EQUALIZATIONEQUALIZATION

Nidhish SinghNidhish Singh

What is Equalization ?What is Equalization ?

Any open ended fund or hedge funds thatAny open ended fund or hedge funds thatpays incentive or performance fees – thepays incentive or performance fees – theterm "Equalization" refers to an accountingterm "Equalization" refers to an accountingmethodology, designed to ensure that notmethodology, designed to ensure that notonly the investment manager is paid theonly the investment manager is paid thecorrect incentive, performance or profitcorrect incentive, performance or profitsharing fee, but also that the incentive fees aresharing fee, but also that the incentive fees arefairly allocated between each investor in the fund.fairly allocated between each investor in the fund.

Why is equalization important?Why is equalization important?

When there is active subscription and When there is active subscription and redemption activity in a fund, equalization is redemption activity in a fund, equalization is necessary to apportion the performance fee necessary to apportion the performance fee fairly amongst shareholders and ensuring that fairly amongst shareholders and ensuring that inequities do not occur between shareholders inequities do not occur between shareholders when a performance fees is levied.when a performance fees is levied.

TERMS OFTEN USED IN EQUALISATIONTERMS OFTEN USED IN EQUALISATION

High Water Mark (HWM)High Water Mark (HWM)

The highest peak in value that an investment fund/account has The highest peak in value that an investment fund/account has reached. This term is often used in the context of fund manager reached. This term is often used in the context of fund manager compensation, which is performance based. compensation, which is performance based.

0

5

10

15

20

25

30

35

40

Apr-06 May-06

Jun-06

Jul-06

Incentive Fee / Performance FeeIncentive Fee / Performance Fee

A fee paid by the fund house to the fund manager for hisA fee paid by the fund house to the fund manager for hisbetter performance (i.e. could be higher than the agreedbetter performance (i.e. could be higher than the agreedbench mark) bench mark)

Performance fees can be a fair and useful tool to align thePerformance fees can be a fair and useful tool to align theinterests of a manager with those of the clients, a way forinterests of a manager with those of the clients, a way forclients to cut their overall fee burden, or a way for anclients to cut their overall fee burden, or a way for aninvestment manager to expropriate large chunks of clientinvestment manager to expropriate large chunks of clientwealth.wealth.

What is a Hurdle Rate?What is a Hurdle Rate?

The required rate of return in a The required rate of return in a discounteddiscounted cash flow analysis, above which an cash flow analysis, above which an investment makes sense and below which it does not. Often, this is based oninvestment makes sense and below which it does not. Often, this is based onthe firm's cost of capital or weighted average cost of capital, plus or minus athe firm's cost of capital or weighted average cost of capital, plus or minus arisk premium to reflect the project's specific risk characteristics. risk premium to reflect the project's specific risk characteristics.

On 1.4.2005 ,an investment is of Rs.10Crores and the minimum assured returnOn 1.4.2005 ,an investment is of Rs.10Crores and the minimum assured return

a person would get say 8% pa (Government Bonds)a person would get say 8% pa (Government Bonds)

Hence the interest return after one year would be 8 lacs.Hence the interest return after one year would be 8 lacs.

At the end of one year, if the manager makes a profit of more than 8 lacs thenAt the end of one year, if the manager makes a profit of more than 8 lacs then

the manager is eligible to get the performance fees, on the difference betweenthe manager is eligible to get the performance fees, on the difference between

the actual return earned (-) minimum assured return i.e. 8lacsthe actual return earned (-) minimum assured return i.e. 8lacs

ii Investor A buys one Share at US$100Investor A buys one Share at US$100

iiii End of first quarter Gross NAV per Share has risen to End of first quarter Gross NAV per Share has risen to US$110US$110

iiiiii NAV per share published at US$108 - (US$110 - US$2 NAV per share published at US$108 - (US$110 - US$2 incentive fee)incentive fee)

iviv New High Watermark - US$110New High Watermark - US$110

vv At end of the following month, the NAV per Share falls to At end of the following month, the NAV per Share falls to US$100US$100

vivi Investor B buys one Share at US$100Investor B buys one Share at US$100

viivii High watermark still US$110High watermark still US$110

viiiviii If NAV per Share rises to US$110 again, Investor B will have If NAV per Share rises to US$110 again, Investor B will have a US$2 (20% of US$10 profit) "Free Ride"a US$2 (20% of US$10 profit) "Free Ride"

THE FREE RIDETHE FREE RIDEA free ride is a person who pays less for a good than her or his A free ride is a person who pays less for a good than her or his true marginal willingnessto pay; that is, a person who true marginal willingnessto pay; that is, a person who underpays relative to the benefits he receives.underpays relative to the benefits he receives.

The Rising Share PriceThe Rising Share Price

i)i) Investor A buys one Share at US$100Investor A buys one Share at US$100

ii)ii) NAV per share rises in the second month to US$110 NAV per share rises in the second month to US$110

iii)iii) NAV per Share published at US$108, net of 20% incentive fee accrual NAV per Share published at US$108, net of 20% incentive fee accrual

iv)iv) Investor B buys one share at US$108 Investor B buys one share at US$108

v)v) At quarter-end, the Gross NAV per Share has risen to US$120 At quarter-end, the Gross NAV per Share has risen to US$120

vi)vi)

Gross profit is US$32, calculated as follows: Gross profit is US$32, calculated as follows: a) Investor A invested: US$100 a) Investor A invested: US$100 b) Investor B invested: US$108 b) Investor B invested: US$108 Total invested: US$208 Total invested: US$208 c) Gross NAV at end Qt: US$240 c) Gross NAV at end Qt: US$240 Gross Profit: US$ 32 Gross Profit: US$ 32

vii)vii) Incentive fee at 20% of US$32 = US$6.4 Gross, or US$3.2 per Share Incentive fee at 20% of US$32 = US$6.4 Gross, or US$3.2 per Share

viii)viii) NAV per Share = (US$240 2) = (US$ 120 - US$3.2 incentive fee) = US$116.8 per ShareNAV per Share = (US$240 2) = (US$ 120 - US$3.2 incentive fee) = US$116.8 per Share

ix)ix)

Therefore: Therefore: a) Investor A effectively pays US$3.2 incentive fee on a profit of US$20, which equals 16.4% of the profit made by a) Investor A effectively pays US$3.2 incentive fee on a profit of US$20, which equals 16.4% of the profit made by Investor A; whereas, Investor A; whereas, b) Investor B effectively pays US$3.2 incentive fee on a profit of US$12, which equals 26.66% of the profit made by b) Investor B effectively pays US$3.2 incentive fee on a profit of US$12, which equals 26.66% of the profit made by Investor B Investor B

The Claw Back SyndromeThe Claw Back Syndrome

i)i) Investor A buys one Share at US$100 per share at launch.Investor A buys one Share at US$100 per share at launch.

ii)ii) At the end of the second month the gross NAV per share has risen to US$110, i.e. US$108 net of incentive fee accrual.At the end of the second month the gross NAV per share has risen to US$110, i.e. US$108 net of incentive fee accrual.

iii)iii) Investor B now buys one share at US$108Investor B now buys one share at US$108

iv)iv) The NAV of the fund is now US$218 excluding incentive fee accrualThe NAV of the fund is now US$218 excluding incentive fee accrual

v)v) The fund loses US$26 in month three. The Gross NAV falls down to US$192 or US$96 per share.The fund loses US$26 in month three. The Gross NAV falls down to US$192 or US$96 per share.

vi)vi) The loss per share should be US$26 2, which equals US$13 per share.The loss per share should be US$26 2, which equals US$13 per share.

vii)vii) Given that the fund lost US$13 per share, the fair value of Investor A's investment should be US$97 (US$110 - US$13) Given that the fund lost US$13 per share, the fair value of Investor A's investment should be US$97 (US$110 - US$13) whereas the fair value for investor B would be US$95 (US$108 less US$13).whereas the fair value for investor B would be US$95 (US$108 less US$13).

viii)viii) The actual loss to Investor A is US$14 (US$110 less US$96), whereas the loss to Investor B is actually US$12 (US$108 The actual loss to Investor A is US$14 (US$110 less US$96), whereas the loss to Investor B is actually US$12 (US$108 invested less US$96).invested less US$96).

Series of shares & consolidated method Series of shares & consolidated method

It requires the fund to issue a new Series of Shares each time there is a 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 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 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 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 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 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, 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.including the Lead Series. This may be quarterly, half-yearly, or annually.

The advantage of this system is that it is a relatively simple procedure and, 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.investors can understand how it works and can see that it is fair to all parties.

Series of shares & consolidated method –rising Series of shares & consolidated method –rising marketmarket

i)i) Investor A buys 1,000 Lead Series Shares at US$1,000 per Share Investor A buys 1,000 Lead Series Shares at US$1,000 per Share

ii)ii) End of first month, GNAV per Share has risen 10% to US$1,100 End of first month, GNAV per Share has risen 10% to US$1,100

iii)iii) NAV published at US$1,080 (US$1,100 less US$20 incentive fee)NAV published at US$1,080 (US$1,100 less US$20 incentive fee)

iv)iv) Investor B now buys 1,000 Series II Shares at US$1,000 per Share Investor B now buys 1,000 Series II Shares at US$1,000 per Share

v)v)End of second month, value of fund has risen by further 10% so that: End of second month, value of fund has risen by further 10% so that: a) GNAV of Lead Series is now US$1,210 = NAV US$1,168; and a) GNAV of Lead Series is now US$1,210 = NAV US$1,168; and b) GNAV of Series II is now US$1,100 = NAV US$1,080 b) GNAV of Series II is now US$1,100 = NAV US$1,080

vi)vi) Investor C buys 1,000 Series III Shares at US$1,000 per Share Investor C buys 1,000 Series III Shares at US$1,000 per Share

vii)vii)

End of third month, fund value has again risen by 10% so that: End of third month, fund value has again risen by 10% so that: (i) GNAV of Lead Series is now US$1,331 = NAV US$1,264.80; (i) GNAV of Lead Series is now US$1,331 = NAV US$1,264.80; (ii) GNAV of Series II is now US$1,210 = NAV US$1,168; and (ii) GNAV of Series II is now US$1,210 = NAV US$1,168; and (iii) GNAV of Series III is now US$1,080 (iii) GNAV of Series III is now US$1,080

viii)viii) As it is the end of the quarter and new HWM has been achieved, the incentive fees are paid As it is the end of the quarter and new HWM has been achieved, the incentive fees are paid

ix)ix) Series II and Series III Shares are then consolidated into Lead Series Series II and Series III Shares are then consolidated into Lead Series

x)x)

Thus: Thus: a) Investor B exchanges 1,000 Series II Shares, now worth US$1,168,000 for 923.466 Lead Series Shares at a) Investor B exchanges 1,000 Series II Shares, now worth US$1,168,000 for 923.466 Lead Series Shares at US$1,264.80 US$1,264.80 b) Investor C exchanges 1,000 Series III Shares, now worth US$1,080,000 for 853.890 Lead Series Shares b) Investor C exchanges 1,000 Series III Shares, now worth US$1,080,000 for 853.890 Lead Series Shares

Series of shares & consolidated method –volatile Series of shares & consolidated method –volatile marketmarket

i)i)Investor A buys 1,000 Lead Series Shares at US1,000 per ShareInvestor A buys 1,000 Lead Series Shares at US1,000 per Share

ii)ii) End of first month, GNAV per Share has risen 10% to US$1,100 End of first month, GNAV per Share has risen 10% to US$1,100

iii)iii) NAV published at US$1,080 (US$1,100 less US$20 incentive fee) NAV published at US$1,080 (US$1,100 less US$20 incentive fee)

iv)iv) Investor B now buys 1,000 Series II Shares at US$1,000 per Share Investor B now buys 1,000 Series II Shares at US$1,000 per Share

v)v)End of second month, value of fund has risen by further 10% so that: End of second month, value of fund has risen by further 10% so that: a) GNAV of Lead Series is now US$1,210 = NAV US$1,168; and a) GNAV of Lead Series is now US$1,210 = NAV US$1,168; and b) GNAV of Series II is now US$1,100 = NAV US$1,080 b) GNAV of Series II is now US$1,100 = NAV US$1,080

vi)vi) Investor C buys 1,000 Series III Shares at US$1,000 per Share Investor C buys 1,000 Series III Shares at US$1,000 per Share

vii)vii)

End of third month GNAV has declined by 4% so that: End of third month GNAV has declined by 4% so that: (a) GNAV of Lead Series is US$1,161.6 = NAV US$1,129.28 (a) GNAV of Lead Series is US$1,161.6 = NAV US$1,129.28 (b) GNAV of Series II is US$1,056 = NAV US$1,044.8 (b) GNAV of Series II is US$1,056 = NAV US$1,044.8 (c) GNAV of Series III is US$960 = NAV US$960 (c) GNAV of Series III is US$960 = NAV US$960

viii)viii) At this time an incentive fee is paid on the Lead Series and Series II, but obviously not on Series III At this time an incentive fee is paid on the Lead Series and Series II, but obviously not on Series III

ix)ix) Therefore, Series II will be consolidated into the Lead Series = but Series III will have to wait until a new HWM Therefore, Series II will be consolidated into the Lead Series = but Series III will have to wait until a new HWM has been achievedhas been achieved

Disadvantage of Series MethodDisadvantage of Series Method

• Many funds only pay incentive fees once a year and this means that the Series Many funds only pay incentive fees once a year and this means that the Series of Shares and Consolidation Method can be quite cumbersome, if a fund is a of Shares and Consolidation Method can be quite cumbersome, if a fund is a heavily traded, expanding fund, then by the end of the year it could have 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 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 possible that that could go up to twenty-four Series being issued, before the next accounting period is finished.next accounting period is finished.

• It’s not possible to publish a single NAV per Share, because each Series had It’s not possible to publish a single NAV per Share, because each Series had its own NAV. There is no real problem in publishing several different NAVs, its own NAV. There is no real problem in publishing several different NAVs, but it could be confusing to some shareholders, particularly if they make 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 several investments into the fund over a period of time and so end up with holdings that have different NAVs. holdings that have different NAVs.

• Fund's whose Shares are listed on a Stock Exchange, will probably be Fund's whose Shares are listed on a Stock Exchange, will probably be necessary to apply to list each Share in issue. This is administratively time 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 consuming and therefore expensive and again there is the problem of having to publish the full list of NAVs.to publish the full list of NAVs.

The Wish ListThe Wish List

• Equitable allocation of incentive feesEquitable allocation of incentive fees• All investors have same capital risk per share.All investors have same capital risk per share.• Single NAV per share.Single NAV per share.• Published NAV accurately reflects the funds Published NAV accurately reflects the funds

performance.performance.• Method used should be easily understood.Method used should be easily understood.

What is Simple Equalization?What is Simple Equalization?

• Simple Equalization", the procedure is to calculate the Simple Equalization", the procedure is to calculate the performance fee and allocate it fairly between each performance fee and allocate it fairly between each investor, or group of investors at the end of each investor, or group of investors at the end of each accounting period. As investors will have come in at accounting period. As investors will have come in at different levels this will mean calculating different different levels this will mean calculating different NAVs per investor. However, in order to get a NAVs per investor. However, in order to get a common NAV for all Shares in the fund, the lowest of common NAV for all Shares in the fund, the lowest of all the NAVs calculated, on an investor-by-investor all the NAVs calculated, on an investor-by-investor basis, is selected to become the NAV of the fund. basis, is selected to become the NAV of the fund.

Types of equalizationTypes of equalization

• Simple equalization-rising market.Simple equalization-rising market.• Simple equalization-volatile market.Simple equalization-volatile market.• Simple equalization –falling market.Simple equalization –falling market.• Equalization factor / Depreciation depositEqualization factor / Depreciation deposit. . • Equalization adjustment approach.Equalization adjustment approach.• Equalization approach-Decline marketEqualization approach-Decline market• Investment Mgmt Agreement-Failure to adjust Investment Mgmt Agreement-Failure to adjust

for redemptionsfor redemptions

Simple equalization-rising marketSimple equalization-rising market

Shareholders with a higher individual NAV perShareholders with a higher individual NAV per

share are issued "Equalization Shares", so that theshare are issued "Equalization Shares", so that the

total number of Shares issued to that investor (i.e.-total number of Shares issued to that investor (i.e.-

the original Shares purchased plus anythe original Shares purchased plus any

Equalization Shares) multiplied by the new NAV ofEqualization Shares) multiplied by the new NAV of

the fund, which we know is the lowest NAVthe fund, which we know is the lowest NAV

calculated, will now enable the investment forcalculated, will now enable the investment for

those investors to be kept constant.those investors to be kept constant.

Simple equalization-rising marketSimple equalization-rising market

i)i) Launch:Launch: Investor A buys 1,000 shares at US$100 Investor A buys 1,000 shares at US$100= US$100,000= US$100,000

ii)ii) End Month 1:End Month 1: GNAV = US$110 GNAV = US$110

iii)iii) Investor A NAV = US$108 (US$110 minus US$2 incentive fee)Investor A NAV = US$108 (US$110 minus US$2 incentive fee)= US$108,000= US$108,000

iv)iv) Investor B buys 1,000 shares at US$108.Investor B buys 1,000 shares at US$108.= US$108,000= US$108,000

v)v) Total NAV of the fundTotal NAV of the fund= US$216,000= US$216,000

vi)vi) End Month 2:End Month 2: GNAV = US$120 GNAV = US$120

vii)vii) Investor A NAV = US$116 (US$120 minus US$4 incentive feeInvestor A NAV = US$116 (US$120 minus US$4 incentive fee= US$116,000= US$116,000

viii)viii) Investor B NAV = US$1176 (US$120 minus US$2.4 incentive feeInvestor B NAV = US$1176 (US$120 minus US$2.4 incentive fee= US$117,600= US$117,600

ix)ix)

Published NAVPublished NAV = US$116 = US$116a) Investor B has 1,000 shares @ US$116a) Investor B has 1,000 shares @ US$116= US$116,000= US$116,000b) Investor B allocated 13.793 shares @ US$116b) Investor B allocated 13.793 shares @ US$116= US$1,600= US$1,600Total ValueTotal Value= US$117,600= US$117,600

Simple equalization-volatile marketSimple equalization-volatile market

i)i) End Month 3: GNAV = US$105 End Month 3: GNAV = US$105

ii)ii) Investor A NAV = US$104 (US$105 minus US$1 incentive fee)Investor A NAV = US$104 (US$105 minus US$1 incentive fee)

iii)iii) Investor B NAV = US$105 (No incentive fee)Investor B NAV = US$105 (No incentive fee)

iv)iv)

Published NAV = US$104 Published NAV = US$104 a) Investor B has 1,000 shares @ US$104 = US$104,000 a) Investor B has 1,000 shares @ US$104 = US$104,000 b) Investor B allocated 9.6154 shares @ US$104 = US$ 1,000 b) Investor B allocated 9.6154 shares @ US$104 = US$ 1,000 Total Value = US$105,000 Total Value = US$105,000

Simple equalization-falling marketSimple equalization-falling market

i)i) End Month 4End Month 4:: GNAV = US$98 GNAV = US$98

ii)ii) Investor A NAV = US$98 - no incentive feeInvestor A NAV = US$98 - no incentive fee

iii)iii) Investor B NAV = US$98 - no incentive feeInvestor B NAV = US$98 - no incentive fee

iv)iv) No Equalization shares issued because NAVs are equalNo Equalization shares issued because NAVs are equal

Equalization Factor / Depreciation DepositEqualization Factor / Depreciation Deposit

• In this case each investor invests at the NAV, plus either the In this case each investor invests at the NAV, plus either the Equalization Factor or the Depreciation Deposit, depending Equalization Factor or the Depreciation Deposit, depending upon whether the NAV of the Fund has increased or declined upon whether the NAV of the Fund has increased or declined from the last high water-mark.from the last high water-mark.

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

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

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

Equalization Factor / Depreciation DepositEqualization Factor / Depreciation Deposit

Equalization Adjustment ApproachEqualization Adjustment Approach

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

Equalization Adjustment ApproachEqualization Adjustment Approachi)i) Launch at US$100 per share Launch at US$100 per share

ii)ii) Investor A buys 1,000 shares @ US$100 Cost = US$100,000 Investor A buys 1,000 shares @ US$100 Cost = US$100,000

iii)iii) End Month 1: GNAV = US$120 End Month 1: GNAV = US$120

iv)iv) Investor A NAV (US$120 minus US$4 incentive) = US$116 NAV = US$116,000 Investor A NAV (US$120 minus US$4 incentive) = US$116 NAV = US$116,000

v)v) Investor B subscribes GNAV (US$120) for 1,000 shares Cost = US$120,000 Investor B subscribes GNAV (US$120) for 1,000 shares Cost = US$120,000

vi)vi)

This comprises: This comprises: 1,000 shares @ US$116 NAV = US$116,000 1,000 shares @ US$116 NAV = US$116,000 Equalization credit = (incentive fee) = US$ 4,000 Equalization credit = (incentive fee) = US$ 4,000 Total subscribed = US$120,000 Total subscribed = US$120,000

vii)vii) End Month 2: GNAV = US$130End Month 2: GNAV = US$130

viii)viii) Investor A NAV = US$124 (US$130 - US$6 incentive fee) NAV = US$124,000 Investor A NAV = US$124 (US$130 - US$6 incentive fee) NAV = US$124,000

ix)ix) Investor B NAV = US$128 (US$130 - US$2 incentive fee) Total = US$128,000 Investor B NAV = US$128 (US$130 - US$2 incentive fee) Total = US$128,000

x)x)

This will be comprised of: This will be comprised of: Investor B = 1,000 shares @ US$124 = US$124,000 Investor B = 1,000 shares @ US$124 = US$124,000 Equalization credit = US$ 4,000 Equalization credit = US$ 4,000 Total = US$ 128,000 US$128,000 Total = US$ 128,000 US$128,000

xi)xi) Total Fund NAV = US$252,000 Total Fund NAV = US$252,000

xii)xii)

Cross check: Cross check: a) GNAV (2,000 x US$130 = US$260,000 a) GNAV (2,000 x US$130 = US$260,000 b)Total Subscribed: Investor A = US$100,000 b)Total Subscribed: Investor A = US$100,000 Investor B = US$120,000 Investor B = US$120,000 Total subscribed = US$220,000 US$220,000 Total subscribed = US$220,000 US$220,000 ADD Gross Profit = US$ 40,000 ADD Gross Profit = US$ 40,000 GNAV = US$260,000 GNAV = US$260,000 DEDUCT Incentive 20% = US$ 8,000 DEDUCT Incentive 20% = US$ 8,000 Thus Net Profit = US$32,000 Thus Net Profit = US$32,000

xiii)xiii) Add net profit to sum subscribed NAV = US$252,000 Add net profit to sum subscribed NAV = US$252,000

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

Equalization approach-Decline marketEqualization approach-Decline market

Equalization approach-Decline marketEqualization approach-Decline market

i)i) Investor A buys 1,000 shares @ US$100 Investor A buys 1,000 shares @ US$100

ii)ii) Investor B buys 1,000 shares @ US$120, inclusive of US$4 Equalization Credit as before Investor B buys 1,000 shares @ US$120, inclusive of US$4 Equalization Credit as before

iii)iii) End Month 2:GNAV = US$105 End Month 2:GNAV = US$105

iv)iv) Investor A NAV = US$104 (US$105 US$1 incentive Investor A NAV = US$104 (US$105 US$1 incentive

v)v)

Investor B = US$105 Investor B = US$105 Comprised of NAV: US$104 Comprised of NAV: US$104 Equalization Credit: US$ 1 Equalization Credit: US$ 1 Total Value US$105 Total Value US$105

vi)vi) End Month 3: GNAV = US$98End Month 3: GNAV = US$98

vii)vii) Investor A NAV = US$98 (no incentive fee) Investor A NAV = US$98 (no incentive fee)

viii)viii) Investor B NAV = US$98 (no Equalization credit)Investor B NAV = US$98 (no Equalization credit)

Investment Mgmt Agreement-Failure to adjust for Investment Mgmt Agreement-Failure to adjust for redemptionsredemptions

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

Investment Mgmt Agreement-Failure to adjust for Investment Mgmt Agreement-Failure to adjust for redemptionsredemptions

i)i)4 Investors subscribe US$1 million each.4 Investors subscribe US$1 million each.

Total NAV = US$4,000,000Total NAV = US$4,000,000

ii)ii) NAV declines by 20%.NAV declines by 20%.Loss = (US$ 800,000)Loss = (US$ 800,000)

iii)iii) Thus, Total NAVThus, Total NAV= US$3,200,000= US$3,200,000

iv)iv)

One Investor redeems his holdingOne Investor redeems his holding=(=(US$ 800,000US$ 800,000))

Remaining NAVRemaining NAV= US$2,400,000= US$2,400,000

v)v)

If Investment Manager has to recoup full lossIf Investment Manager has to recoup full loss= = US$800,000US$800,000

Total NAV will beTotal NAV will be= US$3,200,000= US$3,200,000

vi)vi) Therefore, 3 remaining shareholders will have made US$200,000 "free ride" between themTherefore, 3 remaining shareholders will have made US$200,000 "free ride" between them

THANK YOUTHANK YOU