Fees Structure, Fund Performance and Benchmarking

1Fees in close-ended funds: hurdle, carry and the waterfall

Close-ended AIFs (all Category I and II funds and some Category III funds) usually charge fees in the private-equity style below.

• Management fee: an annual fee (for example 2%), usually charged on committed capital during the investment period and on invested capital or net asset value afterwards.
• Hurdle rate (preferred return): the return investors must receive, often 8–10% a year, before the manager shares in profits.
• Carried interest (carry): the manager's share of profits, typically 20%, paid only after investors get back their capital plus the hurdle.
• Catch-up: after the hurdle is met, the manager receives a larger share (sometimes 100%) of the next profits until it has "caught up" to its agreed share (for example 20%) of all profits.
• Waterfall: the order in which distributions are paid:
  1. return of investors' contributed capital;
  2. the preferred return (hurdle) to investors;
  3. the manager's catch-up, if any;
  4. the remaining profits split, for example 80% to investors and 20% to the manager.
• European (whole-fund) waterfall: carry is paid only after investors get back all their capital and hurdle across the whole fund. It favours investors.
• American (deal-by-deal) waterfall: carry can be paid on each profitable deal as it exits. It favours the manager and needs a clawback.
• Clawback: the manager must return excess carry if, at the end, it has received more than its agreed share.

Example A fund draws ₹100 crore and returns ₹180 crore in total. Profit = ₹80 crore. With a 20% carry and full catch-up, the manager's carry is 20% × ₹80 crore = ₹16 crore, and investors receive ₹164 crore.

Remember

• Waterfall order: capital → hurdle → catch-up → split.
• European waterfall = whole fund, investor-friendly. American = deal by deal, needs clawback.

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2Return multiples for close-ended funds

• IRR (internal rate of return): the annualised return on the actual timing of cash flows into and out of the fund. It is sensitive to timing: quick exits raise IRR.
• MOIC (multiple on invested capital): total value ÷ invested capital.
• DPI (distributed to paid-in): cash distributed ÷ paid-in capital. It shows realised returns.
• RVPI (residual value to paid-in): remaining net asset value ÷ paid-in capital. It shows unrealised value.
• TVPI (total value to paid-in) = DPI + RVPI.

Example Paid-in capital ₹10 crore; distributions so far ₹8 crore; remaining NAV ₹12 crore. DPI = 0.8x, RVPI = 1.2x, TVPI = 2.0x.

A high TVPI with a low DPI means most of the value is still on paper. DPI shows what investors have actually received.

Remember

• TVPI = DPI + RVPI.
• DPI = cash in hand; RVPI = paper value.
• IRR measures speed; multiples measure size.

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3Fees in open-ended hedge funds

Open-ended Category III funds usually charge:

• a management fee, a fixed percentage of NAV each year (for example 1–2%), accrued in each NAV;
• a performance fee (incentive fee), a share of the gains (for example 10–20%), often only on returns above a hurdle rate.

A high-water mark (HWM) is the highest NAV on which a performance fee has already been paid. The manager earns a performance fee only on gains above the HWM. After a loss, the fund must first recover to the HWM before any new performance fee is due, so investors do not pay twice for the same gains.

• Hard hurdle: the fee applies only to returns above the hurdle.
• Soft hurdle: once returns exceed the hurdle, the fee applies to the whole return.
• Crystallisation: the date when the performance fee is fixed and paid (for example annually). After crystallisation, the HWM resets to the new peak.

Example NAV starts at ₹100 (also the HWM). Year 1 ends at ₹120; a 20% fee on ₹20 = ₹4 (ignoring hurdle), so the new HWM is ₹116 after the fee. Year 2 ends at ₹110: no fee. Year 3 ends at ₹125: the fee is 20% × (125 − 116) = ₹1.80.

Exam trap Without a high-water mark, a manager could earn a performance fee for merely recovering earlier losses.

Remember

• Management fee: on NAV, whatever the result. Performance fee: on gains.
• HWM: fee only on new highs. Hard hurdle: fee on the excess only.

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4Measuring returns and benchmarks

• Absolute return: the fund's own return over a period, for example NAV growth from ₹100 to ₹112 = 12%.
• Annualised return (CAGR): the yearly rate that turns the starting value into the ending value over several years.
• Relative return: the fund's return minus its benchmark's return.
• A benchmark should match the strategy: a long-only equity fund against a broad equity index; a market-neutral fund against a money market or risk-free rate; a long-short fund against a blend reflecting its net exposure.
• SEBI requires AIFs to report data to benchmarking agencies, which publish industry benchmarks for each category, so investors can compare funds on a consistent basis.
• Returns should be shown net of fees and expenses, and pre-tax and post-tax figures should not be mixed (chapter 9).

Remember

• Benchmark must fit the strategy; market-neutral → cash-like benchmark.

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5Measuring risk

• Standard deviation (volatility): how widely returns spread around their average. Higher SD = more variable returns.
• Downside deviation: like SD, but counts only returns below a target (often zero or the risk-free rate).
• Skewness: the lopsidedness of returns. Negative skew means occasional large losses (common in strategies that earn small, steady gains, such as selling options). Positive skew means occasional large gains.
• Kurtosis: how "fat" the tails are. High kurtosis means extreme returns, good or bad, happen more often than a normal distribution would suggest.
• Maximum drawdown: the largest fall from a peak to a later trough, in percentage terms. It shows the worst loss an investor who bought at the top would have suffered.
• Value at Risk (VaR): the loss that will not be exceeded over a given period at a given confidence level. A one-day 95% VaR of ₹2 crore means that on 95% of days the loss should not exceed ₹2 crore; on the other 5% it could be larger. VaR does not say how large losses beyond it can be.
• Beta: sensitivity to the market (chapter 3).

Example NAV rises from ₹100 to a peak of ₹150, falls to ₹105, then recovers to ₹140. Maximum drawdown = (150 − 105) ÷ 150 = 30%.

Remember

• Negative skew = rare big losses. High kurtosis = fat tails.
• Drawdown = peak to trough. VaR = loss not exceeded at a confidence level.

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6Risk-adjusted returns

Higher is better for all of them. Compare funds only over the same period and with similar strategies.

Example Fund A returns 16% with SD 12%; Fund B returns 20% with SD 20%. Risk-free = 7%. Sharpe A = (16 − 7) ÷ 12 = 0.75; Sharpe B = (20 − 7) ÷ 20 = 0.65. A gives more return per unit of risk.

Example A fund returns 15% with beta 0.8. Risk-free = 7%, market = 13%. Expected return = 7 + 0.8 × 6 = 11.8%. Jensen's alpha = 15 − 11.8 = 3.2%.

Remember

• Sharpe: SD. Sortino: downside deviation. Treynor: beta.
• Information ratio: excess over benchmark ÷ tracking error.

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