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By Anthony Stocks, President, Tennyson Capital, a London based hedge fund consulting firm. This article appeared in the August 1995 issue of Fund News┐

In the August 1994 issue of Hedge Fund News, I examined five methods of calculating performance fee in funds set up as off shore corporations. The "Holy Grail" of calculations was one where each shareholder would be treated equally - each would pay the performance fee chargeable on the gain made on his investment only, yet all shareholders would refer to the same net asset value of per share. Further, this net asset value should accurately measure the performance of the fund and the mechanism in computing share issuance be easily understood by the share holders. None of the methods discussed approached this ideal. The two most often used methods of those examined are the equalization factor and the simple high water mark. In this article I will discuss particular problems associated with these methods, the allocation of the equalization factor and the calculation of the previous high water mark. The problems stem from the situation where a fund loses money and recoups losses. This is the situation that hedge fund industry has found itself in this year, as the losses in 1994 have been slowly recouped in 1995.

Equalization Factor

Most offering documents written for hedge funds using the equalization factor method mention that the equalization factor is at risk and may be lost. Take for example a new shareholder who invests $1,500,000 in a fund that began the year at $100 a share and is presently trading at $150 a share before performance fee accrual (Gross NAV). The accrued performance fee at this time is $10 a share, assuming a 20% performance fee, and the NAV is $140. The investor will receive 10,000 shares ($1,400,000) and a credit, the equalization factor, of $100,000. The $100,000 credit to the investor is accounted for as a liability of the fund ; every equalization factor is allocated on a shareholder by shareholder basis. This attribution together with the performance fee accrual will equal 20% of excess of the Gross NAV over the previous high water mark NAV, times the number of shares outstanding. At year-end the investment manager is due his performance fee and a new calculation is made of any remaining equalization factor attributable to the shareholder. This amount is credited to the shareholder in the form of new shares. In the above example, if the year ended with a Gross NAV of $150 or more, the new shareholder would be allocated shares in a number equal to $100,000 divided by the year-end NAV. If the year-end Gross NAV is less than $150, having lost some of the gains made in mid-year, our shareholder "loses" a portion or all of his equalization factor. If the Gross NAV had dropped to $125, thus giving rise to a $5 incentive fee, the NAV would be $120 a share and the shareholder would be receiving $50,000 out of the equalization factor: he has "lost" $50,000 of this original $100,000. The fund has lost half of its year’s gains since he subscribed, and he loses a similar proportion of his equalization factor. Some funds will carry over the lost equalization factor from year to year as long as the investor stays in. However, most funds settle the equalization factor at the end of the year in which an interim purchase is made. Where confusion reigns is the practice to freeze the initial equalization factor, attributable on subscription, as a current liability till year-end. Shareholders are informed of a historical, transitory, equalization factor amount, which they believe is theirs by right and may be traded in the when-issued market. Meanwhile a shareholder re deeming in interim periods or making a secondary market transfer is shocked to find that his equalization factor was at risk, as detailed in the fine print. In fact it is only a memorandum account showing each shareholder’s previous high water mark. Each month, only a recalculated factor should be carried as a current liability. Any surplus is credited back to the fund. The treatment should be exactly the same as the provision for the performance fee which is also calculated monthly and moves in line with performance. Otherwise, the monthly calculation of NAV can be distorted. The sum of the performance fee accrual and the equalization factor attributable to shareholders who have not made the requisite gain should equal 20% of the excess of the Gross net asset value of the fund over the high water mark NAV.

Previous High Water Mark

We are assuming that any increase in the net asset value is a gain of the fund where the investment manager retains 20%. Most managers will go back to the previous high water mark before they start accruing a performance fee again. But how is it calculated? The calculation depends on two things - the mix of the shareholders, and the basis of calculation of the performance fee. Do we look to recover a percentage loss, or a dollar loss, or a net asset value per share number or a profit and loss number? That is where the performance fee sections of offering documents are often poorly written. Say, a $200 million fund suffered a 50% loss or $100 million. The offering document states that a performance fee will be charged on new profits after having made up prior losses. The manager has to make $100 million before charging a fee again. But what if, discouraged by the losses, half the shareholders subsequently pull out? The manager has only $50 million left, and still has to make $100 million. The required return of 100% has become 200%. Or he could explain his bullish outlook and raise another $100 million and the required return becomes 50% instead of 100%. Many offering documents do not address this situation, as it was not envisaged in the bull market euphoria of the eighties. The actual treatment becomes a matter of negotiation between the administrator and the investment manager. The usual solution is to consider that the redeeming shareholder has taken his losses with him, i.e. any loss incurred by a redeeming shareholder since the prior high water mark is deducted from those losses that must be recouped before a performance fee is earned again. Another practice is that subscriptions do not dilute the required return to the extent that they replace redemptions, and in turn the redemption does not take losses associated with it. So in the example just given, if the redeeming shareholder of $50 million is replaced by a subscribing shareholder of $50 million, the required return remains at $100 million. If he is not replaced, the required return is decreased by the losses he takes with him: $50 million. But what if there are only subscribers and nobody redeems? If, as shown, the manager only has to make a 50% return because of the larger capital base and can then charge performance fees again, the old shareholders will begin to pay performance fees again once they have recouped only 75% of their losses. Meanwhile the new subscribers pay no fees and have a free ride, for gains up to 50%.

In addition to balancing subscribers and redeemers, other issues arise as to whether or not the performance fee is calculated based on trading profits alone or net profits after expenses and management fees. Many funds calculate performance fee after adding back the management fee charge, and, in that case, the high water mark used may be several percentage points lower than the NAV per share at the time.

These problems only arise when the offering document specifies the profit and loss account approach. If it specifies the net asset value per share approach, the problems are eased. In the last example, a 50% loss in performance and a further 50% in redemptions would only require a 100% return to recover the prior NAV high, irrespective of the capital base. This achieves the same result as deducting the dollar losses of redeeming share holders from the required dollar return: the required percentage return remains the same under both methods. Unfortunately the same does not hold true for new subscribers: they are guaranteed a free ride all the way up to the old high. As I mentioned in my previous article, that is the reason why many managers will not take new money until they have recouped their losses. The solution is to introduce a depreciation deposit for investors who want to buy low. There is no effect on the fund, the deposit is paid by the shareholder and is recoverable by him to the extent it is not used to pay performance fees. The net asset value is uniform, common to all shareholders, measures performance accurately (there is no dilution by issuing bonus shares as in the equalization factor method), there is no need to track individual share holders, and the only complication is recording the depreciation deposit. The net asset value per share high water mark/depreciation deposit method may be the Holy Grail. •

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