Equalization

The presence of incentive fees and high water marks may complicate the calculations of the value of investors’ shares. If investors purchase shares at different times with different net asset values (NAV), naïve calculations of incentive fees may treat the investors differently.

For example, shares in a hedge fund are originally worth $100 when investor X purchases them. Subsequently, the shares fall to $90, which is when investor Y invests. Soon after, shares return to $100. If there is a high water mark at $100, then investor Y can liquidate her shares without incurring a performance fee, because the high water mark has not been passed.

Since Y has made a gross profit of $10 per share, this is obviously unfair. So an adjustment is necessary. To treat both earlier and new investors fairly, the adjustment of profit calculations is an accounting process called ‘equalisation.’

Since new investments are usually limited to certain periods (monthly or quarterly), a very simple form of equalisation is to issue a different series of shares for each subscription period, each with a different high water mark and different accruals of incentive fees. However, this form of equalisation leads to an unwieldy number of series of shares, so it is rarely used.

A more common equalisation method involves splitting new purchases into an investment amount and an equalisation amount that matches the incentive fee of earlier investors. The equalisation amount is used to put earlier investors and the new investor in the same position.

If the hedge fund shares go up in value, the equalisation amount is refunded. If the hedge fund shares lose value, the equalisation amount is reduced or eliminated. Many US hedge funds do not require equalisation, because they are either closed, so they do not allow new investments, or they are structured as partnerships that use capital accounting methods.

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