Equalisation account / depreciation deposit approach
This method issues either equalisation accounts when the GAV is above the HWM or depreciation deposit when the GAV is below the HWM. Incentive fees are calculated at the fund’s level when the GAV is above the HWM as well as at the individual investor’s level. It should be noted that equalisation accounts/depreciation deposit are not considered as shareholder equity but as a liability in the fund’s balance sheet. Thus providing leverage Therefore, they represent an opportunity cost to investors. Equalisation accounts are converted at the end of the fiscal year. As for the equalisation shares method, investors are fairly charged incentive fees. Moreover, there is no free ride or clawback syndrome. There is the same capital at risk for all shareholders. Equalisation shares: equality among investors, one NAV can be reported with treating investors equally. This method main goal is to equalize between shareholders when new capital is accepted when the NAV is below the fund’s high water mark. In such instance, investors are allocated equalization credit/accounts.
During period of negative performance, the gross NAV and the net NAV share are the same. The main advantage is that investors pay incentive fees on the increased value of their own investments aven if they made the subscriptions when at the fund’s level the NAV was below its high water mark allowing investment managers to charge performance fees on any performance made on investor’s subscription.
At the end of the fund’s fiscal year, if it has reached a net NAV which is above its previous high water mark, the incentive fees shares will crystalise i.e. the investment managers will be paid their incentive fees due. The investment’s market value will be adjusted before being allocated shares based on the new high water mark.
I. Subscriptions when the GAV is at a premium of HWM – When the fund’s GAV is above its highwatermark, an equlisation account is issued for any new subscriptions. The formula used is shown below:
(HWM – GAV) * (number of shares issued)
This formula can be subsequently used to evaluate by changing the GAV for NAV. As a rule of thumb, if the NAV at subsequent periods is above the purchased GAV; there are evaluated at cost. If the NAV is below the HWM, they have no value.
II. Subscriptions when the GAV is at a discount of the HWM – When the NAV per share is at discount of the HWM, the investment manager is not due any incentive fees and the fund will publish an NAV similar to the GAV. When the fund’s GAV is below its HWM, depreciation deposits are issued for any new subscriptions. The depreciation deposits issued can be considered as an incentive fees prepayment which will only be effective if the year-end accounting period the fund’s GAV is above or equal to its HWM. At the fund’s level no performance fees will be deducted until the fund has reached its previous highest NAV. The formula used is the same as for subscriptions made at a premium of the HWM:
(HWM – GAV) *(number of shares issued)
Shareholder A
Subscription: This is the most uncomplicated scenario as the subscription was made at the fund’s inception and no equalisation shares/depreciation deposit has been issued. Incentive fees will be taken at the fund’s level.
Investment’s market value at year-end: There is no shares adjustment as all the incentive fees due were taken at the fund’s level.
Shareholder B
Subscription: This investor ploughs $1’250’000.- into the fund at a time when the GAV and the NAV is $120 and $116 respectively. The number of units issued is calculated by dividing the amount invested by the GAV:
$1’250’000/$120 =10’416.67 shares
The difference in money terms between the GAV and the NAV multiplied by the number of shares yields the value of the equalization account:
($120 – $116) * 10’4167 = $41’667
In other words, the equlisation account is equal to the current performance fees due to the invesment manager; had the investor subscribed at the last HWM. Although those equalization shares are not being invested in the fund, the equalisation account should not be considered as up-front incentive fees payment. At the end of the fiscal year, if the fund’s NAV is above $120, his equalisation account will be converted into participating shares as its value will be at its maximum i.e. the purchased price. Moreover, if in further periods, before the end of the fiscal year, the fund’s performance goes above its high water mark, incentive fees will be taken at the fund level.
Investment’s market value at year-end: The equalization account valued at $41’667 is converted into participating shares on December 31st, 2003. It has reached its maximum level as incentive fees should be taken on the individual holding. In this case incentive fees have only been taken at the fund’s level from $120 to $130 for $2. The $41’667 will be used to buy an extra 320.52 shares at the fund’s end of the fiscal year using the net NAV.
At the fund’s level, incentive fees have been calculated from the previous high water mark (USD 100.00) to the December’s gross NAV of USD 116.00. As the investor was invested in the fund only from USD 110.00, he is owed back incentive fees from USD 100.00 to USD 110.00.
Shareholder C
Subscription: as when the subscription is made, the GAV/NAV is below the HWM, a depreciation deposit is issued to avoid the “free ride” syndrome. A synthetic GAV is worked out for the purpose of finding the number of shares to be given.
(HWM – GAV) * incentive fees percentage = $95 + (($100 – $95) * 0.2) = $96
The number of shares issued is therefore 10’416.67 ($1’000’000/$96).
Investment’s market value at year-end: the subscription was made when the net NAV was below its HWM, the incentive fees will taken individually from its investment from purchased price (USD 95.00) to the beginning of the year high water mark (USD 100.00), therefore the value of his equalisation account will be worthless. The incentive fees have been taken at the fund’s level from $100 to $130.
Investor D No perf fees until NAV level above the pur. price, In get 197.628454 shs, USD 115 remain threshold, no fees taken below that level
Crystallisation: performance period when a new high water mark for new investors is set. Previous investment are not affected, shares will be redeemed or subscribed or a loss carry forward on investors’ account