare a thought for your pocket, at least. •

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