Reference Hurdle NAV

A hurdle rate is a percentage. You cannot subtract a percentage from a NAV.

The Reference Hurdle NAV is that percentage turned into money. It is the net asset value the fund would have if it had earned exactly the hurdle rate and nothing more, and it is the line the manager has to clear before a rupee of incentive fee is due. Everything above the line is the manager's share base; everything below it belongs to the investors as their preferred return.

The important word is reference. It is not a promise, not a guarantee, and not a floor on what investors receive — a guaranteed return is neither permitted nor possible. It is a benchmark the fee formula is measured against.

For a close-ended Category I or II AIF the hurdle compounds. Year 1 starts from called-up capital; every year after that starts from the previous year's Reference Hurdle NAV, not from the original capital and not from the actual NAV.

The fee is then computed on the gap between the fund's NAV pre-incentives — gross asset value less amortised set-up costs, less yearly fund expenses, less management fee including GST — and the Reference Hurdle NAV.

Where a high-water mark also applies, as it does for Category I and II managers distributing deal by deal, the NAV that is not eligible for incentives is the higher of the high-water mark and the Reference Hurdle NAV. The two tests are applied together, not as alternatives.

The hurdle is normally struck pre-tax. Indian AIF hurdles run 7 to 12 per cent in rupee terms, against 5 to 8 per cent in dollar terms internationally, and the level is genuinely negotiated: the manager wants it low, the investor wants it high.

Reference Hurdle NAV (year 1) = Called-up capital × (1 + h)
Reference Hurdle NAV (year t) = Reference Hurdle NAV (year t−1) × (1 + h)

NAV pre-incentives  = Gross asset value
                      − amortised set-up cost
                      − yearly fund expenses
                      − management fee (incl. GST)

Incentive fee = Rate × [ NAV pre-incentives − higher of (high-water mark,
                                                        Reference Hurdle NAV) ]

Example 6.3. Fund ABC, close-ended, called-up capital Rs 50 crore in 5,00,000 units, tenure 5 years, management fee 1.5 per cent of gross NAV plus 18 per cent GST, set-up cost Rs 1.25 crore amortised over 5 years, yearly fund expenses Rs 30 lakh, hurdle 10 per cent, incentive fee 15 per cent.

Year 1 hurdle NAV is 50 crore × 1.10 = Rs 55 crore. Year 2 is 55 crore × 1.10 = Rs 60.5 crore, not 50 crore × 1.20 = Rs 60 crore. The compounding is worth Rs 50 lakh of hurdle in year 2 alone.

Now move the hurdle from 10 per cent to 12 per cent and nothing else. The hurdle NAVs become Rs 56 crore and Rs 62.72 crore, and the incentive fee collapses to Rs 6,35,100 and Rs 8,69,250 — roughly a 79 per cent cut in the manager's year 2 fee for a 200 basis point move in a negotiated term.

Chapter 6, sections 6.2 and 6.3, Examples 6.3 and 6.4. This is the paper's signature arithmetic question: build the NAV pre-incentives table, compound the hurdle, subtract, apply the rate. Expect also a conceptual question on whether the hurdle is simple or compound, and one on which of the high-water mark and the hurdle applies when both are in play.

• The hurdle compounds. Year 2 is the previous hurdle NAV grossed up again, not double the first year's return. The workbook says so explicitly.
• It is built on called-up capital, not on committed capital and not on the previous year's actual NAV.
• Deduct the costs before comparing. The comparison is against NAV pre-incentives, which is already net of set-up costs, fund expenses and management fee with GST. Comparing gross asset value to the hurdle NAV overstates the fee.
• Where both tests apply, use the higher of the high-water mark and the Reference Hurdle NAV. Taking the lower one hands the manager a fee twice.
• Computing the fee annually double-counts. The workbook's own conclusion to Example 6.3 is that the sharp rise in year 2 comes from charging again on year 1's excess — which is precisely why Category I and II managers take the incentive fee at the end of the tenure or deal by deal instead.
• The preferred return itself is never part of the incentive fee base. It is allocated entirely to investors, pro rata.