Multi-series and equalization accounting

Multi-series and equalization accounting solve a critical fairness problem in hedge fund management. When investors join a fund at different times, they may be entering when the fund is up significantly from its starting point or down from previous highs. Without proper accounting methods, later investors could end up paying performance fees Performance fee A performance fee is compensation paid to a hedge fund manager based on the fund's investment profits, typically calculated as a percentage (commonly 20%) of returns above a specified threshold, subject to high-water marks and potentially hurdle rates. on gains they never actually experienced, while early investors might avoid fees on performance they did benefit from.

These accounting methods ensure that each investor pays incentive fees only on the actual performance achieved during their specific time in the fund. This prevents a situation where one group of investors effectively subsidizes another group's fees based purely on timing differences.

Multi-series accounting creates separate "series" or classes of shares for different investment dates. Each series maintains its own performance benchmark, called a high-water mark High-water mark High-water mark is the highest value that an investment in a hedge fund has previously reached. This benchmark ensures that fund managers only receive performance-based compensation when they generate new profits that exceed this previous peak. The high-water mark protects investors from paying performance fees multiple times on the same gains. , based on the price when that series was first issued. Fund managers calculate performance fees separately for each series.

Here's how it works: when a fund reaches a performance measurement date and a particular series has exceeded its high-water mark, that series may be "rolled up" or converted back into the main series. This process simplifies record-keeping while preserving fairness.

Historically, offshore funds Offshore fund An offshore fund is a hedge fund established outside the United States, typically in low-tax jurisdictions like the Cayman Islands or British Virgin Islands. These funds primarily serve non-U.S. investors and U.S. tax-exempt organizations by offering tax advantages and greater regulatory flexibility than domestic fund structures. organized as corporations have issued different series of shares on each subscription dateThe date when an investor purchases shares or interests in a fund, determining their entry price and series classification.. Since funds commonly establish a new series for each investment date, managers must track the high-water mark for each series independently. Some offshore funds simplify this process by creating a separate series for each individual investor, using that same series for both their initial investment and any subsequent contributions.

At the end of each fiscal year, funds typically convert each non-original series back into the original series of shares. This conversion process involves redeeming the existing series and using those proceeds to purchase shares of the original series at the current net asset valueThe total value of a fund's assets minus its liabilities, divided by the number of outstanding shares or units. per share.

However, funds will not perform this conversion if either the particular series or the original series is trading below its respective prior high net asset value. Investment managers call this conversion process a "series roll-upA process where offshore funds convert series shares that have exceeded their high-water mark back into the main series to simplify record-keeping.." This mechanism helps streamline record-keeping and reduces the number of different series the fund must track over time.

Some hedge funds structured as corporations take a different approach. Instead of issuing different series on each subscription date, they issue shares of a single, undifferentiated series at the current net asset value. This creates potential fairness problems.

Under this approach, investors making interim-year purchases might buy shares that have already gained value and will trigger incentive compensationPerformance-based pay structures that reward fund managers based on the fund's returns or achievement of specific targets. payments. Alternatively, they might purchase shares that have accumulated losses, which the investment manager must recover before receiving any incentive compensation. Without correction, this would lead to unfair treatment among shareholders.

To address this issue, funds use "share equalizationAccounting methods used by corporate hedge funds to ensure performance fees are only charged based on gains that occurred after each investor's purchase date.." This system ensures that incentive compensation is charged only on shares that have actually appreciated in value since each investor acquired them.

Investment managers apply an equalization factor when investors purchase shares at a time when the current price exceeds the prior high net asset value. In this situation, part of the purchase price for new shares becomes an equalization amount.

The fund calculates this amount as the incentive fee percentage multiplied by the difference between the current offering priceThe price at which securities are sold to investors in a public or private offering, typically set during the pricing process. and the prior high net asset value. This amount serves as a credit against future incentive compensation that the investor may owe.

If the value increase that created the equalization factor is not lost during the current year, the fund returns the equalization factor to the shareholder at year-end. This ensures the investor doesn't pay incentive fees on gains that occurred before they invested.

Conversely, managers use a depreciation deposit when investors purchase shares at a time when the offering price sits below the prior high net asset value. Under these circumstances, a shareholder will owe additional incentive compensation for any appreciation on their shares until the appreciation reaches the prior high net asset value.

When the fund recovers the losses that created the depreciation deposit by the end of any fiscal year, the fund pays the depreciation deposit to the investment manager as part of the incentive compensation. This ensures that the manager eventually receives fees on the full recovery back to previous high levels.

Funds structured as partnerships or limited liability companies handle this situation differently. These funds use capital accounts to track each investor's individual investments and typically maintain any prior losses in a separate record called a loss carryforward Loss carryforward Loss carryforward is a provision in hedge fund fee structures that ensures managers must recoup previous losses before earning new performance fees, typically implemented through memorandum accounts that track losses that must be recovered before incentive compensation resumes. account.

Under this system, the investment manager cannot receive any incentive compensation until the fund has recovered all prior losses and reduced the balance of the loss carryforward account to zero. This approach provides a simpler but equally fair method for ensuring proper fee allocation.

Some fund administrators Fund administrator A fund administrator is an independent third-party company that handles essential day-to-day operations for hedge funds. These companies calculate how much the fund is worth, serve investors, ensure regulatory compliance, and manage back-office operations. They work separately from the investment manager to provide oversight and protect investors. prefer either the series roll-up method or the equalization method based on their operating systems and capabilities. The choice between methodologies typically depends on several factors: the fund's legal structure, operational preferences, and administrative capabilities.

There is also a growing trend toward structuring offshore funds as partnerships. These funds use legal documents that match their domestic counterparts but elect to be treated as corporations for U.S. tax purposes. This structure can provide operational flexibility while maintaining favorable tax treatment.