Equalisation

In fund management, equalisation is the name for several accounting mechanisms that ensure investors who enter or leave a pooled fund at different times are treated fairly relative to one another. A fund is a single pool, but its investors arrive at different dates and prices. Without adjustment, a newcomer could receive income earned before joining, escape a performance fee that earlier investors bear, or benefit from investments funded by others. Equalisation corrects for these timing differences.

The term is used in three main settings: income equalisation in retail funds that pay distributions, performance fee equalisation in hedge funds, and equalisation payments by investors admitted to a private fund after its first closing. It is unrelated to the equalisation of pension benefits or of taxes between regions, and distinct from the profit equalisation reserve used by Islamic banks to smooth returns to depositors.

A fund that distributes income accumulates dividends and interest between distribution dates, and this accrued income is included in the unit price. An investor who buys units part-way through a period therefore pays for income already earned. At the next distribution every unit receives the same amount per unit, but for the newcomer part of that payment is simply a refund of money it paid in. That part is the equalisation amount.

In the United Kingdom, where the practice is long established for a unit trust and open-ended investment company, the first distribution received after purchase is split on the tax voucher into income and equalisation. The equalisation element is treated as a return of capital: it is not taxed as income, and it reduces the cost of the units for capital gains tax. Funds that operate full equalisation track the income content of every purchase; others apply an average for all units bought in the period. Accumulation units, which reinvest income, are affected in the same way. The calculation is part of fund accounting and is reported to investors by the transfer agency function.

A hedge fund usually charges a performance fee on gains above a high-water mark, accrued in the net asset value per share. Because the fee is calculated for the fund as a whole but investors subscribe at different prices, a single share price can produce unfair results. Two cases illustrate the problem.

• Subscription below the high-water mark. An investor who buys after a fall in value enjoys gains up to the old peak without any fee being charged, a free ride, unless an adjustment is made.
• Subscription above the high-water mark. An investor who buys when a fee has already been accrued in the price pays for part of a fee on gains it never received, and would be overcharged if the fund later fell.

Equalisation accounting solves this while keeping one share price. In the first case the investor is charged its own fee on the recovery by redeeming a small number of its shares, often called a depreciation deposit or contingent redemption. In the second, the investor pays an extra amount on subscription, an equalisation credit, which is returned as additional shares if the fund continues to perform, or partly lost if it falls. The alternative is series accounting, in which each month's subscribers receive a separate series of shares with its own price and fee accrual, later merged into the main series once all are above their high-water marks. A separate fund share class for each dealing date achieves the same result with more operational complexity.

Private equity, real estate and infrastructure funds raise money over several closings, often a year or more apart. Investors at later closings join a fund that has already called capital, paid fees and made investments. To place everyone in the position they would have been in had all joined at the first closing, the fund rebalances. The new investor contributes its proportionate share of capital already drawn, including past management fees, and this money is paid across to the earlier investors, reducing their funded amounts. Each limited partner commitment is then funded in the same proportion.

The newcomer also pays equalisation interest, an additional amount at a rate fixed in the partnership agreement, to compensate earlier investors for having financed the fund alone. The interest goes to the existing investors, not the fund, and does not usually count towards the newcomer's commitment. The adjustment is communicated through a capital call notice to the new investor and a matching distribution to the others, and is handled within private equity fund administration.

Each method adds work for the fund administration team and must be described in the fund's offering documents. Errors feed directly into investor balances and can require compensation. For performance fees, regulators in Europe expect the crystallisation frequency, the reference indicator and the treatment of new subscriptions to be disclosed, and the method chosen should prevent both free riding and double charging. Investors should check which method a fund uses, since the cash flows and tax reporting differ even where the economic outcome is the same.