Cayman Islands: Performance-Based Incentive Fees and Equalization Mechanisms

• During a period when the fund generates profits, incentive fees are accrued which reduce the NAV per share. In the absence of an equalization mechanism, a new investor will buy shares at the NAV after the incentive fee accrual. If the fund performance subsequently declines, the incentive accrual would reverse at the fund level, which will benefit all shareholders including the new investor. This would be inequitable since all shareholders would benefit when only the original investors incurred the cost of the incentive fee.
• When the fund's performance declines prior to the issuance of new shares, without equalization new investors may benefit from a "free ride" until losses have been recovered and the fund achieves a new "high-water" mark. This is inequitable because the new investors have not paid a performance-based incentive, even though they have benefited from a positive return on their investment. Depending upon how this is handled, it is to the detriment of the investment manager, the original shareholders, or both.

The two most common ways to handle these problems are Series of Shares, each with its own NAV, and Equalization. The disadvantage of multiple series is that administering and reporting all of these series becomes difficult and time consuming. Instead, various "equalization" methods have been developed as alternatives that offer the benefit of equitable incentive allocations, and at the same time ensure only one NAV per share for all shareholders.

Three of the most common equalization methods utilized are the Equalization Shares Approach, the Equalization and Depreciation Deposit Approach, and the Equalization/Adjustment (or Mandatory Redemption) Approach. The following is a brief outline of each of these methods.

Under this mechanism, individual shareholders may be issued a small number of equalization shares each month to ensure equitable allocations of incentive fee accruals and reversals. Therefore, each investor is charged or refunded incentive fees based on their individual circumstances.

The primary advantage of this method is that there is no depreciation deposit (discussed below) to track and report to investors.

The disadvantage is that as more shares are issued, it dilutes the ownership interest in the fund and reduces the NAV. The fund's NAV must be adjusted for the equalization share(s) issued to determine the true return of the fund. Furthermore, administrators must notify investors of equalization shares issued each month, in order for the investor to monitor the value of their account.

With this approach, the offer price for new shares is adjusted for either an equalization factor or depreciation deposit. At year-end (or whenever incentive fees are paid to the investment manager), the equalization or depreciation deposit balances are adjusted, refunded or paid either to the investor or to the investment manager. These adjustments ensure the investment manager is paid the appropriate amount of incentive by each individual investor and that no investor benefits from a "free ride".

The advantage of this method is that the equalization and/or depreciation deposit tends to clear itself within a year or two, placing all existing shareholders on the same basis. This method also eliminates the need for monthly adjustments to every account, as may occur under the Equalization Shares Approach.

The disadvantage of the depreciation deposit element is that the deposit related to the subscription amount must be held in an interest bearing risk-free investment, while investors and the investment manager generally prefer that 100% of the subscription proceeds be invested in the fund.

Under this mechanism, adjustments to shareholder accounts are made on an annual basis through the issue or redemption of shares, for no consideration, based on individual circumstances and the terms of the investment management agreement.

One advantage of this method is that no subscription funds are allocated to risk-free investments. Another important benefit of using this method is that it allows for more flexibility in the terms of the incentive fee calculation.

Over the past several years, equalization methods have become more common in offshore funds and several variations have been developed to achieve the particular objectives of the fund and investment manager. Some of the more common variations are:

• Minimum return requirements after incentive fees
• Benchmark returns based on LIBOR or other risk-free rate(s) of return
• Post-Incentive Expense treatments which exclude certain expenses (such as management fees) from the incentive determination
• Variation in carry-forward treatment for losses and unachieved benchmarks

Since sophisticated investors and managers have come to understand the inequities that exist in the absence of Equalization, demand has increased for funds to implement one of the Equalization methodologies. When administered correctly, Equalization achieves its objective of ensuring shareholder equity. However, Equalization mechanisms are complex to set up and maintain. Administrators must implement proper controls and review procedures to ensure that calculations are performed accurately, consistently, and in accordance with each particular fund offering document. An appropriate software solution is critical for the following reasons:

• Equalization calculations can be very complex and error prone. Spreadsheet models that may work for a small number of investors or transactions quickly become unmanageable over time. Individual shareholders are often in different positions in terms of loss carry-forwards, high water marks, equalization paid, equalization lost in prior years, and depreciation deposit balances. It is very difficult to administer and review the calculations for a large number of funds which may use different Equalization methods and still produce reliable and timely NAVs. It is also difficult to ensure that the methodology is applied consistently across funds and across months.
• Individual investment detail must be maintained. Separate investments cannot be aggregated and still produce accurate calculations. Many existing share register systems do not allow for segregated investment lots for a particular investor.
• Nominee shareholders acting on behalf of many underlying investors must also be able to track individual share holdings. On redemption, the nominee must be able to identify which shares have been redeemed. Otherwise, an underlying investor may incorrectly receive another underlying investor's equalization adjustment or depreciation deposit refund.
• Investors may require a more detailed analysis of their shareholdings and often do not understand the complex calculations. As a result, administrators must accommodate specialized reporting requirements and additional questions from investors.
• Auditing Equalization mechanisms is difficult and time consuming. Spreadsheet models must be carefully reviewed to ensure that they consider all possible scenarios, that the calculations conform to the offering document, and that they were properly controlled and consistently applied throughout the year. Without adequate reporting and controls, this can increase audit costs.

Offshore Financial Solutions, Ltd. ("OFS") offers the only commercially available software specifically written to assist in the administration of offshore funds that use one of the many forms of equalization previously discussed.

OFS software maintains comprehensive share register information and calculates Gross and Net NAV, incentive fees, equalization, depreciation deposits (if applicable), high water marks and loss carry forwards on a shareholder and individual investment basis. It also performs year-end procedures, including automatically issuing equalization shares as applicable.

The most important benefits of the OFS software is that it reduces the likelihood of error, and significantly reduces the time required to generate NAVs, record shareholder transactions and to generate useful reports and shareholder information.

In addition, this software has been widely used since 1995 by many major offshore fund administrators and hedge funds and has been proven to be reliable and accurate.

During 1999-2000 OFS will be releasing a Windows-based version of the software which will handle complex Equalization mechanisms, and also offer advanced shareholder services features. OFS and its partner, Investment Management Services will be writing and supporting this software. Designed and developed by experienced industry professionals, who have an ongoing commitment to fund administration, this software will include many features not available in other share register systems currently on the market.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

This article also appears in the 'International Offshore and Financial Centres Handbook 1999/2000'. For further information about this highly informative guide to offshore centres, or to order your copy, please phone +44 (0) 207 820 7733 or send an email to iofch@mondaq.com