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Investment Management

Performance fees and equalisation

Performance fees are a common feature of most alternative investment funds and are a fundamental part of the remuneration of many hedge fund investment managers. Often the performance fee makes up the largest part of the investment manager's remuneration. Such fees are often also referred to as incentive fees. There are numerous methods of calculating performance fees, with some more common than others. The calculation method adopted by a fund is detailed in the fund's offering documents and is often summarised in the annual financial statements. Generally there are no regulations governing the method of calculation, with most hedge funds free to choose a method. The underlying principle is that the investment manager is rewarded for its performance. At its simplest level the performance fee is generally expressed as a percentage (typically 15-30%) of the increase in net asset value or net profits of the fund. In many cases there is a high water mark above which these performance fees apply. There are two basic methods of calculating the performance fee: on a fund level basis, or on a per share basis. method such as Equalisation accounting or Multi-Series accounting used.

Equalisation accounting

There are a number of variants of the equalisation method of accounting including the `Equalisation Credit /Contingent Redemption' approach, the `Equalisation Credit/Depreciation Deposit' approach and the `Equalisation Shares' approach.

Equalisation credit/contingent fedemption approach

Under this approach, an investor who subscribes at an interim date during a calculation period when the NAV per share of the fund has increased above the high water mark is required to pay an amount in excess of the NAV per share equal to the accrued performance fee. The subscription price paid is the gross asset value (GAV) per share (equal to NAV before performance fee accured) and the difference between the GAV per share and the NAV per share is referred to as an `equalisation credit'. The equalisation credit ensures that every shareholder has the same amount at risk in the fund. If the fund maintains its performance to the end of the calculation period the equalisation credit will be refunded by issuing new shares to the investor. In the case of an interim investor who subscribes at a time when the NAV is below the high water mark, such an investor will be required to pay a performance fee in relation to any subsequent increase in the net asset value per share up until the high water mark is reached. As other investors in the fund have not passed their high water mark, these other investors will not pay a performance fee. The payment of the performance fee by the interim investor is achieved by means of a partial redemption of that investors shareholding (sometimes referred to as contingent redemption).

Fund level basis vs per share basis

For the fund level basis, performance is calculated at the overall fund level, and not at the individual shareholder level, and is measured by the increase in the net asset value of the fund, after adjusting for subscriptions and redemptions. Alternatively a similar measure of determining performance can be arrived at by looking at net profits of the fund, which usually represents the net of realised and unrealised gains and losses for the period plus net investment income. The performance fee rate is then applied to the net increase or net profits. In both instances, provision generally exists in the prospectus to ensure that where losses or decreases in net asset value arose in previous calculation periods, they must be made good before any performance fee can be earned in a subsequent period. The fund level performance fee is simple for investors to comprehend and easily calculated. However it has two basic shortcomings. Firstly if a shareholder subscribes during a calculation period at a time when there are accumulated losses or a decrease in net asset value carried forward from a prior period, that shareholder will not suffer any performance fee on the increase in NAV per share required to make good the carried forward losses. A similar situation occurs where a new investor purchases shares during a calculation period when there is an accrual for performance fee and later sells the shares at a lower NAV per share. That shareholder will receive the benefit of the decline in the accrued performance fee even though the shareholder did not bear the accrual of the fee included in the NAV at the time the purchase took place. In order to overcome these shortcomings, performance fees are often calculated on a per share basis and a

Equalisation credit/depreciation deposit approach

An alternative to contingent redemptions is to require the payment of a depreciation deposit by the interim investor equal to the amount of the performance fee which will accrue on the increase in NAV per share up until the high water mark is reached. The depreciation deposit will be partially or fully paid to the investment manager at the end of a calculation period if the NAV per share exceeds the subscription price or high water mark.

Equalisation shares approach

Under the equalisation shares approach, individual adjustments are made to each shareholder's account by issuing a small number of equalisation shares each month, if necessary. Performance fees will accrue when the fund has increased in value from the prior month even though the fund may not have exceeded the high water mark. Shareholders are compensated for this fee by issuing equalisation shares to them where necessary. There is one NAV per share for the entire fund and there is no depreciation deposit or equalisation credit to track.

Contacts

However shareholders must be informed of the new share issues, typically monthly, and the stated NAV per share of the fund tends to reduce over time.

For more details on the above please contact:

Brian Forrester Partner T: +353 1 417 2614 E: [email protected] Glenn Gillard Partner T: +353 1 417 2802 E: [email protected] Michael Hartwell Partner T: +353 1 417 2303 E: [email protected] Christian MacManus Partner T: +353 1 417 2658 E: [email protected] Colm McDonnell Partner T: +353 1 417 2348 E:[email protected] Deirdre Power Partner T: +353 1 417 2448 E: [email protected]

Multi-series accounting

This method of accounting uses multiple series of shares (one for each period of issue), each with a different NAV per share. Therefore the performance fee is calculated separately for every subscription and the performance fee will be charged equitably based on the performance of each investor's shareholding. Performance fee is allocated at each valuation point to each series in the proportion that the net assets of each series bears to the net asset value of the entire fund at the prior valuation point. Each series has its own high water mark. At the end of the calculation period (typically calendar year) the individual series may be consolidated into the earliest issued series paying a performance fee. Where losses arise there may be a need for more than 12 series. This method has the advantage of being easily understood, however it can result in a shareholder having multiple NAVs per share for the same investment where subscriptions are made at more than one time during a calculation period.

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