Ensuring Fair Treatment of Investors in UCITS and AIFs: Performance Fees and Income Equalization

Investor fairness is a cornerstone of fund governance, particularly in Europe’s highly regulated landscape of UCITS and Alternative Investment Funds (AIFs). Ensuring that investors are treated equitably requires addressing two key challenges:

• The allocation of performance fees, which are driven by the fund’s investment performance.

• The distribution of distributable income, which is generated from dividends, interest, and other cash flows.

Both challenges significantly impact investor returns, but each raises unique operational and regulatory questions. Let’s examine them.

1. Performance Fees: Fairness in a Performance-Driven World

   
   

The Challenge

Performance fees are intended to reward managers for delivering superior returns. However, when investors subscribe or redeem at different times, fairness can be compromised. New investors might benefit from past performance without paying their fair share of performance fees, while redeeming investors might avoid paying fees that accrued during their holding period.

Traditional Tools

• High Water Marks: Ensure that fees are charged only on gains that exceed prior peak values, preventing fees on recovered losses.

• Hurdle Rates: Require that a minimum return be achieved before performance fees are levied.

Limitations

Although these mechanisms provide a sense of fairness at the fund level, they often fail to align fees precisely with each investor’s individual investment experience:

• High water marks and hurdles apply at the fund or share class level, not to individual investors.

• New investors may benefit from past performance without paying appropriate fees.

• Redeeming investors might avoid paying fees they contributed to generating.

How Funds Address This

To improve fairness at the investor level, funds may implement:

• Equalization Accounting

  • Assigns credits or debits to each investor based on their entry point and time in the fund.

  • Ensures each investor’s performance fee reflects their actual contribution to the fund’s growth.

• Series Accounting

  • Allocates new subscriptions into separate share classes (series) with their own performance fee calculations.

  • Maintains fairness by ensuring that each investor’s share of fees or income reflects their own investment experience, not that of others.

• Crystallization Clauses

  • Resets performance fees periodically (e.g. annually or quarterly).

  • Aligns performance fees with realized performance over time.

Drawbacks of These Methods

• Operational Complexity: Requires detailed record-keeping, particularly in daily-dealing funds with frequent subscriptions and redemptions.

• Computational Intensity: Calculating individual fee entitlements can be resource-heavy and require specialized systems.

• Investor Understanding: Some investors find these calculations opaque, which can affect transparency and confidence.

Why Some Funds Choose Simpler Approaches

Due to complexity and costs, some funds prefer simpler mechanisms (like high water marks and hurdle rates) even if they are not fully fair at the individual level. This trade-off balances administrative feasibility with a baseline sense of fairness.

2. Distributable Income: Fairness in Fund Earnings

   
   

The Challenge

Funds earn income through dividends, interest, and other cash flows. This income is ultimately owed to investors. Without proper equalization, investors who enter just before a distribution could unfairly benefit from income they didn’t help generate, while investors who leave just before might miss their rightful share.

Methods to Ensure Fairness:

• Income Adjustment at Subscription/Redemption

  • Adjusts the subscription or redemption price to account for accrued income entitlements.

  • Ensures that each investor pays or receives their fair share of income based on their time in the fund.

• Dividend Equalization Reserve (DER)

  • Maintains a reserve account that tracks each investor’s contribution to distributable income.

  • Ensures that investors receive the correct share of income distributions.

Drawbacks of These Methods:

• Administrative Complexity: Requires tracking each investor’s holding period and income contribution.

• Data Management: Can be challenging to maintain accurate records in funds with frequent dealing and high investor turnover.

• System Limitations: Some fund accounting systems may not be equipped to handle these calculations easily.

Why Some Funds Choose Simpler Approaches

To avoid administrative burdens and additional costs, some funds distribute income based on simple pro-rata calculations, even though this may result in cross-subsidization among investors.

3. Conclusion

   
   

Ensuring the fair treatment of investors in UCITS and AIFs demands balancing fairness with operational feasibility. While mechanisms like equalization accounting, series accounting, and dividend equalization reserves help align fees and distributions with each investor’s actual experience, they can also introduce significant complexity and costs.

This trade-off often leads funds to adopt simpler models that provide approximate fairness without the administrative burden of more sophisticated systems. As the fund industry evolves, finding the right balance between fairness, transparency, and efficiency will remain key to maintaining investor trust and regulatory compliance.

If you’d like to discuss how to implement fair treatment mechanisms in your fund or explore customized solutions, please feel free to get in touch. Let’s work together to build transparency and investor confidence.