Following the recent update and consolidation of the Cyprus legislative framework governing AIFs, the jurisdiction has experienced a significant boost in assets under management as well as in number of AIFs. Although the primary strategic targeting of the jurisdiction is towards illiquid AIFs, such as private equity, real estate etc., it has been identified that managers of liquid funds looking into the alternative space are also now choosing Cyprus as their jurisdiction of choice. The latter type of funds has certain specificities in terms of operation which create new needs to be addressed in the legal framework, one of which is enabling the application of equalisation techniques on performance fee calculations for AIFs structured as companies.

What is an equalisation technique

In calculating performance fees, the overriding concern among fund managers is to determine how to fairly reward themselves for positive performance while at the same time ensuring that investors are treated equitably. When applying performance fees, fund managers have to deal with the “free rider” issue, a situation where investors benefit from their subscription into an under-performing fund and the appreciation of their investment’s value below a predefined threshold applied at fund level e.g. a high watermark. 

This is where the performance fee equalisation comes in. Equalisation is a method implemented by fund managers in order to ensure that the performance fee is always charged to those investors whose investment in the fund has appreciated in value, irrespective of the time of their subscription to the fund. The method is used in the case of open-ended funds which issue units or shares and apply a performance fee. 

Through time, a few equalization methodologies have been developed to accommodate the “free rider/unfair clawback” issue.

Examples of equalization techniques applied

(a) Credit Adjustment Equalization

One of the most common methods of equalization is the Credit-Debit Adjustment, also known as the Credit/Contingent Redemption Approach. This method ensures that a single GAV/NAV per unit or share is issued across all investors, even after the adjustment takes place. In practice, the equalisation is achieved through the implementation of certain adjustments in the holdings of investors, either through issuance of new units/shares or partial cancellation of existing ones. The adjustment takes place at the end of a predefined reference period or during an investor’s redemption, whichever occurs first. The value of units/shares issued or cancelled is equal to the performance fee amount that needs to be adjusted (equalization credit or debit) in order to ensure that inequities that could otherwise result for the benefit of the “free rider” investor, or of the fund manager in other cases, are resolved.

Consider a fund which issues shares with the following key features:

High Watermark currently at $110

Performance Fee Rate: 20% (for simplistic purposes, no hurdle rate or benchmarking shall be applied)

Investor A subscribes to 100 shares in the fund on the applicable dealing day for a price of $105 per share. In the next crystalisation period, the fund’s share value appreciates to $108, prior performance fee charges. In the absence of an equalization method, the fund manager shall not charge a performance fee since the fund has not exceeded its previous higher price for which a performance fee was already paid by other existing investors. However, in this case, Investor A has benefited from an increase of $3 ($108-$105), per every share held. If an equalisation is not performed, the investor shall get away with a total positive performance of $300 ($3*100 shares) and no equivalent fee amount due to the fund manager (“free rider situation”).

Using the Credit-Debit Adjustment methodology, the fund administrator must charge Investor’s A account with $60 ($300 * 20%) and therefore cancel 0,56 shares ($60 / $108) owned by the latter. This will normally leave the investor with 99,44 shares, however in the case of a Cyprus fund structured as a company, fractions cannot be recognized.

(b) Series Equalization

Another popular equalisation method is the Series equalisation. Under this method the initial subscription of shares is set as the Base series, while future subscriptions dates are issued in separate series allocated to that specific dates. Future NAV movements are allocated to each series separately and each series has its own allocated NAV. At future year ends or other performance fee crystalisation dates set, the profitable future series are converted back to equivalent Base series shares by adjusting the number of shares held by the investor.

Using the data from the previous example, and assuming the Base series shares are valued at the crystalisation  date  at $103 per share, Investor A's shares will be converted  from 100 subscription series shares to 104,854 base series shares (100*$108/$103), again resulting in a fractional share result.

Legal limitations of applying equalisation techniques on Cyprus AIFs structured as companies

Currently applying such equalisation techniques on Cyprus AIFs structured as companies is not an option as the existence of fractional shares is restricted by the AIF Law 124(I)/2018, Section 58(3)(b).

As a result, managers of liquid AIFs wishing to apply equalisation techniques have been opting to setting up their structures in the form of the common fund where the equalisation of units does not fall under the legal restrictions for fractions, sacrificing in the meantime the benefits that a Cyprus corporate structure brings on the table. Others have chosen to ignore equalisation effects all together.

Over time, alternative practices have been identified to work around the technical matter of fractional shares disapplication for AIFs structured as companies. These include the holding of a second register with notional units assigned to each investor and entail practices such as performing notional adjustments with no monetary consideration until redemption day.

Despite the good effort, the implementation of alternative solutions creates additional administrative workload, increases the risk of miscalculation and adds complexity in the eyes of international fund managers and investors alike.

As Cyprus is currently taking steps in expanding it's strategic targeting horizon to include liquid funds and managers through the introduction of a tailored tax system for funds, it would be beneficial if technicalities such as the implementation of equalisation techniques are addressed through the update of the legal framework governing AIFs.

George Karatzias
Board Member
Cyprus Investment Funds Association

Constantinos A Constantinou
Senior Manager
PricewaterhouseCoopers Limited