Foundation — Management fees, incentive fees and the other expenses of an AIF

A transport contractor pays his driver a monthly wage and a bonus for every consignment delivered ahead of schedule. The wage is paid whether the lorry runs empty or full. The bonus is paid only for performance.

That is the difference between the two AIF fees, and the workbook is emphatic about the first.

Management Fee is FIXED and paid to the Investment Manager, IRRESPECTIVE OF ANY FUTURE GAINS OR LOSSES MADE BY THE FUND. Management Fees are paid FOR THE FUND MANAGEMENT SERVICES PROVIDED by the Investment Manager AND NOT FOR PROFIT-GENERATION.

That last clause is the one to remember, because it answers the complaint investors make in a bad year. The fee is not a share of profit that has failed to arrive; it is payment for a service that was in fact rendered — research, sourcing, monitoring, reporting — all of which happened whether or not the portfolio rose.

The bonus is the INCENTIVE FEE, also called PERFORMANCE FEES or CARRIED INTEREST, charged as a percentage of the INCREMENTAL RETURN earned by the AIF, generally between 0 and 20 percent.

And the workbook explains what it is for: incentive fees help to ALIGN THE INTEREST of the Investment Manager with the interest of the fund and ENCOURAGE THE INVESTMENT MANAGER TO SEEK BEST EXECUTION of investments for the interest of the investors.

Two fees, two purposes. One buys the work; the other buys the alignment. An investor who resents the first has misunderstood what it pays for; an investor who does not scrutinise the second has misunderstood how much it can cost.

A trader hires a godown. Under one contract he pays rent on the whole godown, whether or not it is full. Under another he pays on the value of goods actually stored.

That is the choice of management fee base, and the workbook sets out both.

Management Fees in the Category I and II AIF industry are charged AS A PERCENTAGE OF THE COMMITTED CAPITAL, DURING THE COMMITMENT PERIOD. Thereafter, it MAY BE REDUCED to a percentage of ONLY THE ACTUAL INVESTED CAPITAL, in case it is lesser than the committed capital, OR AS A PERCENTAGE OF THE UNDERLYING VALUE OF THE ASSETS UNDER MANAGEMENT (AUM).

Example 6.1 shows the first. Fund ABC with INR 50 crore committed pays 1.5% × 50 crore = INR 75 lakh, plus 18% GST of INR 13.50 lakh, giving INR 88.50 lakh — and the workbook computes the same amount in both Year 1 and Year 2, because the NAV rising from 58 to 65 crore changes nothing.

Example 6.2 shows the shift. Fund ABC with INR 500 crore committed pays on committed capital in Year 1 — 1.5% × 500 crore = INR 7.5 crore plus GST 1.35 crore = INR 8.85 crore — and on GNAV from Year 2 — 1.5% × 650 crore = INR 9.75 crore plus GST 1.755 crore = INR 11.505 crore.

The fee rose 30 per cent in one year because the fund did well. That is the essential asymmetry: a committed-capital base is stable; an AUM base rewards the manager as the portfolio rises — and, importantly, shrinks as it falls.

And there is a third negotiation the workbook records. Investors request that the management fee after the commitment period be charged ON THE ORIGINAL AMOUNT OF INVESTED CAPITAL AND NOT ON THE AMOUNTS UTILISED TOWARDS EXPENSES OR MANAGEMENT FEES — otherwise the investor pays a fee on money that was spent on fees.

A vaulter who clears 4.20 metres scores nothing if the qualifying height is 4.50. Only the part above the bar counts.

The workbook grounds the AIF hurdle in a clear economic idea. The investors in AIF have an OPPORTUNITY COST of investment — the return foregone on the NEXT BEST POSSIBLE INVESTMENT in the market, in any asset class such as equities, fixed income securities, real estate, commodities or money market instruments. So investors look for securities or investment funds that have HIGHER EXPECTED RETURNS, compared to the opportunity cost.

Hence every AIF Manager sets a HURDLE RATE, or the MINIMUM RATE OF RETURN TO BE ACCRUED TO FUND INVESTORS every year, or any shorter reporting period such as quarter or half-year. The return generated using it is the PREFERRED RETURN — the portion of the total return of the fund that ACCRUES TO THE INVESTORS ONLY.

And crucially: the Preferred Return WILL NOT BE TAKEN INTO ACCOUNT DIRECTLY for the purpose of computation of Incentive Fees. Incentive Fees is paid on the return generated OVER AND ABOVE such Preferred Return.

The rates are examinable and the comparison is striking. In the Indian market, hurdle rates in the AIF industry are GENERALLY 7 PERCENT TO 12 PERCENT PER ANNUM IN INR TERMS, and are meant to be HIGHER than the international standards of GENERALLY 5 PERCENT TO 8 PERCENT PER ANNUM IN USD TERMS.

The negotiation is genuinely two-sided, and the workbook says so. If the Hurdle Rate is HIGH, the Investment Manager will NOT be able to generate high incentive fees. Hence the Investment Manager will PREFER TO KEEP THE HURDLE RATE LOW. And the Investors will prefer to keep the Hurdle Rate HIGH, in order to generate higher accrued return from the fund.

But the purpose is not a promise. It is TO BENCHMARK THE EXPECTATIONS OF THE INVESTORS RATHER THAN TO PROVIDE A GUARANTEED RETURN (WHICH IS NEITHER PERMISSIBLE NOR POSSIBLE).

A man deposits Rs 50 lakh at 10 per cent. After one year he has Rs 55 lakh. In the second year the interest is computed on Rs 55 lakh, not on Rs 50 lakh — and everyone accepts that without argument.

The AIF hurdle behaves identically, and the workbook states it in terms that leave no room for doubt.

Reference Hurdle NAV is computed using the CALLED-UP CAPITAL AT THE BEGINNING OF THE YEAR and adding the hurdle return on the called up capital. FROM THE SECOND YEAR ONWARDS, THE HURDLE NAV IS CALCULATED BY ADDING THE PREVIOUS YEAR HURDLE NAV WITH THE HURDLE RETURN in a closed ended fund (Cat I and II). IN OTHER WORDS, THE HURDLE RATE IS A COMPOUND RATE, NOT A SIMPLE RATE.

Example 6.3 shows it working. Called-up capital INR 50 crore, hurdle 10 per cent. Year 1 hurdle NAV = 50 × 1.1 = INR 55 crore. Year 2 hurdle NAV = 55 × 1.1 = INR 60.5 crore — not 50 + 5 + 5 = 60.

The half-crore difference matters more than it looks, because it is subtracted before the incentive fee is computed, and the effect grows every year. Over a five-year fund at 10 per cent, compounding raises the hurdle from 150 to 161 per cent of capital.

And the workbook adds a detail examiners like: TYPICALLY, HURDLE IS CALCULATED AS PRE-TAX HURDLE.

Example 6.3 also carries a warning about paying incentives annually at all. There is a sharp increase in the Incentive Fees computed for Year 2... DUE TO DOUBLE COMPUTATION OF INCENTIVE FEES, ON THE EXCESS RETURN EARNED IN YEAR 1. The remedy the workbook gives is the market practice: Investment Managers are paid Incentive Fees ONLY AT THE END OF THE FUND TENURE, OR AT THE TIME OF MAKING EXITS, instead of yearly — which also ensures that Incentive Fees is paid AFTER PROVIDING FOR FUTURE POSSIBLE LOSSES OR DECLINE IN THE NAV.

Old buildings by a river carry a painted line showing the highest flood ever recorded. A later flood matters only if it goes above the line.

That is the high-water mark, and the workbook explains why an AIF needs one. Due to inherent market risks, it is possible that the investment strategy adopted MAY GENERATE A LOSS IN ANY YEAR of the fund life-cycle. For instance, a Category II AIF may generate a 20 percent return in its first year, MINUS 5 PERCENT returns in the second year and 11 percent return in the third year.

In order to ensure alignment of interest of the Investment Manager with the AIF, and to safeguard the interest of investors, NO INCENTIVE FEES SHOULD BE PAID ON LOSSES MADE IN ANY YEAR, THROUGHOUT THE LIFE CYCLE OF THE FUND. The concept of High-Water Mark is introduced for this purpose.

The definition to memorise: High-Water Mark is THE HIGHEST NET ASSET VALUE, NET OF OPERATING EXPENSES, TRANSACTION EXPENSES AND MANAGEMENT FEES, ACHIEVED BY THE AIF AT THE END OF THE YEAR. IF THE NET ASSET VALUE HAS ONLY DECREASED SINCE INCEPTION OF THE FUND, HIGH-WATER MARK IS TAKEN AS THE INITIAL SUBSCRIPTION PRICE OF UNITS.

Note the three deductions in that definition — OPERATING EXPENSES, TRANSACTION EXPENSES AND MANAGEMENT FEES — and the fallback to the initial subscription price, which is why the first year's high-water mark in Example 6.4 is INR 1,000 per unit.

And the workbook gives it a second, diagnostic use. If the High-Water Mark of the AIF is CONSISTENTLY RISING above the previous High-Water Mark, it denotes SUPERIOR PAST AND PRESENT PERFORMANCE and is a good indicator for the future estimated returns. But if the High-Water Mark REMAINS UNCHANGED in previous years, IT IS AN INDICATOR OF POOR PERFORMANCE.

A flat line on the wall means the river has not risen since.

A goods vehicle must pass under two bridges on its route. Only the lower bridge matters to the driver — clearing the higher one is irrelevant if the lower one stops him. For the AIF manager the arithmetic is reversed: he must clear the HIGHER of two levels.

The workbook sets out the rule in Example 6.4: for the purpose of computing Incentive Fees, it is important to ascertain THE APPLICABLE NAV NOT ELIGIBLE FOR AN INCENTIVE FEE, WHICH IS HIGHER OF REFERENCE HURDLE NAV AND THE HIGH-WATER MARK.

If the difference between the NAV (Pre-incentives) and such applicable NAV is POSITIVE, then the Investment Manager is eligible for an Incentive Fee at the given rate on such difference. IF THE DIFFERENCE IS NEGATIVE, THEN THE INVESTMENT MANAGER SHALL NOT BE ELIGIBLE FOR ANY INCENTIVE FEES.

The worst-case scenario in Example 6.4 shows exactly why both gates are needed. In Year 2, NAV (pre-incentives) is INR 52.49 crore. The high-water mark is INR 53.48 crore and the reference hurdle is INR 60.50 crore. The higher is the hurdle, and the NAV clears neither — so no incentive fee.

But the workbook draws out a subtler point from the same table, and it is the one worth carrying away. In Year 2 of the Worst-case Scenario, the Net Asset Value of the Fund was BELOW THE HIGH-WATER MARK, due to which the Investment Manager was ineligible. IN SUCH CASES, IF INVESTORS HAVE NOT NEGOTIATED A HURDLE RATE AT THE TIME OF SUBSCRIPTION, THE HIGH-WATER MARK PREVENTS UNDUE INCENTIVE FEES BEING PAYABLE TO THE INVESTMENT MANAGER AND SERVES AS AN ADDITIONAL THRESHOLD.

The two protections are not duplicates. The hurdle says: beat the opportunity cost. The high-water mark says: do not charge twice for recovering ground you lost. An investor with only one of them is half protected.

And the arithmetic difference is stark. Across two years, the best case produced INR 63,34,350 of incentive fees and the worst case zero.

Three men split the proceeds of a joint venture. One has agreed to take a fifth of the whole profit. But the first tranche of money went entirely to repay the other two their capital. When further money arrives, he takes all of it until his fifth is made up — and only then does normal sharing begin.

That is catch-up, and the workbook defines it precisely. Catch-up Rate is THE RATE AT WHICH RESIDUAL PROFITS, AFTER RETURNING INVESTORS' CAPITAL AND HURDLE, WILL BE DISTRIBUTED TO THE MANAGER IN ORDER TO CATCH-UP TO AND RECEIVE THE PRE-DETERMINED SHARE OF THE TOTAL PROFITS OF THE FUND, as indicated in the Performance Fees rate (generally 10-20%).

Therefore, from the additional returns generated by the fund over and above the hurdle rate, THE MANAGER GETS PAID THE AGREED CATCH UP AMOUNT FIRST. Thereafter, from the residual additional returns, the distribution is done according to the agreed ratio.

Example 6.5 makes the size of the effect unmistakable. XYZ Fund: capital INR 50 crore, NAV at end of Year 3 INR 70 crore, hurdle 10 per cent, incentive 20 per cent of total profits.

Total profit = INR 20 crore. The manager's pre-determined share = 20% × 20 = INR 4 crore. The hurdle return over three years = 50 × (1.10)³ − 50 = INR 16.55 crore. So the residual is only INR 3.45 crore.

Without a catch-up clause: the residual is shared 20:80, so the manager gets INR 0.69 crore and investors INR 2.76 crore on top of their INR 66.55 crore.

With a 100 per cent catch-up: the manager takes the entire INR 3.45 crore, because even that is short of his INR 4 crore entitlement. Investors receive INR 66.55 crore and nothing more.

The manager's take goes from INR 69 lakh to INR 3.45 crore — five times — on identical fund performance. As the workbook concludes: this difference is SOLELY ON ACCOUNT OF THE INCLUSION OF A CATCH-UP CLAUSE IN THE CONTRIBUTION AGREEMENT.

And the warning is explicit: HIGHER THE CATCH UP RATE, HIGHER IS THE RISK TO INVESTORS OF RECEIVING A REDUCED SHARE OF THE ADDITIONAL RETURN OR IN SOME CASES, NO ADDITIONAL RETURN AT ALL.

A factory pays tax on the raw material it buys and recovers it against the tax it charges on what it sells. A household buying the same material recovers nothing, because it sells nothing.

An AIF is in the household's position, and the workbook states the reason in one sentence. AIFs DO NOT PROVIDE ANY SERVICES AND THEREFORE DO NOT NECESSARILY COLLECT GST ON OUTPUT SERVICES. THE ABSENCE OF RECOVERABILITY OF INDIRECT TAX SUCH AS GST INCREASES THE COST FOR INVESTORS IN THE FUND.

And the base on which it falls is wide. AIFs pay professional fees to Fund Administrators, Registrars, Custodians, Auditors, Brokers, Investment Advisors and other third-party professional experts, all taxable at the rate of 18% currently — and GST is also applicable at 18% on MANAGEMENT FEES AND TRUSTEESHIP FEES.

Example 6.6 quantifies it, and the total surprises people. Fund N with a corpus of INR 98 crore pays management fees of INR 1.96 crore plus six service provider fees, and the GST on all of them comes to INR 79,63,200 — which is 0.81 per cent of committed capital, in a single year.

That is comparable to half a year's management fee, paid purely in indirect tax that nobody can reclaim.

The workbook draws the conclusion an adviser should draw for an investor: the impact of GST can be HIGH AS A PERCENTAGE OF THE GROSS NAV of the fund, and a large outflow of fees to service providers, trustee and investment manager WILL RESULT IN A HIGHER LIABILITY TOWARDS GST for the fund, WHICH MAY NOT BE RECOVERABLE IN FORM OF INPUT CREDITS.

Which is why the chapter's advice on capping expenses is not a trivial point of housekeeping. Every rupee of avoidable service provider fee costs the fund Rs 1.18 — and the eighteen paise are gone for good.