This articles is based on a Podcast episode of a same title:
Greetings from Ho Chi Minh City.
Every October I find myself back in Vietnam. This year is no different.
As I travelled from the airport into the city, I found myself comparing what I was seeing to Dar es Salaam, Tanzania, where I had been only a few weeks earlier.
Both cities are growing.
The difference is largely one of timing.
Perhaps ten years.
Perhaps twenty.
One city appears to be following a path the other has already travelled.
Investment often looks very much like that. It is, in many ways, a study of time.
And so are funds.
Many of the structures used within funds exist because people enter the same investment opportunity at different points in time.
The challenge is simple:
How do we treat those investors fairly?
In the previous article, I wrote about waterfalls and the relationship between General Partners (GPs) and Limited Partners (LPs).
The question was:
What is fair between managers and investors?
This time, the question changes slightly.
What is fair among investors themselves?
That is where equalisation begins.
Fairness Is Not Only a GP-LP Problem
When people think about fund economics, they often focus on the relationship between GPs and LPs.
How much carried interest is fair?
What should the hurdle rate be?
Should waterfalls be Deal-by-Deal or Whole Fund?
All of those are important questions.
However, private funds face another challenge.
Even LPs within the same fund are not always in the same position.
They may enter at different times.
They may see different information before investing.
They may take different levels of risk.
And if those differences exist, how should they be reflected?
Equalisation is one answer.
A Hedge Fund Example
Let us start with a simple example.
Assume a fund launches with a NAV of 100.
Investor A subscribes at launch.
Several months later, the NAV falls to 95.
Investor B enters at that point.
By year-end, the NAV has recovered to 110.
Now consider performance fees.
Investor A earned a gain of 10.
Investor B earned a gain of 15.
Both investors end at the same NAV.
Yet they clearly experienced different economic outcomes.
Should they pay the same performance fee?
Most investors would say no.
This is where equalisation mechanisms appear.
The objective is not to alter the NAV.
The objective is to ensure that investors bear the appropriate economic impact of the gains they personally benefited from.
Equalisation Is An Adjustment for the Benefit of Hindsight
One way I think about equalisation is this:
It is an adjustment for the benefit of hindsight.
Investor A entered without knowing what would happen.
Investor B entered later.
Investor B had information that Investor A never had.
Even if that difference is small, it exists.
Equalisation attempts to account for it.
The mechanism itself varies from fund to fund.
The underlying principle does not.
Investors who participate under different circumstances should not automatically be assumed to have taken identical risks.
The Same Question Appears in Private Equity
Many people associate equalisation with hedge funds.
The same economic issue appears in private equity.
Consider a fund that has already completed a first closing.
Capital has been called.
Investments have already been made.
Several months later, a second investor joins the fund.
From a legal perspective, dilution can solve part of the problem.
The later investor acquires an economic interest in the portfolio.
But another question immediately appears:
Did both investors truly take the same risk?
The first investor entered a blind pool.
The second investor could see at least part of the portfolio before committing capital.
Those situations are not identical.
The first investor accepted uncertainty that the second investor never faced.
Equalisation attempts to compensate for that difference.
Someone Funded the Position
I often find it useful to view this through a funding lens.
Suppose Investor A funded the investment months before Investor B joined.
When Investor B eventually enters, part of Investor A’s capital is effectively replaced.
From that perspective, Investor A has been financing the position on Investor B’s behalf.
If capital was being funded earlier by one investor, should there be compensation for the time value of that capital?
This is where equalisation interest, catch-up payments and similar concepts begin to appear.
Interestingly, this brings us back to the hurdle-rate discussion from the waterfall article.
In both cases, the question is remarkably similar:
Who bore the economic cost of carrying the capital?
When Templates Become a Substitute for Thinking
At this point, a different concern appears.
Occasionally I encounter provisions in domestic documentation that seem to exist simply because they appeared in a template.
Templates are useful.
Templates are necessary.
But templates are not answers.
A provision should exist because it solves a problem.
Not because it appeared in a previous document.
When equalisation adjustments are treated as ordinary fund profits, strange economic outcomes can emerge.
People can end up paying amounts that effectively return to themselves through the allocation mechanism.
The accounting may work.
The economics often become difficult to explain.
Whenever I see situations like this, I find myself asking a simple question:
What problem is this provision actually trying to solve?
The answer matters far more than the wording itself.
Who Should Receive Gains Realised Before the Final Closing?
Another interesting example appears when an investment is realised before the final closing.
Suppose early investors funded a deal.
The investment is sold successfully.
Only later does a new investor join the fund.
Should that new investor participate in gains generated before becoming an investor?
I have always found this question revealing.
The answer may vary depending on the structure.
The underlying principle remains the same.
The gains arose from risks borne by someone.
Understanding who accepted those risks is usually the starting point for understanding who should receive the associated rewards.
Administrative Convenience Is Not Fairness
From an administration perspective, it is often easier when everyone receives identical treatment.
The calculations become simpler.
The reporting becomes easier.
The recordkeeping becomes cleaner.
But convenience and fairness are not the same thing.
A fund administrator’s job is not to choose the easiest answer.
It is to implement the agreed answer.
The same principle applies to exclusion provisions, excusal rights and other special allocations.
The calculations may become complicated.
The complexity exists because economic reality is complicated.
The solution is not to ignore the complexity.
The solution is to respect it.
Equalisation Is Not an Accounting Adjustment
People often describe equalisation as a technical adjustment.
An accounting process.
A calculation.
A spreadsheet problem.
I don’t think that captures what it really is.
Equalisation is an attempt to answer a fairness question.
Who took the risk?
Who provided the capital?
Who possessed the information?
Who arrived later?
Only after answering those questions does the adjustment itself become meaningful.
Conclusion
In the previous article, the question was:
What is fair between GPs and LPs?
This time, the question becomes:
What is fair among LPs themselves?
Equalisation exists because investors participate under different conditions and at different points in time.
Without adjustment, those differences can create unintended advantages and disadvantages.
The purpose of equalisation is not to make calculations more complicated.
The purpose is to preserve fairness.
The more time I spend in this industry, the more I suspect that funds are not merely investment vehicles.
They are systems for allocating capital, certainly.
But they are also systems for designing fairness.
Waterfalls address fairness between managers and investors.
Equalisation addresses fairness among investors.
Both are attempts to answer the same underlying question:
How should people who participate together be treated fairly?
And perhaps that question is far more important than any calculation itself.
Leave a Reply