STUDY NOTES FOR NISM SERIES XIX-B: ALTERNATIVE INVESTMENT FUNDS (CATEGORY III) DISTRIBUTORS

Chapter 6: Fees Structure, Fund Performance and Benchmarking (Part 2 of 5)

1. Hurdle Rate (Preferred Return) Dynamics

In Alternative Investment Funds (AIFs), the Hurdle Rate—also referred to as the "Preferred Return"—represents the minimum threshold rate of return that investors must receive before the Investment Manager becomes eligible to receive any Performance Fees (Incentive Fees).

Key Characteristics of Hurdle Rates:

• The Opportunity Cost Concept: The hurdle rate is directly correlated to the opportunity cost of capital for the investor. When committing capital to a highly illiquid asset class like a Category III AIF, investors demand a minimum return to justify bypassing traditional liquid options.
• Benchmark of Expectations: The hurdle rate is designed to benchmark investor expectations rather than serve as a guaranteed return, which is neither ethically permissible nor practically viable in volatile securities markets.
• Indian vs. International Benchmarks: Hurdle rates in the Indian AIF industry typically range between 10% and 12% per annum. This is significantly higher than international standards, which generally hover between 7% and 8% per annum. This difference is driven by the historically higher average returns generated in Indian stock markets (estimated around 12% to 13%).
• Impact on Incentive Fee Payouts: The height of the hurdle rate directly affects manager incentives. A lower hurdle rate (such as 10%) makes it easier for the manager to generate excess returns, resulting in higher incentive payouts. Conversely, a higher hurdle rate sets a more demanding standard of performance to protect the investor's baseline capital appreciation.

2. High-Water Mark (HWM) Mechanics

To ensure complete alignment of interests between the Investment Manager and investors, the fee structure incorporates a High-Water Mark (HWM) clause.

Key Characteristics of High-Water Marks:

• Definition: The High-Water Mark is the higher of the subscription price of units issued to a particular class of investors, or the highest Net Asset Value (NAV) achieved at the end of any previous financial years.
• Preventing Undue Incentives: The primary purpose of an HWM is to protect investors from paying performance fees on recovered losses. If a fund's NAV falls during a period, the manager must navigate the portfolio back above the previous highest peak (the "high-water mark") before earning any further performance fees.
• Handling Absolute Decreases: If the Net Asset Value of the fund has only decreased since its inception, the initial subscription price of the units acts as the default High-Water Mark.
• A Crucial Safeguard: In open-ended Category III AIFs where returns may fluctuate dynamically, the HWM serves as a crucial defensive threshold for investors who may not have negotiated custom hurdle structures.

3. Performance and Incentive Fee Structures

While management fees are fixed and payable regardless of performance, Performance Fees (Incentive Fees) are variable rewards paid to the Investment Manager for outperforming both the hurdle rate and the high-water mark.

Key Characteristics of Performance Fees:

• Basis of Calculation: Performance fees are calculated as a fixed percentage of the "Additional Return" (or excess return) generated by the fund above the minimum eligible threshold.
• The "2-20" Rule of Thumb: In global asset management, many funds employ a "2-20" fee model (signifying a 2% fixed management fee and a 20% performance fee). However, the "2-20" structure is not a standardized rule in the evolving Indian Category III AIF market. Fee percentages are highly competitive, depending on manager credibility, track record, and fund strategy.
• Crystallisation and Timing Mitigation: If incentive fees are calculated and paid out on a yearly basis, managers could potentially receive high payouts in a positive Year 1, only for the fund's NAV to crash in Year 2. To prevent this, incentive fees are typically assessed on exits and are payable only upon the liquidation of the fund (at the end of its tenure). This protects the fund against intermediate declines or subsequent losses.

4. Comprehensive Numerical Case Studies (Best-Case vs. Worst-Case)

To understand how Hurdle Rates, High-Water Marks, and Incentive Fees interact, let us analyze a detailed 2-year simulation of Fund ABC, a Category III AIF.

Base Parameters of the Fund:

• Committed Capital = Rs. 50,00,00,000 (Rs. 50 crore)
• Total No. of Units Issued = 5,00,000
• Initial Value (NAV per Unit) = Rs. 1000.00
• Management Fees (excluding GST) = 1.5% per annum of Gross NAV
• GST on Management Fees = 18%
• Initial Set-up Cost (amortized over 5 years) = Rs. 25,00,000 per annum
• Yearly Fund Expenses = Rs. 30,00,000
• Hurdle Rate = 10% per annum
• Incentive Fees Rate = 15%

Scenario 1: Best-Case Scenario (Above-Average Returns)

In this scenario, the fund performs exceptionally well.

• Gross Asset Value (GNAV) at end of Year 1: Rs. 58,00,00,000
• Gross Asset Value (GNAV) at end of Year 2: Rs. 65,00,00,000

Year 1 Calculations:

1. Calculate Management Fees (including GST):
   Base Management Fee = Rs. 58,00,00,000 * 1.5% = Rs. 87,00,000
   GST on Fee = Rs. 87,00,000 * 18% = Rs. 15,66,000
   Total Management Fees = Rs. 87,00,000 + Rs. 15,66,000 = Rs. 1,02,66,000
2. Calculate Net Asset Value (Pre-Incentives) [A]:
   NAV (Pre-Incentives) = GNAV - Amortized Setup Cost - Fund Expenses - Management Fees
   NAV (Pre-Incentives) = Rs. 58,00,00,000 - Rs. 25,00,000 - Rs. 30,00,000 - Rs. 1,02,66,000 = Rs. 56,42,34,000
   NAV (Pre-Incentives) per Unit = Rs. 56,42,34,000 / 5,00,000 = Rs. 1128.468
3. Determine High-Water Mark [B]:
   HWM = Rs. 50,00,00,000 (Subscription Price of Rs. 1000.000 per unit)
4. Calculate Reference Hurdle [C]:
   Reference Hurdle = Rs. 50,00,00,000 * (1 + 10%) = Rs. 55,00,00,000 (Rs. 1100.000 per unit)
5. Identify Minimum NAV Eligible for Incentives [D]:
   Minimum Eligible NAV = Higher of HWM [B] and Reference Hurdle [C] = Rs. 55,00,00,000 (Rs. 1100.000 per unit)
6. Calculate Eligible Excess Amount [E]:
   Eligible Excess = NAV (Pre-Incentives) [A] - Minimum Eligible NAV [D]
   Eligible Excess = Rs. 56,42,34,000 - Rs. 55,00,00,000 = Rs. 1,42,34,000
7. Calculate Incentive Fees Payable:
   Incentive Fees = Rs. 1,42,34,000 * 15% = Rs. 21,35,100 (Rs. 4.2702 per unit)
8. Calculate Final Post-Incentive NAV:
   Post-Incentive NAV = NAV (Pre-Incentives) - Incentive Fees
   Post-Incentive NAV = Rs. 56,42,34,000 - Rs. 21,35,100 = Rs. 56,20,98,900 (Rs. 1124.198 per unit)

Year 2 Calculations:

1. Calculate Management Fees (including GST):
   Base Management Fee = Rs. 65,00,00,000 * 1.5% = Rs. 97,50,000
   GST on Fee = Rs. 97,50,000 * 18% = Rs. 17,55,000
   Total Management Fees = Rs. 97,50,000 + Rs. 17,55,000 = Rs. 1,15,05,000
2. Calculate Net Asset Value (Pre-Incentives) [A]:
   NAV (Pre-Incentives) = GNAV - Amortized Setup Cost - Fund Expenses - Management Fees
   NAV (Pre-Incentives) = Rs. 65,00,00,000 - Rs. 25,00,000 - Rs. 30,00,000 - Rs. 1,15,05,000 = Rs. 63,29,95,000
   NAV (Pre-Incentives) per Unit = Rs. 63,29,95,000 / 5,00,000 = Rs. 1265.990
3. Determine High-Water Mark [B]:
   HWM = Highest Previous Net NAV (Pre-Incentives) = Rs. 56,42,34,000 (Rs. 1128.468 per unit)
4. Calculate Reference Hurdle [C] (Compounded over 2 Years):
   Reference Hurdle = Rs. 55,00,00,000 * (1 + 10%) = Rs. 60,50,00,000 (Rs. 1210.000 per unit)
5. Identify Minimum NAV Eligible for Incentives [D]:
   Minimum Eligible NAV = Higher of HWM [B] and Reference Hurdle [C] = Rs. 60,50,00,000 (Rs. 1210.000 per unit)
6. Calculate Eligible Excess Amount [E]:
   Eligible Excess = NAV (Pre-Incentives) [A] - Minimum Eligible NAV [D]
   Eligible Excess = Rs. 63,29,95,000 - Rs. 60,50,00,000 = Rs. 2,79,95,000
7. Calculate Incentive Fees Payable:
   Incentive Fees = Rs. 2,79,95,000 * 15% = Rs. 41,99,250 (Rs. 8.3985 per unit)
8. Calculate Final Post-Incentive NAV:
   Post-Incentive NAV = NAV (Pre-Incentives) - Incentive Fees
   Post-Incentive NAV = Rs. 63,29,95,000 - Rs. 41,99,250 = Rs. 62,87,95,750 (Rs. 1257.592 per unit)

Scenario 2: Worst-Case Scenario (Average/Below-Average Returns)

In this scenario, market conditions are unfavorable and the fund delivers muted performance.

• Gross Asset Value (GNAV) at end of Year 1: Rs. 55,00,00,000
• Gross Asset Value (GNAV) at end of Year 2: Rs. 54,00,00,000

Year 1 Calculations:

1. Calculate Management Fees (including GST):
   Base Management Fee = Rs. 55,00,00,000 * 1.5% = Rs. 82,50,000
   GST on Fee = Rs. 82,50,000 * 18% = Rs. 14,85,000
   Total Management Fees = Rs. 82,50,000 + Rs. 14,85,000 = Rs. 97,35,000
2. Calculate Net Asset Value (Pre-Incentives) [A]:
   NAV (Pre-Incentives) = Rs. 55,00,00,000 - Rs. 25,00,000 - Rs. 30,00,000 - Rs. 97,35,000 = Rs. 53,47,65,000
   NAV (Pre-Incentives) per Unit = Rs. 53,47,65,000 / 5,00,000 = Rs. 1069.530
3. Determine High-Water Mark [B]:
   HWM = Rs. 50,00,00,000 (Subscription Price of Rs. 1000.000 per unit)
4. Calculate Reference Hurdle [C]:
   Reference Hurdle = Rs. 50,00,00,000 * (1 + 10%) = Rs. 55,00,00,000 (Rs. 1100.000 per unit)
5. Identify Minimum NAV Eligible for Incentives [D]:
   Minimum Eligible NAV = Higher of HWM [B] and Reference Hurdle [C] = Rs. 55,00,00,000 (Rs. 1100.000 per unit)
6. Incentive Eligibility Evaluation:
   Because the Net Asset Value (Pre-Incentives) (Rs. 53,47,65,000) is below the Minimum Eligible NAV (Rs. 55,00,00,000), the fund is NOT ELIGIBLE for any Incentive Fees in Year 1.
7. Final Post-Incentive NAV:
   Post-Incentive NAV = Rs. 53,47,65,000 (Rs. 1069.530 per unit)

Year 2 Calculations:

1. Calculate Management Fees (including GST):
   Base Management Fee = Rs. 54,00,00,000 * 1.5% = Rs. 81,00,000
   GST on Fee = Rs. 81,00,000 * 18% = Rs. 14,58,000
   Total Management Fees = Rs. 81,00,000 + Rs. 14,58,000 = Rs. 95,58,000
2. Calculate Net Asset Value (Pre-Incentives) [A]:
   NAV (Pre-Incentives) = Rs. 54,00,00,000 - Rs. 25,00,000 - Rs. 30,00,000 - Rs. 95,58,000 = Rs. 52,49,42,000
   NAV (Pre-Incentives) per Unit = Rs. 52,49,42,000 / 5,00,000 = Rs. 1049.884
3. Determine High-Water Mark [B]:
   HWM = Highest Previous Net NAV (Pre-Incentives) = Rs. 53,47,65,000 (Rs. 1069.530 per unit)
4. Calculate Reference Hurdle [C]:
   Reference Hurdle = Rs. 55,00,00,000 * (1 + 10%) = Rs. 60,50,00,000 (Rs. 1210.000 per unit)
5. Identify Minimum NAV Eligible for Incentives [D]:
   Minimum Eligible NAV = Higher of HWM [B] and Reference Hurdle [C] = Rs. 60,50,00,000 (Rs. 1210.000 per unit)
6. Incentive Eligibility Evaluation:
   Because the Net Asset Value (Pre-Incentives) (Rs. 52,49,42,000) is below the Minimum Eligible NAV (Rs. 60,50,00,000), the fund is NOT ELIGIBLE for any Incentive Fees in Year 2.
7. Final Post-Incentive NAV:
   Post-Incentive NAV = Rs. 52,49,42,000 (Rs. 1049.884 per unit)

5. Self-Assessment Practice Questions

Question 1

In the Worst-Case Scenario calculated for Fund ABC, why was the manager ineligible for performance fees in Year 2 despite generating an absolute increase over the initial committed capital?

A) The NAV was below the management fee base
B) The NAV failed to exceed both the Reference Hurdle and the Year 1 High-Water Mark
C) GST of 18% eroded the excess profits
D) The setup costs were not fully amortized

Answer: B
Explanation: To be eligible for incentive fees, the pre-incentive NAV must exceed the higher of the High-Water Mark and the compounded Reference Hurdle. In Year 2, the pre-incentive NAV of Rs. 52,49,42,000 was below the HWM of Rs. 53,47,65,000 and the Reference Hurdle of Rs. 60,50,00,000.

Question 2

Under standard industry terms, which metric is calculated to prevent an Investment Manager from charging performance fees multiple times on the same asset gains after a market correction?

A) Amortization of Set-up Costs
B) Total Expense Ratio (TER)
C) High-Water Mark (HWM)
D) Preferred Hurdle Rate

Answer: C
Explanation: The High-Water Mark ensures that the manager is only rewarded for generating incremental absolute gains and cannot charge incentive fees for recovering past losses.

Question 3

If a Category III AIF has an initial subscription price of Rs. 1,000 per unit and the Net NAV consistently decreases over the first three years of the scheme, what remains the High-Water Mark for the fund?

A) The lowest NAV reached during the decline
B) The average NAV of the first three years
C) Rs. 1,000 per unit
D) The fund is exempt from HWM rules

Answer: C
Explanation: If the Net Asset Value decreases consistently from inception, the initial subscription price of units is taken as the High-Water Mark.