Series accounting

Offshore hedge funds often face a challenging problem: how do they treat investors fairly when people invest at different times and the fund's value changes? Series accounting provides one solution to this problem.

When offshore funds are set up as corporations, they create a new "series" of shares each time someone invests money. Each series has its own 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. —essentially a record of the highest value that series has ever reached. This system ensures that when new money comes into the fund at a different price per share, the performance measurement starts fresh for that new investment.

Here's why this matters: imagine the fund is worth $100 per share when Investor A puts money in, but it's worth $120 per share when Investor B invests six months later. Without series accounting, both investors might be treated the same way for fee purposes, even though they entered at very different performance levels.

Some funds use a variation where each individual investor gets their own series. This approach allows the same investor to make multiple contributions over time while keeping all their investments grouped together under one series designation.

Corporate-structured hedge funds handle performance tracking differently than funds organized as partnerships. Partnerships typically use loss carryforward mechanisms—a system that tracks each investor's contributions and losses over time. Corporate funds, however, use the series approach instead.

Here's how it works: the fund issues a distinct series of shares each time someone invests. When it's time to calculate 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. , the fund looks at each series separately. The fund only collects incentive compensationPerformance-based pay structures that reward fund managers based on the fund's returns or achievement of specific targets. when a series's net asset value (the total value divided by the number of shares) rises above its previous high-water mark from the last time fees were calculated.

This method ensures that the fund managers only get paid performance fees when they actually create value for that specific group of shares, not when they're just recovering from earlier losses.

At the end of each performance measurement period (usually quarterly or annually), the fund simplifies its structure through a process called conversion. All the subsidiary share series—everything except the main, original series—get converted back into the primary series.

This conversion works like a redemption and reinvestment process. The fund essentially "buys back" the subsidiary series shares and then immediately "sells" the investor an equivalent value of primary series shares at the current market price.

However, this consolidation has an important rule: it only happens when both the subsidiary series and the primary series are above their respective high-water marks. If either one is still below its previous peak value, the series remain separate. This preservation of separate tracking continues until both series recover their losses.

The consolidation process, commonly called a "series roll-up," serves two main purposes. First, it reduces administrative burden by decreasing the number of separate share classes the fund must track and maintain records for. Second, it ensures fair treatment across investors who entered the fund at different times and performance levels.

When performance thresholds are met, the roll-up merges multiple series into one unified series. This creates administrative efficiency while maintaining the core principle of equitable treatment—investors don't get penalized or rewarded unfairly based solely on when they decided to invest.

The series structure creates some interesting scenarios. For example, a fund might pay its managers performance fees based on gains in one series while another series from an earlier investment date remains below its high-water mark. This means managers get compensated for genuine performance improvements rather than just market timing.

The hedge fund industry has also evolved in how it structures these offshore vehicles. A notable trend involves forming offshore funds as partnerships—similar to how domestic funds are typically organized—but then electing to be taxed as corporations for U.S. tax purposes. This approach combines the operational flexibility of partnership structures with certain tax advantages.

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. often prefer either series accounting or equalization methods based on their operational systems and technical capabilities. Both approaches solve the same fundamental problem: ensuring fair treatment among investors who enter the fund at different times.

Series accounting achieves this fairness through distinct share classesDifferent categories of fund shares with varying fee structures, rights, or redemption terms offered to different investor types.. Each group of shares has its own performance history and high-water mark. Equalization methods, by contrast, use a single share class for all investors but make computational adjustments to ensure fairness. These adjustments account for when each investor entered and what the fund's performance has been since their entry.

Both methods accomplish the same goal—equitable return treatment among investors with staggered entry dates—but through fundamentally different mechanisms. The choice between them often comes down to which system the fund administrator's technology and processes can handle more efficiently.