NISM Series XIX-C · Chapter 9: Fee Structure and Fund Performance

L1 · Foundation

Foundation — The complete fee stack, hurdle, high-water mark and catch-up

Management fees for Category III versus Categories I and II, incentive fees, set-up costs, operating expenses, transaction expenses and trusteeship fees, the 18 per cent GST drag, and how hurdle rate, high-water mark, catch-up and clawback combine to decide what the manager is actually paid.

30 min read · Worth 13% of the paper · Written from pages 146–222 of the official NISM workbook · Updated 18 September 2026

9.1 Management Fees and Other Expenses

AIF is a pooled investment vehicle, which collects capital contributions from investors to invest the pooled capital in eligible securities, as per the investment strategy of the Fund. An AIF appoints an Investment Manager, who provides fund management services using their investment knowledge, market experience and industry exposure. In return of such services, the Investment Manager charges an investment management fee to the fund, known as Management or investment management Fees. Management Fees are allocated to every investor on a pro-rata basis, based on their value of investment in the fund.

The two different bases

Management Fees are charged as a fixed percentage, ranging from 1 percent to 2.5 percent, of the Gross Net Asset Value of a Category III AIF. The rates at which the fees are charged are pre-determined and fixed before the launch of the scheme and mentioned in the offer document. The Management Fees shall accrue from the date of the First Close, up to the date when the AIF is dissolved.

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).

	Category III	Category I and II
Base	Gross Net Asset Value	Committed Capital during the commitment period, then invested capital or AUM
Rate	1% to 2.5%	1% to 2.5%
Accrual	From First Close to dissolution	Same

Investors also 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. That is a sharp negotiating point — otherwise the investor pays a fee on money that went to pay fees.

With Indian AIF market growing at a rapid pace, Investment Managers are looking at reducing the fixed Management Fees, between 1 percent and 1.75 percent depending on the scale of investments.

Three facts about management fees

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.

Management Fees are to be paid to the Investment Manager on a periodic basis, generally quarterly, semi-annual or yearly, as specified in the private placement memorandum issued by the fund. Management Fees are generally paid in arrears at a periodic interval like monthly or quarterly, when the Gross Net Asset Value (GNAV) of the AIF is computed.

And the definition that gets tested:

GNAV is the gross value of the underlying investments of the fund (and liquid balances if any) after deducting outside liabilities as of date but before accounting for management fee and incentives.

So GNAV is after outside liabilities but before management fee and incentives.

It should be noted that fees may vary depending on the amount the investor commits and timelines of commitment; these are usually captured as fees in different classes of units issued by the fund.

Incentive Fees

Apart from Management Fees, the Investment Manager is also eligible for a share in the profits earned by the fund. If the AIF earns a profit in any particular year, the Investment Manager is entitled to a fee for profit-sharing, known as Incentive Fees or Performance Fees or Carried Interest.

Incentive Fee is charged as a percentage of the incremental return earned by the AIF, generally between 0 and 20 percent, and is computed in accordance with the fee structure and computation methodology mentioned in the PPM. Such Incentive fees are an additional cost for the investors in the Fund and are allocated on a pro-rata basis to all investors, based on their value of investment in the fund.

The payment of additional returns and the quantum thereof could depend entirely on the credibility and track record of the sponsor/ manager, type of fund, scheme focus and size of the corpus.

When is the incentive fee paid?

Incentive fees are paid as an incentive to the Investment Manager to generate profits for the fund. This helps to align the interest of the Investment Manager with the interest of the fund and encourages the Investment Manager to seek best execution of investments for the interest of the investors in the fund.

Incentive Fees are computed and payable to Investment Manager, after completion of the stated fund tenure, in case of closed-ended Category III AIFs. Generally, Category I or Category II AIFs could also follow a Deal-by-Deal Distribution mechanism, wherein the Incentive Fees are computed and paid after every exit from portfolio companies. After a successful exit, the Investment Manager will be eligible to receive the Incentive Fee, subject to certain clauses such as Clawback Provisions and Catch-up Rates. For Category III AIFs, performance or incentive fees mostly is calculated at 3-year cycle or at the end of the term of the fund.

Note the 3-year cycle for Category III — a number the exam likes.

The other charges

Set-up Costs or Organizational Expenses

The Investment Manager will charge one-time Set-up Costs from the unit-holders as a percentage of their total capital commitments, which can go up to 1.5 percent or 2.5 percent of total capital commitments raised by the fund.

The Set-up costs are incurred towards any offering costs, drafting of Private Placement Memorandum, registration and compliance costs, fees and commissions to be paid to intermediaries or professionals, increased by appropriate Goods and Service Tax (GST) rates and other applicable statutory taxes charged thereon.

Such Set-up Costs can be amortized over the first 36 months (or as defined in PPM), or the entire life of the AIF, commencing from the date of First Closing of the fund. Set-up costs are allocated on a pro-rata basis to all investors, based on their value of total capital commitments in the fund.

Three numbers: up to 1.5 per cent or 2.5 per cent of commitments, amortised over the first 36 months or the fund's life, from the date of First Closing.

Operating Expenses

Typically, these are recurring expenses of the fund which the fund would charge to all investors as a whole and are subject to some limit like 10-50 basis points charged on the Net Asset Value or the capital commitments of the firms, whichever is higher. This limit is yearly and includes majority of expenses which are over and above the investment management fees.

10 to 50 basis points, on NAV or capital commitments, whichever is higher, yearly.

The list includes: statutory, legal, tax, accounting, audit, consulting and other third-party and professional fees; banking, broken-deal, registration, qualification, finders and similar fees or commissions; expenses in connection with meetings of the capital contributors (though travel, accommodation and out-of-pocket expenses of contributors will be borne by themselves); expense incurred by the Fund for collection of Capital Contributions; operating, legal and statutory expenses; interest on borrowings, if any (applicable for Category III AIFs); costs of financial statements and other reports; communications, travel and other expenses; expenses associated with maintenance of books of accounts; administration, communication, advertising, promotional, operating, and transactional expenses (including bank charges); fees payable to banks, merchant banks, and any consultants; reasonable premiums for insurance for protecting the directors, partners, key personnel, officers, shareholders, employees and agents of the Trustee and Investment Manager; taxes, duties and costs incurred in acquiring, holding and selling the Fund's assets; proportionate liquidation expenses of the Trust and the Fund.

Note the small trap: interest on borrowings applies for Category III AIFs only, since only Category III may leverage.

Transaction Expenses

An AIF shall bear and pay all transaction expenses on actual basis only, without any limits, in relation to buying, selling or disposal of Investments. The Transaction Expenses are borne by the Fund and allocated on a pro-rata basis, across all classes of units, based on Capital Contributions or NAV:

brokerage charges
depository charges
custodian transaction charges
securities transaction taxes
costs and charges as imposed by stock exchanges

The distinguishing phrase is on actual basis only, without any limits. Operating expenses are capped; transaction expenses are not.

Trusteeship Fees

Trusteeship Fees, to be in accordance with the terms agreed with the Trustee in the offer letter. Typically, this is a fixed fee in the range of INR 1 lakh to 5 lakhs per year, depending on the size of the fund.

What investors should cap

It is important for investors to identify and note the avoidable expenses being incurred by the Fund and negotiate a "Cap" or an upper limit on such expenses with the Investment Manager. These include Trusteeship Fees, Professional fees, Administrative Costs attributable to the investors, Out-of-pocket expenses incurred by the Investment Manager, and Fees to third parties such as Custodians, Fund Administrators, Legal Advisors, Auditors, Investment Advisors, among others.

The best-case scenario for investors would be to negotiate with the Investment Manager to net-off such expenses against the Management Fees, already being paid.

By their nature, AIFs are illiquid and their underlying investments cannot be reliably valued until the investments are exited.

9.3.4 The GST drag

AIFs pay professional fees on an annual basis to multiple service providers, such as Fund Administrators, Registrars, Custodians, Auditors, Brokers, Investment Advisors and other third-party professional experts. The services provided by such external service providers are taxable on a yearly basis, at the rate of 18% currently as per Indian regulations. Apart from services of external service providers, GST is also applicable at the rate of 18% on Management Fees and Trusteeship Fees.

The workbook's Example 9.6 works out that for a INR 98 crore fund, the impact of GST can be as high as 0.81% of the Gross NAV of the fund, if GST is charged on services provided by all external service providers.

And the crucial explanation of why this is a pure loss:

Since the external service providers are providing 'financial services', GST is chargeable at 18% annually. 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. 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.

Read that carefully. A manufacturer pays GST on inputs and offsets it against GST on outputs. An AIF has no output services, so there is nothing to offset against. The 18 per cent is a dead cost, not a recoverable credit.

9.2 Hurdle Rate

The investors in AIF have an opportunity cost of investment, when investing in the fund. The opportunity cost is 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.

For this purpose, 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 the Hurdle Rate is known as "Preferred Return", which is the portion of the total return of the fund that accrues to the investors only.

The Preferred Return will not be taken into account directly, for the purpose of computation of Incentive Fees. Incentive Fees is paid to the Investment Manager on the return generated over and above such Preferred Return. The preferred return is entirely allocated to all the investors in the fund, on a pro-rata basis based on their value of investment in the fund.

Indian hurdle rates are higher, and here is why

In Indian market, hurdle rates in AIF industry (generally 7 percent to 12 percent per annum — INR terms) are meant to be higher than the international standards (generally 5 percent to 8 percent per annum — USD terms) as the historical average returns in the Indian stock market is estimated around 12 percent.

	India	International
Hurdle rate	7% to 12% p.a., INR terms	5% to 8% p.a., USD terms
Reference	Indian stock market historical average around 12%	—

Note the currency labels. Indian hurdles are in INR terms, international ones in USD terms — much of the gap is simply the currency.

The tug of war

The Hurdle Rate is important for the Investment Manager, as it serves as a threshold return over which the Investment Manager will be eligible to earn Performance Fees. If the Hurdle Rate is high, the Investment Manager will not be able to generate a high incentive fees every year. Hence the Investment Manager will prefer to keep the Hurdle Rate low, in order to generate a higher incentive fees.

Similarly, the Hurdle Rate is important for the Investors too. The Investors will prefer to keep the Hurdle Rate high, in order to generate higher accrued return from the fund. Thus, deciding on the appropriate hurdle rate for the fund is critical and involves serious negotiations between the Investment Manager and investors in the fund.

The purpose of having a hurdle rate is to benchmark the expectations of the investors rather than to provide a guaranteed return (which is neither permissible nor possible).

Manager wants it LOW. Investor wants it HIGH. And it is never a guarantee.

The workbook's Example 9.2 makes the sensitivity concrete. With a 10 per cent hurdle, incentive fees were INR 21,35,100 in Year 1 and INR 41,99,250 in Year 2. If the Hurdle Rate is increased to 12 percent, the Incentive Fees drops significantly as follows: Year 1 — INR 6,35,100; Year 2 — INR 8,69,250. Two percentage points on the hurdle cut the manager's Year 2 fee by nearly 80 per cent.

The example also flags a structural problem: there is a sharp increase in the Incentive Fees computed for Year 2. This is due to double computation of Incentive Fees, on the Excess Return earned in Year 1. To avoid this, Investment Managers are paid Incentive Fees only at the end of the fund tenure, or at the time of making exits from investee companies, instead of being paid Incentive Fees on a yearly basis. This also ensures that Incentive Fees is paid, after providing for future possible losses or decline in the NAV of the fund.

Typically, hurdle is calculated as pre-tax hurdle.

9.3 High-Water Mark

Incentive Fees are payable to the Investment Manager as an incentive to generate profits or 'Alpha' for the AIF. However, 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 III AIF may generate a 20 percent return in its first year, -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 in the fund, no incentive fees should be paid on losses made in any year, through-out 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 issued by such fund.

The High-Water Mark is an important input used in addition to the Hurdle Rate, to compute the Incentive Fees payable to the Investment Manager for an AIF.

High-Water Mark is generally applied to AIF Managers which permit its unit-holders to redeem their money based on pre-determined Redemption Gates (applicable for open-ended Category III AIFs), or at the time of making an exit from a portfolio company (applicable for Category I AIFs or Category II AIFs following a deal-by-deal distribution waterfall).

Reading the high-water mark as a signal

If the High-Water Mark of the AIF is consistently rising above the previous High-Water Mark, it denotes superior past and present performance of the fund and is a good indicator for the future estimated returns of the Fund. This is important for the Investment Manager to showcase superior fund performance to investors and prospective clients, while earning higher Incentive Fees. However, if the High-Water Mark remains unchanged in previous years, it is an indicator of poor performance.

A stationary high-water mark is a red flag. It means the fund has not made a new peak since whenever it last did.

How the two thresholds combine

This is the mechanism at the heart of Example 9.3 and it is worth stating precisely:

For the purpose of computing Incentive Fees, it is important to ascertain the minimum NAV 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 minimum NAV is positive, then the Investment Manager is eligible for an Incentive Fees at the given rate on such difference. If the difference between the NAV (Pre-incentives) and such minimum NAV is negative, then the Investment Manager shall not be eligible for any Incentive Fees.

Minimum NAV eligible for incentives = HIGHER of (Reference Hurdle, High-Water Mark).

Incentive Fee = rate × [NAV (Pre-incentives) − that higher figure], if positive.

By taking the higher of both the amounts, viz. High-Water Mark and Reference Hurdle, it can be verified if the Investment Manager has achieved the Reference Hurdle for investors as well as added value for them, by increasing Net Asset Value of the Fund.

The workbook's conclusion from the worst-case scenario is important: 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 for Incentive Fees. In such cases, if investors have not negotiated a Hurdle Rate at the time of subscription, the High-Water Mark prevents undue Incentives Fees being payable to Investment Manager and serves as an additional threshold.

Two thresholds, and each covers for the absence of the other.

9.3.1 Catch-up

'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 between investors and the manager.

With a catch-up provision in a Deal-by-Deal Distribution, the Manager of a Category I AIF or Category II AIF receives a larger share in the profit distribution, after the investors' capital and hurdle return is paid. Hence, as a manager, it is advisable to have a high catch-up rate, above the pre-determined rate of 10-20%, as a higher proportion of the residual profits will be allocated to the manager.

The deal-by-deal distribution waterfall

Table 9.1 — Illustrative Deal-by-Deal Distribution Waterfall, followed by a closed-ended Category I or Category II AIF:

Priority	Description
1. Expenses, taxes and statutory payments	Expenses chargeable to the fund, Income tax on investment gains, GST and other statutory dues payable from time to time.
2. Reserves	The investment manager may decide to retain some proceeds to create reserves for meeting future liabilities entirely at its discretion. Such terms would be mentioned in the PPM.
3. Management Fees and other costs	The management fees of the investment manager as well as other costs chargeable to the fund.
4. Net Proceeds	If the fund has different classes of units, there may be priority in payment inter-se among such classes... For example, investors from the First Close may have priority over investors from subsequent closes. Then net proceeds are to be applied first to repay corpus contributions of investors of a particular class on a pro-rata basis and then towards preferred return.
5. Additional Returns / Incentives / Carry with Catch Up	If the manager is entitled to incentive fees or carry with a catch up clause, the catch up gets paid at this stage so that it equates them to the agreed share on the total return of the scheme / fund.
6. Residual distribution	Distributed in the ratio of sharing between investors and managers holding carry. In case there is no catch up clause in the investment agreement, step (5) above is skipped and residual proceeds are shared after step (4).

Memorise the order: expenses and taxes → reserves → management fees → net proceeds (capital then preferred return) → catch-up → residual split. Note that expenses, taxes and statutory payments come FIRST, ahead even of reserves and management fees.

What a catch-up rate of 100 per cent means

In case of close-ended Category III AIFs, the investment manager will receive the incentive fees on completion of the fund tenure, with or without a Catch-up clause. Managers may prefer to include the catch-up clause in the Contribution Agreement, with a catch-up rate of 100 percent. This signifies that all residual profits in the fund, after returning investors' capital and hurdle, will be distributed to the Manager till the manager receives the pre-determined share of the total profits. Similarly, if the catch-up rate is 40%, then 40% of the residual profits in the fund, after returning investors' capital and hurdle, will be distributed to the Manager till the manager receives the pre-determined share of the total profits.

High Catch-up Rates are preferred by the investment manager of an AIF. 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.

If the Manager chooses not to include the catch-up clause in the Contribution Agreement, then all residual profits in the fund, after returning investors' capital and hurdle, is distributed amongst the manager and the investors as per the pre-determined share of the profits. In the event of limited profits, in excess of the hurdle return, the manager may not be able to receive the pre-determined share of the total profits.

The Example 9.4 result is dramatic and worth remembering as a headline: on a INR 50 crore fund growing to INR 70 crore over three years with a 10 per cent hurdle and 20 per cent incentive fee, the total distribution to the Manager is INR 69 lakhs in the first scenario (no catch-up) and INR 3.45 crore in the second scenario (100 per cent catch-up). This difference in the amount distributed to the manager is solely on account of the inclusion of a catch-up clause in the Contribution Agreement. A five-fold difference from one clause.

9.3.2 Clawback

In case of a Deal-by-Deal Distribution, there is usually a clawback provision built in for safeguarding the investors. In a Clawback Provision, the Carried Interest or Performance Fees based on early successful exits can be clawed-back or recovered by the investors from the manager to offset the losses on subsequent failed investments.

A precise computational detail that is easy to miss:

The losses are generally calculated after reducing the sales proceeds from the capital committed. However, the hurdle return on such capital committed is not considered for this calculation, even though Hurdle refers to the Opportunity Cost of capital for the investor.

The hurdle is NOT included in the clawback computation. Only capital.

Therefore, a clawback right entitles investors to reverse any incentive fees taken by the manager during the life of the investment to ensure that performance fees or carried interest is paid as per the pre-determined ratio, based on the total profits or losses over its life. However, this clause is only as good as the manager's ability to refund the excess return, so it is important that the manager has high credibility and a balance sheet to support. This is another reason why some funds choose to charge the performance fees only at the end of the tenure of the fund to avoid any situations related to Clawback.

9.3.3 Gross and Net Returns

A high pay-out of the Incentive Fees can substantially impact the Net Return earned by the investors. An AIF, making a high pay-out of Incentive Fees, will deliver decreasing Net Return on Investment, to the investors. Hence, investors should check the quantum of incentive fee being charged by the Investment Manager, for every class of units being issued by the AIF.

Pre-expense return, or the gross return on investment, is calculated using the Gross Asset Value of the AIF. Such return is the gross return earned on investments, before deducting the fund expenses, costs, management fees and incentive fees.

Post-expense return will be calculated on the following two parameters:

Net Return (Pre-Incentives): This return is calculated using the Net Asset Value of the AIF, after deducting the fund expenses, costs and management fees, but before deducting the incentive fees.
Net Return (Post-Incentives): This return is calculated using the Net Asset Value of the AIF, after deducting the fund expenses, costs, management fees as well as the incentive fees.

Three levels of return:

Level	Computed on	After deducting
Gross / Pre-expense	Gross Asset Value	Nothing
Net (Pre-Incentives)	NAV	Expenses, costs, management fees
Net (Post-Incentives)	NAV	Expenses, costs, management fees AND incentive fees

The workbook's Example 9.5 shows the drag in real numbers. In the best case, Year 1: gross 16.00% → Net Pre-Incentives 12.85% → Net Post-Incentives 12.42%. That is 358 basis points of a 16 per cent gross return consumed by costs. In the worst case, Year 1: gross 10.00% → net 6.95%, with no incentive fee because the NAV was below the Reference Hurdle, so pre- and post-incentive returns were identical.

Over two years on a CAGR basis, best case: gross 14.02% → 12.52% → 12.14%. Worst case: gross 3.92% → 2.46% → 2.46%.

Compounded Annual Growth Rate (CAGR) is the measure of the annual growth rate of the fund, after accounting for the effect of compounding: CAGR = (Ending Value / Beginning Value)^(1/n) − 1.

One more subtlety worth carrying: there is a concept of Performance Fees Crystallization date in certain funds, which essentially means that they would accrue performance fees on a daily basis to get accurate return. However, the payment of the said fees to manager would be made only at the end of the term of the fund. Accrual daily; payment at the end.

Global Investment Performance Standards (GIPS)

Fund performance is most actively monitored by all the stakeholders of an AIF, being the investment manager, investors, sponsor, trustees, financial institutions as well as the market regulator. Return attribution plays a crucial role for the Investment Manager to get future capital contributions from new and existing investors... However, investors need to be cautious that historical performance does not guarantee the same return in future.

Alternative Investment Funds are recommended to comply with the Global Investment Performance Standards (GIPS), to ensure full disclosures and fair performance presentation which helps to advance fair competitive practices within the industry and meet the demands of prospective clients and investors. The GIPS are recognized as a global standard for calculating and presenting investment performance around the world.

The mission of the GIPS standards is to promote ethics and integrity in the investment management industry and to build trust within the investors, by achieving standardized performance reporting and compliance by asset owners and asset managers.

AIF being a pooled investment vehicle must report the consolidated performance of all its schemes in different composites. A Composite can be defined based on investment strategy or investment objective to be followed by the schemes within the composite.

In addition to this, the GIPS require firms to adhere to certain calculation methodologies, which ensure integrity of the input data used in performance presentations, such as Gross IRR and Net IRR on pre-tax basis, Time-weighted Rate of Return, Money-weighted Rate of Return and valuation methodologies of underlying portfolio holdings of the fund.

The reporting-period rule is a favourite question:

An AIF should present annual investment performance, compliant with the GIPS, for a minimum period of five years, or since the inception of the fund. Prospectively, the AIF must present an additional year of performance each year, building up to a minimum of 10 years of GIPS-compliant performance.

Start at 5 years, build to 10.

Think of it like this

The taxi meter and the tip

Get into a taxi in Mumbai. Two things happen to your wallet.

The meter runs whether the driver takes you by the best route or the worst, whether you reach on time or late. That is the management fee: 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.

The tip you give only if he beat the traffic and got you there early. That is the incentive fee — paid as an incentive to the Investment Manager to generate profits for the fund.

Now imagine a rule: you tip only if he beats a stated time (the hurdle rate), and you never tip twice for the same journey (the high-water mark). And if you agreed a special clause, he collects the first slice of everything above the stated time until his tip reaches an agreed share of the whole fare (the catch-up).

That is the entire fee architecture of an AIF in one taxi ride. The meter always runs. Everything else has conditions.

Why the manager wants the hurdle low and you want it high

A hurdle rate is not a target the manager is trying to reach. It is a gate he must clear before he gets paid.

If the Hurdle Rate is high, the Investment Manager will not be able to generate a high incentive fees every year. Hence the Investment Manager will prefer to keep the Hurdle Rate low, in order to generate a higher incentive fees. And, symmetrically: the Investors will prefer to keep the Hurdle Rate high, in order to generate higher accrued return from the fund.

How much does it matter? The workbook does the arithmetic on one fund. At a 10 per cent hurdle the manager earned INR 21.35 lakh in Year 1 and INR 41.99 lakh in Year 2. At a 12 per cent hurdle on the identical fund performance: INR 6.35 lakh and INR 8.69 lakh.

Two percentage points on a number in a document you might skim past, and the manager's Year 2 pay drops by about 79 per cent.

That is why deciding on the appropriate hurdle rate for the fund is critical and involves serious negotiations between the Investment Manager and investors in the fund. Read the hurdle line in a PPM the way you would read the interest rate on a loan.

The high-water mark, or why the pole vaulter cannot lower the bar

A pole vaulter clears 5.20 metres and is paid a bonus. Next season he manages only 4.90. The season after, 5.10 — an improvement of 20 centimetres on last year.

Does he get a bonus for the 5.10? No. He has still not cleared his own best.

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. Once the bar is at 5.20, it stays at 5.20. 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 issued by such fund — the bar starts at the height you entered.

The reason is a fairness one. Without the high-water mark, a manager could take a fee on the rise, take no penalty on the fall, and take a fee again on the recovery — being paid twice for the same rupees.

And here is the signal an investor should read: if the High-Water Mark remains unchanged in previous years, it is an indicator of poor performance. A bar that has not moved in three years tells you the vaulter has not cleared a new height in three years.

The catch-up clause, worth INR 2.76 crore in one sentence

Two identical funds. INR 50 crore in, INR 70 crore out after three years, 10 per cent hurdle, 20 per cent incentive fee. The only difference is one clause.

Without a catch-up: investors take capital plus hurdle (INR 66.55 crore). The residual INR 3.45 crore is split 20:80. Manager gets INR 0.69 crore.

With a 100 per cent catch-up: investors take the same INR 66.55 crore. Then all residual profits in the fund, after returning investors' capital and hurdle, will be distributed to the Manager till the manager receives the pre-determined share of the total profits — which would be 20 per cent of the INR 20 crore total profit, i.e. INR 4 crore. The residual is only INR 3.45 crore, so the manager takes all of it.

Manager gets INR 3.45 crore. Investors get nothing above their hurdle.

This difference in the amount distributed to the manager is solely on account of the inclusion of a catch-up clause in the Contribution Agreement. Five times the money, from one line. And the workbook warns exactly this: 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.

GST you can never get back

A textile mill in Surat buys yarn and pays 5 per cent GST on it. When it sells cloth, it charges GST on the sale and offsets what it already paid. The input tax is a wash.

An AIF pays 18 per cent GST on management fees, trusteeship fees, custodian fees, audit fees, legal fees, fund administration and advisory. And then it sells... nothing. AIFs do not provide any services and therefore do not necessarily collect GST on output services.

So there is nothing to offset against. The absence of recoverability of indirect tax such as GST increases the cost for investors in the fund, and it may not be recoverable in form of input credits.

The workbook sizes it: on a INR 98 crore fund, the impact of GST can be as high as 0.81% of the Gross NAV of the fund. Eighty-one basis points a year, gone, before the manager has picked a single stock.

Which is why the smart investor does not just negotiate the fee. He negotiates the cap on expenses — and best of all tries to net-off such expenses against the Management Fees, already being paid.

Three prices for the same dinner

A restaurant bill can be quoted three ways. The menu price of the dishes. The price after service charge. The price after service charge and the tip.

An AIF return is quoted the same three ways, and the difference is not small:

Gross (pre-expense) return — computed on Gross Asset Value, before any expenses, costs, management fees or incentive fees. In the workbook example, 16.00%.
Net Return (Pre-Incentives) — after fund expenses, costs and management fees, before incentive fees. Same fund, same year: 12.85%.
Net Return (Post-Incentives) — after incentive fees as well: 12.42%.

A manager quoting "we did 16 per cent" is telling the truth about the kitchen and nothing about your bill. 358 basis points of that 16 disappeared before the money reached the investor.

And notice the worst-case asymmetry. When the fund made only 10 per cent gross, net was 6.95% — but pre- and post-incentive were identical, because the NAV never crossed the hurdle. Costs bite in every year; incentive fees only in good ones. Which is exactly why the gap between gross and net is widest in the years the manager most wants to talk about.

Key terms in this chapter

CAGR: Compounded Annual Growth Rate = (Ending Value / Beginning Value)^(1/n) − 1, the annual growth rate after accounting for compounding.
Catch-up Rate: The rate at which residual profits, after returning investors' capital and hurdle, go to the manager until his carry equals the pre-determined share of total profits. A 100 per cent catch-up sends all residual profit to the manager until that share is reached.
Clawback: Investors' right to recover incentive fees already taken on early exits, to offset losses on later investments. Losses are computed after reducing sales proceeds from capital committed — the hurdle return is NOT considered in this calculation.
Composite: Under GIPS, a grouping of schemes defined by a common investment strategy or objective, in which a pooled vehicle reports consolidated performance.
Concentration Risk: The risk of holding a few large positions. SEBI caps single-investee exposure at 10 per cent of AUM or investable funds for Category III, and 25 per cent for Categories I and II.
Cyber Security Risk: Risk of cyber-attacks on fund and service-provider data. All securities market intermediaries must store data within Indian geographical boundaries per CERT norms, and report any incident to the sector regulator and central government within 6 hours.
Direct Alpha: A variation of KS-PME that expresses out- or under-performance against the market as a percentage, by taking the IRR of market-compounded cash flows.
Downside Risk: The probability of a loss on account of reducing asset prices in changing market conditions.
DPI: Distributions to Paid-in Capital, the realisation multiple: total distributions divided by total capital contributions. It tells investors how much money they actually got back.
Effective rate of interest: r = (1 + k/m)^m − 1, where k is the nominal rate and m the frequency of compounding per year.
EIRR: Economic Internal Rate of Return, which also considers wider direct and indirect economic benefits — to be distinguished from the financial IRR.
Fiduciary duty (fund-level risk): The workbook's name for risks of fund structure and governance — reliance on the trustee, manager, committees, valuers and auditors. It is described as the most important part of fund level risks.
GIPS: Global Investment Performance Standards — the global standard for calculating and presenting investment performance. AIFs report by composites and must present a minimum of five years of compliant performance, building to ten.
Gross IRR: IRR computed on fund-level cash flows before deducting management fees, incentive fees, fund expenses and taxes.
Gross Net Asset Value (GNAV): The gross value of the fund's underlying investments and liquid balances after deducting outside liabilities, but BEFORE accounting for management fee and incentives. The base for Category III management fees.
High-Water Mark: The highest NAV, net of operating expenses, transaction expenses and management fees, achieved by the AIF at any year end. If NAV has only fallen since inception it is the initial subscription price. It never resets downward.
Hurdle Rate / Preferred Return: The minimum rate of return to be accrued to investors before the manager earns incentive fees. In India generally 7 to 12 per cent p.a. in INR terms, against 5 to 8 per cent in USD terms internationally. It benchmarks expectations, never guarantees a return.
Incentive Fee / Performance Fee / Carried Interest: A percentage of the incremental return, generally between 0 and 20 per cent, computed per the PPM and allocated pro rata to investors. For Category III it is usually computed on a 3-year cycle or at the end of the term.
Internal Rate of Return (IRR / FIRR): The rate at which the present value of cash outflows equals the present value of inflows. Unlike ROI, it accounts for the time value of money and the timing of each cash flow.
J Curve: The cash flow and IRR profile of a closed-ended fund — negative in early years while capital is drawn and invested with no exits, turning positive and rising as realisations and distributions occur.
KS-PME: Kaplan-Schoar Public Market Equivalent = (future value of distributions + NAV) / future value of capital calls, compounding cash flows at index returns. A market-adjusted TVPI; above 1 means the AIF outperformed the market.
Kurtosis: The degree to which a distribution is more or less peaked than normal. A normal distribution has kurtosis of 3; excess kurtosis is the amount above 3. Above 3 is riskier.
Leptokurtic: A distribution with kurtosis above 3 (excess kurtosis above zero), whose values are either close to the mean or substantially deviating from it — fat tails and a high peak.
Leverage Risk: Only Category III AIFs may leverage, capped by SEBI prudential norms at two times the NAV of the fund, with any breach of leverage limits reported monthly.
Management Fee: Charged at 1% to 2.5% — on Gross NAV for Category III, on committed capital during the commitment period then invested capital or AUM for Categories I and II. Accrues from First Close to dissolution and is payable whether or not the fund profits.
Maximum Drawdown (MDD): (Trough Value − Peak Value) / Peak Value — the peak-to-trough decline in AUM during a reporting period. It reveals nothing about how often large losses occur or how long recovery takes.
Minimum NAV eligible for incentives: The HIGHER of the Reference Hurdle and the High-Water Mark. The incentive fee is charged only on the positive difference between NAV (pre-incentives) and this figure.
MOIC: Multiple on Invested Capital — realised and unrealised value divided by total invested capital. Equals TVPI once all capital calls are met. A consistently large MOIC-to-RVPI ratio is a red flag on valuations.
Net IRR: IRR computed on investor-level cash flows, treating all fund-level expenses, fees and taxes as borne by investors. Always lower than the Gross IRR.
Net Return (Post-Incentives): Return computed on NAV after deducting fund expenses, costs, management fees and incentive fees — the return the investor actually experiences.
Net Return (Pre-Incentives): Return computed on NAV after deducting fund expenses, costs and management fees, but before deducting incentive fees.
Operating Expenses: Recurring fund expenses subject to a yearly limit of about 10 to 50 basis points on NAV or capital commitments, whichever is higher. Interest on borrowings is included only for Category III AIFs.
Outliers: Extreme returns, positive or negative. Their presence signifies increased market risk and a volatile fund strategy, and they are what create skewness and kurtosis.
Over-commitment strategy: An institutional practice of committing more than current cash balances, so that forecasted capital calls exceed available cash — adopted because holding idle cash to meet calls dilutes performance.
Performance Fees Crystallization date: A mechanism in some funds where performance fees accrue daily for accurate return computation, but are paid to the manager only at the end of the fund's term.
PIC Multiple: Paid-in Capital divided by Capital Commitments — a measure of how invested the fund is. A high PIC means the fund is near the end of its drawdown phase.
Platykurtic: A distribution with kurtosis below 3 (excess kurtosis below zero), whose values have consistent frequencies around the mean with no significant deviations.
Reference Hurdle: The NAV level the fund must reach to satisfy the hurdle — computed on called-up capital at the beginning of the year grossed up by the hurdle rate. Typically calculated pre-tax.
Risk of Adverse Selection: The investor-level risk of choosing the wrong fund manager, since PPMs make forward-looking statements and past track records are no assurance of future performance. It leads to sub-optimal returns or moral hazards.
ROI / Holding Period Return: The total return of an investment, averaging absolute returns over the life cycle without considering the time value of money or the timing of cash flows.
RVPI: Residual Value to Paid-in Capital, the unrealised multiple: AUM divided by total capital contributions. Early in a fund it is more representative of future returns than DPI, but it rests on valuation estimates.
Set-up Cost: One-time charge of up to 1.5 or 2.5 per cent of total capital commitments for offering costs, PPM drafting, registration and compliance, and intermediary fees. Amortised over the first 36 months or the fund's life from the date of First Closing.
Sharpe Ratio: (Rp − Rf) / σp — excess return over the risk-free rate per unit of TOTAL risk. Ratios above 1 are preferable, and Sharpe is the measure to prefer for undiversified portfolios.
Since-inception IRR / Life-time IRR: IRR computed from the fund's launch date to the reporting date; called Life-time IRR when computed for a fund that has been liquidated.
Skewness: The extent to which a distribution is not symmetrical across the mean. Zero for a normal distribution; above zero is positive skew (long right tail, Mean > Mode); below zero is negative skew (long left tail, Mean < Mode). Positive skew is preferred over negative.
Standard Deviation: σ = √[Σ(Ri − R)²/n], measuring the volatility of returns around the mean. The most common measure of a fund's historical risk.
Transaction Expenses: Brokerage, depository charges, custodian transaction charges, securities transaction tax and exchange charges — borne on actual basis only, without any limits, and allocated pro rata across classes.
Treynor Ratio: (Rp − Rf) / β — excess return over the risk-free rate per unit of SYSTEMATIC, non-diversifiable risk. For well-diversified portfolios it may give results identical to Sharpe.
Trusteeship Fees: A fixed annual fee agreed with the trustee, typically in the range of INR 1 lakh to 5 lakh per year depending on fund size. GST at 18 per cent applies.
TVPI: Total Value to Paid-in Capital, the fund's investment multiple and the fundamental private-fund metric. Equals DPI + RVPI, also called the Net Multiple. It fluctuates until the fund is fully realised.
Unsuccessful First Close risk: If the manager cannot achieve First Close within 12 months from the date of SEBI intimation, the AIF must file a fresh application for launch.
Value at Risk (VaR): The maximum expected loss over a given time frame at a pre-defined confidence level. Its key limitation is that it says nothing about the size of the loss once the threshold is breached.
Vintage year: The milestone year in which the first influx of investment capital is delivered. A boom-economy vintage means high entry valuations and lower returns; a bottom-of-cycle vintage magnifies returns.
Yield to Maturity (YTM): The IRR of a debt instrument from purchase to maturity — the rate making the present value of receivable cash flows equal to the present value of the initial investment.

Check you have understood it

The L1 test for this chapter has 9 questions. Score 60% to unlock L2 Application (worked numericals and scenarios) and then L3 Exam-Ready (NISM-style traps, timed, with this paper's real marking). Tests, the higher levels and full mock exams need a free account so we can track your progress.

Create a free account

Original explanatory writing based on the official NISM workbook for Series XIX-C, which is published and copyrighted by NISM. Check figures against the current edition at nism.ac.in.

Something look wrong? Report it