Equalisation
What It Is; Why It Is Necessary; and How It Works

A Presentation given by Dermot S. L. Butler at the
"Hedge Fund Administration and Prime Brokerage: Benefiting from Industry ExpansionWorkshop"
held at the Conrad Hotel, Dublin, Ireland on the 13^th of February 2002

I have seen the mere mention of the subject of "Equalisation" cause the eyes of the most sophisticated fund accountants to acquire the glazed, almost frightened, look of someone who has just seen "The Exorcist".

What is Equalisation and why does it cause these problems?

In the context of alternative investment and hedge funds - indeed any open ended fund that pays incentive or performance fees - the term "Equalisation" refers to an accounting methodology, designed to ensure that not only the investment manager is paid the correct incentive, performance or profit sharing fee, but also that the incentive fees are fairly allocated between each investor in the fund.

Why is this a problem? The easiest way to answer this is by way of examples:

The Free Ride

Firstly the famous "free ride", which was the original reason and justification for the introduction of Equalisation in the first place.

Table I - The "Free Ride"

This example, which is illustrated in Table 1, assumes that a fund starts trading at US$100 per share and that there is an initial investor - Investor A - who buys one share at US$100. Let is now assume that, at the end of the first quarter, the gross NAV per share has risen to US$110. This will result in an NAV per share of US$108, net of the incentive fee of US$2 (20% of the US$10 profit), which has been paid.

Let us now assume that one month later the NAV per share has fallen to US$100 again and a second investor - Investor B - comes in and buys one share for US$100. If the Gross NAV was once again to climb back up to US$110, unless one of the Equalisation methods being applied, the fund manager would not be able to charge any incentive fees on this second investor's subscription until the NAV per share had risen back up to over US$110. If that happens, Investor B will get a "free ride" of US$2 per share, being the incentive fee that he will not be paying on his profit of US$10 per share.

Equalisation will eliminate this anomaly, by charging an incentive fee to Investor B.

Rising Share Price

There are those who believe that the "free ride" is the sole justification for Equalisation, but this is not true. It is a fact that without some form of Equalisation being applied when investors subscribe at different NAV levels, one shareholder will always be subsidising another shareholder, to some extent or another, even with consistently rising NAVs. Let us look at the example shown in Table 2,

Table II - "Rising Share Price"

where again we assume that Investor A buys one share at US$100 when it is launched. We again assume the market rises, but this time by the end of the second month, to US$110 Gross NAV per share.The NAV per share is published at US$108, net of the 20% incentive fee accrual.

Investor B now buys one share at US$108, being the published NAV. Let us now assume that at the quarter end the gross NAV per share has in fact risen to US$120. This results in gross profits of US$32 based on the following calculation:

Investor A invested US$100 and Investor B invested US$108, for a total sum invested of US$208. The Gross NAV ("GNAV") of the fund at the end of the quarter was US$240 (2 x shares at US$120). This represents a gross profit of US$32 over the total sum invested of US$208.

To be equitable the profits should be allocated as US$20 to Investor A, who bought at US$100 and US$12 to Investor B who bought at US$108. However let us look at how the incentive fee, which will now be due, will be calculated.

The incentive fee should be 20% of the gross profit of US$32, which is US$6.40, or US$3.20 per share. Thus the gross NAV of US$240 less the incentive fee of US$6.40, results in a net NAV of US$233.60, or US$116.80 per share.

What does this mean?
It means that Investor A has effectively paid US$3.2 incentive fee on a profit of US$20, which equates to 16.4% of Investor A's profit, whereas Investor B, who also effectively pays US$3.20 incentive fee, but does so on a profit of US$12, which equates to an incentive fee of 26.66% of Investor B's profit. This is obviously inequitable.

Equalisation will eliminate this anomaly by allocating the correct incentive fee to each investor's account.

The Claw Back Syndrome

And of course Equalisation is also necessary to avoid what is known as the "claw-back" syndrome. This occurs where, following in the initial rise to US$110 shown in the two examples we have already reviewed, but the price per share falls back to say US$96 at the end of the quarter as shown in Table 3.

Table III - "Claw Back" Syndrome

The incentive fee accrual made at the end of the second month would now revert back to the fund., Without Equalisation, that accrual would benefit all shareholders, including the new investor, whereas the original incentive fee accrual was only accrued in respect of Investor A's investment and not Investor B's investment.

Remember, the Gross NAV of the fund at the end of the second month is in fact US$218, even though the NAV was published at US$216 (US$108 per share), because the US$2.00 incentive fee had only been accrued, it had not been paid out. Because in the following month the fund declined and lost US$26, the NAV of the fund declined from US$218 to US$192. Thus, the NAV per share at the end of the quarter was US$96.

However, as the fund had lost US$26 the equitable allocation would have been to debit US$13 to each investor's account. Thus Investor A, whose account was worth US$110 at the end of the second month, before accruing the incentive fee, would have declined by US$13 to US$97. Whereas Investor B, who only subscribed US$108 and the end of the second month, should also have seen his NAV per share decline by US$13 to US$95. As stated above, the incentive fee accrual of US$2, which was applied at the end of the second month, related to unrealised gains on Investor A's account. However, because this has been "clawed back" by the fund as a whole, it has been allocated to shareholders on a pro-rata basis. Thus, without Equalisation, the value of Investor A's holding has dropped not to US$97 but to US$96, a loss of US$14, whereas Investor B benefits from an allocation from part of Investor A's incentive fee accrual, to the value of US$1, so that the NAV per share of his investment is now US$96, a loss of only US$12, instead of US$95.

Equalisation will eliminate this anomaly by reimbursing the accrued incentive fee to Investor A, who had already "paid" it.

How is Equalisation achieved and how are these anomalies eliminated?

Before discussing Equalisation methods, I must say that it is surprising how many alternative investment and hedge funds still operate without applying any form of Equalisation. This is mainly done in order to avoid the complications, hassle and heartache involved in applying one of the Equalisation methodologies to a fund's accounts. All of the systems are to a greater or lesser extent investor "unfriendly" and, frankly some investors, not only have great difficulty in understanding them, but are often inclined to assume that there is a "fiddle" going on. Having said that, I think it is clear that Equalisation is necessary, not just to ensure that the Investment Manager takes home every crust he earns, but, more importantly, to ensure that those incentive fees, when paid, are equitably distributed between shareholders. It is not right (and cannot be right) that, in order to avoid a complicated accounting procedure, one investor should be penalised to the advantage of another investor.

As I have mentioned before, Equalisation is an accounting methodology which enables each individual investor, or group of investors, who invest in a fund at the same time to be individually assessed for their own incentive fee liability and charged accordingly. If this can be achieved, this will eliminate the problem of one investor being penalised to the advantage of another.

There are several different Equalisation Methodologies used. In discussing these, I am going to include the Series of Shares and Consolidation Method as well as a number of different "Equalisation Methods".

Series of Shares and Consolidation Method

This is, in my opinion, the most user-friendly and the simplest of all the Equalisation Methods to understand. It 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 correct incentive 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 usually known as the "Lead Series". The objective is to consolidate each of the subsequent 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, including the Lead Series. This may be quarterly, half-yearly, or annually.

How does it Work?

By way of example:

TABLE IV THE SERIES OF SHARES AND CONSOLIDATED METHOD RISING MARKET

Let us assume that Investor A purchases 1,000 Shares at the launch of the fund, at US$1,000 per Share. This will be the "Lead Series" of Shares. (For this example we are assuming that the incentive fees are being paid quarterly).

Let us then assume that at the end of the first month the Gross NAV ("GNAV") (the NAV before deduction of incentive fee) per Lead Share has risen to US$1,100 and therefore the NAV will be US$1,080, net of US$20 / 20% incentive fee. At this time Investor B subscribes US$1 million for 1,000 Series II Shares at, again US$1,000 each.

At the end of the second month, the value of the fund has risen by a further 10%, so that GNAV for the Lead Series is now US$1,210, whereas the GNAV for Series II is now US$1,100. The NAVs for the Lead Series will now be US$1,168 and, for Series II US$1,080, net of 20% incentive fee accrual. At this stage Investor C subscribes a further US$1 million for 1,000 Shares of Series III at US$1,000 per Share.

Let us now assume that, at the end of the third month, the GNAV has yet again risen by a further 10%, so that:

a) The GNAV per Share of the Lead Series is US$1,331, which translates to an NAV of US$1, 264.80;
b) The GNAV of Series II is US$1,210, equalling an NAV of US$1,168; and
c) The GNAV for Series III is US$1,100, equalling an NAV of US$1,080.

Thus, at the end of the first quarter and because a new High Water-Mark ("HWM") has been reached and each of the Series of Shares have paid incentive fees, the Series II and Series III Shares can now be consolidated into the Lead Series. This means that, in effect, the owners of Series II and Series III Shares will sell, or exchange their Shares for Lead Series Shares. Therefore, Investor B's Shares are worth US$1,168.00, which equates to 923.466 Shares at the NAV per Lead Series, at US$1,264.80 each. Similarly Investor C will effectively liquidate his 1,000 Shares of US$1,080,000 and effectively invest those proceeds of that liquidation into the Lead Series at US$1,264.80 per Share, to receive 853.890 Lead Series Shares.

Table V - The Series of Shares and Consolidation Method - Volatile Market

If at the end of the third month the value of the fund has declined by say 4%, then the Lead Series and Series II would still be profitable and could be consolidated. However, the Series III would be showing a loss, at GNAV of US$960 and so would not be consolidated. The Series III would remain in existence until a new HWM had been achieved, which would put the Series III into profit.

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.

One of the disadvantages of this approach, however, is the fact that many funds only pay incentive fees once a year and this means that the Series of Shares and Consolidation Method can be quite cumbersome, because, if a fund is a heavily 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 is possible that that could go up to twenty-four Series being issued, before the next accounting period is finished.

The other obvious disadvantage of the Series Method is that it is not possible to publish a single NAV per Share, because each Series had its own NAV. Of course, there is no real problem in publishing several different NAVs, but 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 with holdings that have different NAVs.

The third main drawback of issuing several Series of Shares occurs with fund's whose Shares are listed on a Stock Exchange, because it will probably be necessary to apply to list each Share in issue. This is administratively time consuming and therefore expensive and again there is the problem of having to publish the full list of NAVs.

US Partnerships

I would point out that this Equalisation problem does not generally occur in the United States, because most, if not all, US Alternative Investments and Hedge Funds are structured as Partnerships, primarily for tax reasons. Therefore, because Partnership books are kept on a capital accounting basis, these Equalisation problems just do not occur. Of course the Series of Shares Method, in effect, replicates the relevant components of partnership accounting at a corporate level. US investors need to have full tax transparency in order to comply with US tax reporting requirements and, ironically, it is largely because of this tax transparency that offshore investors tend to shy away from Partnerships, because they do not wish to have a tax liability occurring on an annual basis, but only when they liquidate their holdings.

Equalisation Accounting Methodology

Equalisation Methods are a very much more complex way of achieving the same result as the Series of Shares Method, but with the advantage of producing one NAV per Share.

The Wish List

As I mentioned before, there are several different variations on the Equalisation Method, the objective of all of which (including the Series Method) is to try and ensure:

Table VI - The Wish List

1. the equitable allocation of incentive fees between each investor in a fund, to ensure that the Investment Manager is paid the correct amount and that each investor pays the amount that it should be paying and is not subsidized by, or does not subsidize, another investor;
2. that all investors have the same capital risk per Share;
3. that there is a single NAV per Share;
4. that the published NAV accurately reflects the fund's performance; and
5. finally that the Method used should be easily understood by all parties including the investors.

It has to be said that nobody has yet produced a perfect Equalisation Method that meets all of these objectives and is unlikely to do so, until investors have been fully educated in this subject. As I have already said, it is, I think, reasonable to claim that the Series Method is easily understood by most investors, however the Series Method does not provide a single NAV. The other Equalisation Methods, which I will describe in a moment do provide a single NAV, but are not easily understood by most investors, although many more investors do understand these procedures than did a couple of years ago.

Simple Equalisation

The first of the more common Methods of Equalisation is what had been described as "Simple Equalisation", which some might consider to be an oxymoron. Be that as it may, the procedure is to calculate the performance fee and allocate it fairly between each investor, or group of investors at the end of each accounting period. As investors will have come in at different levels this will mean calculating different NAVs per investor. However, in order to get a common NAV for all Shares in the fund, the lowest of all the NAVs calculated, on an investor-by-investor basis, is selected to become the NAV of the fund.

Shareholders with a higher individual NAV per Share are then issued "Equalisation Shares", so that the total number of Shares issued to that investor (i.e.- the original Shares purchased plus any Equalisation Shares) multiplied by the new NAV of the fund, which we know is the lowest NAV calculated, will now enable the investment for those investors to be kept constant.

By way of example, let us assume that, at launch, Investor A buys 1,000 shares at US$100 to invest US$100,000.

Table VII - Simple Equalisation - Rising Market

At the end of month one, the Gross Net Asset Value per share is US$110, which gives us a Net Asset Value of US$108 less US$2 incentive fee. The shareholding is now worth US$108,000.

Investor B buys 1,000 shares at US$108 so the total Net Asset Value of the Fund will now be US$216,000.

At the end of month two, the Gross Net Asset Value per share has now risen to US$120.

Investor A's NAV per share is now US$116, which is US$120 minus the US$4 incentive fee.

Investor B's NAV per share is US$117.6, which is US$120 less the US$2.4 incentive fee on the US$12 profit between US$108 and US$120. This equates to US$117,600 total NAV. However, the published NAV per share will be the lowest NAV per share at US$116.

Therefore, Investor B, who has 1,000 shares at US$116, is short of US$1,600. This is made up by allocating 13.73, effectively "notional", shares, at US$116, which equals US$1,600 to bring up the total value of his investment to US$117,600.

What happens when the Net Asset Value subsequently declines?

Table VIII - Simple Equalisation - Volatile Market

Firstly, if we assume now at the end of month three, the Gross Net Asset Value per share is US$105, then there's the following situation:

Investor A's NAV per share is US$104, that's US$105, less US$1 incentive fee, whereas Investor B's NAV per share is US$105 because there is no incentive fee chargeable. The published NAV per share, therefore, will be the lowest at US$104. Investor B now has 1,000 shares at US$104 to give US$104,000 and that's US$1,000 short of the US$105,000 NAV that he should receive. He will, therefore, be allocated 9.6154 shares at US$104, which equals US$1,000 to give him a full NAV value of US$105,000.

If the NAV per share falls below the launch price, or the previous high watermark, no incentive fee accrues on either of the shares and the NAV will be the same for each share in issue.

Table IX - Simple Equalisation - Falling Market

For example, let us now assume, at month four, the GNAV per share has declined to US$98. There is no incentive fee due on either holding, therefore, the NAV per share for both Investor A and Investor B holding will be US$98 and so, obviously, no "notional" shares will be issued to either investor.

The advantages of this system are that it is relatively simple to calculate the NAV for each shareholder and you end up with a single NAV per Share for the fund.

However, there are two main disadvantages. Firstly, that the NAV does not accurately reflect the fund performance, because it is continually discounted and, secondly, the addition of Equalisation Shares to investors' accounts, on what, to many probably seems an arbitrary basis, can confuse those investors.

Equalisation Factor / Depreciation Deposit Approach

The most common Methods of Equalisation are the "Equalisation Factor / Depreciation Deposit Approach" and what is known as the "Equalisation Adjustment Approach". They are both very similar.

Under the Equalisation Factor / Depreciation Deposit Approach, each investor invests at the NAV, plus either the Equalisation Factor or the Depreciation Deposit, depending upon whether the NAV of the Fund has increased or declined from the last high water-mark.

I think it is fair to say the Equalisation Factor Method has been overtaken in the popularity stakes by the Equalisation Approach - so I propose to briefly explain the first and show you examples of the Equalisation Approach.

If the NAV has risen during the period, then a new subscriber would invest the equivalent of the GNAV, to place the same amount of money at risk as the existing shareholders, the difference between the NAV and the GNAV being the Equalisation Factor. If the fund maintains its performance, the Equalisation Factor paid will be refunded in Shares, at the end of the incentive fee calculation period. If, however, the fund subsequently loses value the Equalisation will be lost for that period, but is refundable, in the future, if the fund recovers. This avoids the claw-back syndrome.

If, on the other hand, the fund's NAV is at a discount to the high water-mark at the time that an investor makes a subscription, then the investor will be required to pay a Depreciation Deposit equal to the incentive fee that would be payable if his shares rose to the HWM. If the fund starts to improve and recoup its losses, then the Depreciation Deposit becomes payable to the Investment Advisor as a performance fee. This avoids the 'free ride' syndrome.

If the NAV declines, then the Deposit is paid back to the investor upon a redemption.

Equalisation Adjustment Approach

The Equalisation Adjustment Approach is similar to the Equalisation Factor / Depreciation Deposit Method, in that the investor will subscribe at the GNAV, but if the NAV, at the time of subscription, is above the previous high watermark, then the investor will receive an Equalisation Credit for that portion of the NAV which represents the incentive fee accrual, (which the investor has paid within the GNAV). Like the Equalisation Factor, if, at the end of the accounting period the NAV is still showing a profit, or an increased profit, the investor will be paid his Equalisation Credit by way of an allocation of additional Shares in the fund. If, however, the fund's NAV declines before the accounting period ends, then the Equalisation Credit will decline pro rata, but is recoupable, if the NAV rises again.

Both the Equalisation Credit and Equalisation Factor Methods enable all of the investor's money to be utilized in the fund.

If the investor subscribes during a draw down, or loss, period, he will still pay the GNAV (which, in this case, will be the same as the NAV), so that he has the same amount of capital risk as existing shareholders, but he will also receive what is described as an "Equalisation Deficit". If the fund subsequently increases in value by the end of the calculation period, a certain number of the investor's Shares will be redeemed to equate to the Equalisation Deficit, (or that part of it that is applicable) and the proceeds paid to the Investment Manager.

Table X - Equalisation Adjustment Approach

Here we assume that Investor A buys 1,000 shares at US$100 per share at launch and at the end of month one the gross Net Asset Value has risen to US$120.

Investor A's NAV will now be US$116 that is US$120 minus US$4 incentive, so the value of his portfolio is now US$116,000.

Investor B subscribes US$120 for 1,000 shares at the gross Net Asset Value for a cost of US$120,000. This US$120,000 comprises firstly 1,000 shares at the NAV of US$116, which is US$116,000 and an Equalisation Credit, which will equate to the incentive fee of US$4,000 making up the total subscribed sum of US$120,000.

Let us now assume that at the end of month two the gross Net Asset Value has risen to US$130.

Investor A's NAV is US$124,000, that is US$130 minus US$6 incentive, whereas Investor B's NAV should be US$128, that is US$130 minus the US$2 incentive on the US$10 rise that he has had on the money he invested, which equals US$128,000. This valuation will, in fact, be comprised because the Investor will receive a valuation showing 1,000 shares at the NAV of US$124,000 plus his Equalisation Credit of US$4,000 totalling US$128,000. Thus at this stage the total NAV of the Fund is US$252,000.

To check this is correct we can look at it in another way - the gross NAV of the Fund at the end of month two is at US$260,000, that is 2,000 shares at US$130 each.

This is comprised of the total sum subscribed by Investor A of US$100,000 and Investor B of US$120,000 totalling US$220,000. If you add to that the gross profit, which is the US$40,000 to bring it up to the total Gross Net Asset Value of US$260,000. If you deduct an incentive fee off that US$40,000, which would be US$8,000 you end up with a net profit of US$32,000 add that to the sum subscribed and you come to a total NAV of US$252,000 so it all adds up.

If the price doesn't change before the end of the year then the US$4,000 Equalisation Credit will be used to purchase additional shares at the NAV.

Let us now assume that the Fund isn't quite such a dramatically good performer and at the end of Month 2, the Gross Net Asset Value has fallen to US$105 as shown in Table XI.

Table XI - Equalisation Approach - Declining Market

Investor A's NAV will now been US$104, that's US$105 less US$1 incentive fee equals. Investor B's Gross NAV will be US$105, which is comprised of the actual NAV (same as Investor A), at US$104, plus an Equalisation Credit, which has now declined to US$1, making US$105 in total.

Now let us assume at the end of Month 3, the Gross NAV has declined further to US$98. Investor A's Net Asset Value will be US$98, because there is no incentive fee involved, and, similarly, Investor B's Net Asset Value will be US$98, because there will be no Equalisation Credit left, as that will have been eaten up in the decline (although if the price was to recover, then Investor B could recoup his Equalisation Credit).

One difference between the Equalisation Deficit Method and the Equalisation Depreciation Deposit Method is that, with the Equalisation Deficit Method, the investor's money is fully invested in the fund, whereas under the Depreciation Deposit Method, the deposit is usually invested in T-Bills, Money Market Funds, or some other passive low-risk investment, which means that the investor is not getting full exposure to the fund.

I think I am going to stop there describing the various Equalisation methods and giving you examples, because I can see lots of glazed eyes. I have two other small points to make. The first concerns the Investment Management Agreement.

Investment Management Agreement

It is essential to ensure that the Equalisation method chosen complies with the Investment Management Agreement. Many Investment Management Agreements state that the Investment Manager will be paid an incentive fee of 20% of profits. Thus, if a loss occurs, the Investment Manager has to recoup the total loss before any further incentive fees can be paid. What must be made clear is that, if an investor redeems during a draw down period and thereby accepts a portion of the loss, the amount of loss that the Investment Manager has to recoup will be reduced pro rata.

Table XII - Failure to Adjust for Redemptions

Thus if a fund with four shareholders, who have subscribed US$1 million each, loses US$800,000, or 20% of the portfolio, and one shareholder redeems, thereby reducing the fund by a further US$800,000 (US$1 million less US$200,000 share of loss). There will now only be three shareholders left in the fund with the fund value standing at US$2.4 million. The wording of the Investment Management Agreement may require the Investment Manager to still earn back the full US$800,000 before he can earn any incentive fee, when in fact the remaining shareholders have only suffered a loss of US$600,000. Thus if the Investment Manager was required to earn back US$800,000 those shareholders would get a "free ride" on that US$200,000 profit.

Choice

The final problem as far as Equalisation goes is the choice of which Method is appropriate for a particular fund. This is usually dictated by a combination of market needs (for example, the choice as to whether to use the Series Method may be dictated by the fact that the Shares are listed on the Irish Stock Exchange) and, to a large extent, the Method that the Fund Manager is most comfortable with.

Another factor that must be seriously considered is the ability of the chosen Administrator to calculate the NAV, utilizing the Equalisation Method selected. At this point I must declare a conflict of interest a number of administrators, including my own company, have elected to utilize software that automates the Equalisation process. As a result the Administrator has had to make their own selection as to the process they deem most appropriate. With our system, Custom House is able to provide Equalisation on an automated basis, utilizing both the Series of Shares and the Equalisation Adjustment Approach i.e.- Equalisation Credits and Deficits because we believe that this provides most of the components of the "wish list", although it cannot be described as investor friendly, or easy to understand. But you can't have everything!

Thank you.

Dermot S.L. Butler is Chairman of Dublin-based Custom House Administration & Corporate Services Limited ("Custom House"), a company that specialises in assisting clients in the organisation, establishment and administration of alternative investment and hedge funds. Custom House is authorised by the Irish Financial Services Regulatory Authority ("IFSRA"), (formerly the Central Bank of Ireland) under the Investment Intermediaries Act, 1995.

Custom House Administration & Corporate Services Ltd.
Address: 25 Eden Quay, Dublin 1, Ireland.
Tel: +353 (0)1 878 0807 / Fax: +353 (0)1 878 0827
E-mail: Dermot S.L. Butler (Chairman) dermot.butler@customhousegroup.com
        or David P.M. Blair (Managing Director) david.blair@customhousegroup.com