Index Page No

Fund Accounting Overview 1

Types of Investors in the Fund 2
Asset Management Company’s- Fund Launch Process - Overview 3
Mutual Funds, Private Equity & Hedge Funds – Meaning 4
Intermediaries in the Market 6
Mutual Fund Life Cycle/Overview 7
Types of Mutual Funds 9
Net Asset Value 13
Investment Strategies in Mutual Funds 17
Private Equity Fund 20
Operations in Private Equity Fund 21
Launch of Private Equity Fund 22
Key terms in Private Equity Fund 23
Structure of P/E funds, Master/Feeder Structure/Standalone funds 25
Blocker Entity 27
Close/First close/2nd Close/Final Close and Vintage Year 28
Cash Flows in P/E Fund and Commitments 29
Capital Call Notice/Drawdown Notice, Distribution Notice 30
Recallable Distribution 31
Unfunded Commitment/Remaining Commitment 32
Management Fee 33
Types of Management fee methods 36
Exceptions in Management Fee 39
Incentive fee, Carried interest, Performance fee 40
Waterfall Methods 42
Cash flow hierarchy distribution GPs & LPs consider points 43
Waterfall Provisions 44
Hurdle Rate, Preferred Return 45
Catchup, Clawback 48
Investment Strategies in Private Equity Funds 50
Fund of Funds, Venture Capital Strategy 51
Real-Estate Strategy 52
Property Accounting, REITS 54
Leverage Buy-out 55
Infrastructure Funds, INVIT, Mezzanine funds, Credit Funds 56
Valuation of investments and disclosures related to valuations 57
Discounted Cash Flow Method 58
Financial Reporting of P/E Funds 59
Common Points -Financial Statements Preparation 70
Few terms related to Financial Reporting 74
Equalisation and Rebalancing 78
Differences between MF vs P/E vs HF 79
Hedge Funds 80
Short only Strategy, Quantitative Strategy, Long/Short strategy 81
Macro Strategy 82
Fund of Funds, Fund to make profit, Arbitrage Strategies 83
Incentive Fee / Performance Fee, Crystallisation Period 84
GAV and NAV in hedge funds 85
Side pocket, Investments made by Hedge funds 87
Securitisation of Assets, MBS, ABS 88
CDO Market, Credit Default Swap 89
Derivatives 90
OTC Contracts and Exchange Traded Derivatives 92
Futures 94
Mark to Market (MTM) in Futures 96
Options 98
Swaps 102
Swap options, Contract for Difference (CFD) 103
Fixed Income Securities 104
Top Fund Houses in the World and India 108
Assets under Custody (AUC), Assets under Administration (AUA) 109
Regulatory Reporting 110
Difference between Open ended funds and closed ended funds 111
Interval Funds, Numbers format US vs India 112
Corporate Actions 113
Important dates in Corporate Actions 115
Meaning of few terms related to Corporate Actions 117
Reconciliations 118
Position Reconciliation 119
Cash Reconciliation 120
Fund Accounting:

Fund accounting refers to the maintenance of the financial records of an

investment fund. Accounting records must be kept for the investor activity, the
portfolio activity, the income earned and the expenses incurred by the fund.

If Investor like: -

1. Retail Investor (Salaried Person/Student etc.),

2. High Network Individuals (HNIs like Cricketers/ Business People etc.),
3. Institutions like LIC/Provident Funds,
4. Governments like Govt. of Dubai has surplus money and they can invest
that money into any asset class like Shares, Bonds, Real Estate, Gold,
Crypto Currencies, to Start any business etc.

If those investors are directly investing the money in to any of these assets, they
may make the below mistakes and make loss.

1. Investing in wrong asset for the time of market.

Ex: Interest rates are increasing in the market in 2021/2022 after Covid, now
buying the bonds that are paying low interest rates is not correct.

Buying the gold may not be good idea, when the economy is recovering and
growing, in these times equity markets can pay better return than gold.

2. Buying an asset at high price than actual price/intrinsic value.

Ex: Buying Reliance stock at Rs 2300 can be a good idea so you can sell that
stock at Rs 2600/2800 in 12 months of time. If you buy at Rs 2600 today and sell
at same price after 1 year is not a good idea.

If Real Estate property went up by 100% in last 12 months and it is purchased at

that high price like 1cr per acre is not a good idea since the appreciation in next
3 years can be only 10%, if that money is invested in stocks etc. the return can be
40% or more in those 3 years.

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3. Investing in an asset/business with limited or no knowledge. So, all that
money is lost.

Ex: Investing in Bitcoin/other crypto currency or derivatives etc. since some

friends of that investor invested and made good profit in the last one-year etc. in
this year, same asset may give negative 80% return also.

Types of investors in the fund:

1. Retail Investors

Salaried employees, students etc. who can invest less money and they can
take less risk. MFS equity shares bonds etc. are preferred investments for them.

2. Institutional Investors

Institutions like provident funds pension funds etc. …who can invest more
money and they can take more risk they are registered with regulators like SEBI
to participate in IPOs to invest in markets etc.

3. HNIs-High Net worth Individuals

Individuals with net worth of more than 1 million dollars/7.5cr rupees who
can invest in lacs/crores and ready to take risk.

4. SEF-Sovereign Wealth Funds

These are funds owned by governments like govt. of Dubai/Singapore etc.

who can invest huge amounts like 100s of crores to lakhs of crores.

Asset Management Companies (AMCs) or Asset Management Industry-

Introduction (Source: YouTube)

Asset Management Companies like Mutual Fund Houses (Like SBI

AMC/HDFC AMC etc.), Private Equity Fund Houses (Like Blackstone/KKR)
can help these investors by finding the best asset to invest in that year/time to
provide these investment/asset management services to many people at a time.

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These AMCs do the following:

1. Launch a fund and pool the money from investors who are willing to invest in
that fund

Ex: SBI can launch a large cap equity fund, they can collect Rs 10crore from
investors with an intention to invest that money into shares of large companies in
India like Infosys/reliance/TCS etc.

2. Do the research and find out the right companies to invest as of today. If needed
change those stocks on a regular basis.

Ex: Invest more money in to Health Care Stocks like Apollo Hospitals/Cipla etc.
in 2020. Since all the companies are doing good business due to Covid in
2021/2022. After Covid, these businesses will have normal growth to sell those
and buy other stocks like Tata motors if people are buying more cars etc.

3. Launch new funds and close old funds depends on market conditions, investors
etc. This can help these AMCs to generate more profits by catching the trend in
a market and manage the risk by selling those assets once the growth is not there
in that asset.

Ex: When Crypto market is good and investors are willing to invest in those
assets, they can launch crypto currency funds. If they are not giving returns,
liquidate those funds and launch other type of fund like equity funds.

There are different types of investors like retail investors who can invest less
amount of money like Rs 100 to Rs 10000 in a fund and expect a return like 10%
to 15% per year or wealthy investors who can invest Rs 1 Crore to Rs 1000 crore
and expect more than 20% return per year etc.

All these funds offered by these AMCs, can be grouped in to below categories:
1. Mutual Funds
2. Private Equity Funds/Venture Capital Funds
3. Hedge Funds

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Mutual Funds: Pool the money from investors (Mainly Retail Investors) and
invest money in to Low-Risk Assets like shares of listed/Public companies (like
Infosys/Reliance etc.), bonds, gold etc.

Ex: Canara AMC Launched a Blue-chip fund and invested that money in to
HDFC Bank/ICICI Bank share etc. Any investor having Rs 100/500/10000 etc.
can invest in that fund any time.

Private Equity: Pool money from Wealthy investors like HNIs, Institutional
investors like Provident Funds, Sovereign Wealth Funds (Government Funds)
etc. so they can pool more money like 1000cr to 1 lack crores etc. in each fund.
These funds can invest money in any asset class like start-up company shares,
Real Estate Assets, Infrastructure Assets etc. since these investors in the funds
can take that risk.

Hedge Funds: Pool money from Wealthy Investors. They generally invest in
public company shares, derivatives like futures/options, Crypto currencies etc.
They take more and try to give more returns in short term also.

(Note: P/E funds are less risky than Hedge funds, since they invest for long term
and try to 20% kind of return, Hedge Funds try to invest for short term and try for
more return by investing in derivatives etc. So, hedge funds are generally riskier
than P/E funds).

Within Mutual funds or P/E funds or Hedge funds also, there are many types of
funds. So, investors can choose the right fund based on their expected returns.

Ex: In mutual funds, there are equity funds, these funds invest in to equity shares
of companies like Infosys/Just Dial/PVR etc. If the business of those companies
is doing well, value of the company and share price of the company will increase,
that will increase the mutual fund value. If that company is reporting losses due
to recession/other reasons, share price of that company will go down so that
mutual fund also will report losses.

If SBI equity fund invested Rs 100 crore in Infosys company shares (at Rs 1500/-
per share), if that company share price went up to Rs 1,650/- in a year, there is a
10% increase (150/1500*100=10%) in share price so fund will report around 10%
profit. If you have invested Rs 1, 00,000/-, that will become Rs 1.10 lakhs (10%
increase)

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If an investor like retired employee cannot take risk, they are ok with low returns,
they can invest in debt funds. These debt funds invest in bonds/debentures etc.
issued by companies. Companies will pay interest like 8% per year on these
bonds. So, these debt funds can also give a return like 6 to 8% in that case.

When these fund houses are offering different types of funds to investors,
investors are investing more money in to these funds. This asset management
industry is growing and the assets under management (AUM) of these companies
is also growing.

Ex: In 2012, total AUM of mutual funds in India is around Rs 8 lacks crores, by
2022 it is increased by 5 times to Rs 40 lacks crores (Appx). Similar way, AUM
across the globe is also increasing since investors are able to get better returns by
investing in these funds.

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To support these Asset Management Companies, there are many other
companies/intermediaries in the market. They are like:

1. Custodian: This party keeps the assets of the fund in their safe custody

Ex: If BlackRock launches a mutual fund and invest in reliance company shares,
these shares will be with custodian bank/custodian. Assuming "the custodian to
this fund Is Citi bank, shares will be with Citi bank.

2. Fund Administrator/Fund Admin: This party takes care of day-to-day

activities in the fund like preparation of financials, audit support, NAV
calculation’s, filing relevant papers with regulator like SEBI, initiating all
bank payments/receipts of the funds etc.

Ex: If Goldman Sachs launches a hedge fund and appoints state street company
as fund administrator, State Street will take care of that fund admin activities and
Goldman Sachs can concentrate on investments like where to invest etc.

3. Auditors: Each fund will be separately registered as Trust or Company or

Partnership etc., separate set of financials will be prepared for each fund. All
these is funds financials will be audited by audit companies like KPMG/PWC
etc.

4. Registrar and Transfer Agent (RTA): These registrars keep the records of
investors/details of owners in a fund.

Ex: In IIFL fund, if there are 1000 investors, this RTA Company like CAMS/Fin-
Tech etc. will keep the details of those people and units owned by each one of
those investors.

5. Stock Brokers/Prime Brokers: These stock brokers like Zerodha/JP Morgan

Securities/ HSBC Securities etc. are members of stock exchanges (like
Bombay stock exchange, New York stock exchange etc.). If these funds want
to buy/sell securities like shares in those exchanges, these stock brokers/prime
brokers will help them.

6. Depositories: All securities purchased by these funds will be held in

dematerialised format/in soft copies with these depositories like NSDL/CDSL
etc.

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MUTUAL FUNDS-OVER VIEW - LIFE CYCLE OF A MUTUAL FUND

1. A fund house/AMC like IIFL/SBI launches a fund and accept investments from
the public. That period like 10 to 20 days is called as "New fund offer (NFO)"
before announcing this NFO, these fund houses prepare a document like
prospectus (scheme information document/SID), get approval from regulator like
SEBI.

2. To announce this NFO/fund launch, these fund houses do the research and find
out on what type of fund can attract more investors and they will announce a fund
like small cap fund/large cap fund/ fund of funds etc.

3. In this NFO time, any investor can invest in that fund. If the minimum
investment as per the scheme documents is Rs 500/5000 etc., investors have to
invest that money. Investors will be allotted units (like shares)

Ex: If you are investing Rs 500 in IIFL tax saver fund on 13th Dec 2022, you will
get 50 units at Rs 10 per unit.

4. If the fund collected Rs 50 crore by selling 5 crore units at Rs 10/- per unit,
they will invest that money in to shares like Reliance/ICICI bank etc. in the next
few weeks. This fund is Nifty 50 index fund. So, they can only invest the money
in to stocks that are part of the Nifty 50 index (top 50 companies in India)

5. If that fund is open ended fund, investors can invest more money in to that fund
any time and they can also redeem their investment any time.

Ex: You have invested Rs 500/- today, after a month, you can redeem/with draw
that and you may get Rs 520/- with profits if that fund is making profits.

6. If that fund is closed ended fund, it will have specific life time like 5 years.
Investors can invest at the time of launch and fund will repay me the money after
5 years by selling all those investments.

Note: These closed ended funds will list these mutual fund units in stock
exchange. So, investors can sell their investment/units to other investors in the
stock exchange. However, fund manager/fund house will not be responsible to
arrange money to investors.

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7. If that is open ended fund, investors can enter in to fund or exit from fund any
time. AMC/fund house will take money and issue units to investors if they are
investing (subscriptions in to the fund). Same way, if investor is exiting from the
fund, fund house will take units and pay money to investors.

8. All these transactions like investors entry in to the fund (subscriptions) and
investor exit from the fund (redemption) will happen based on the net asset value
of units in that fund.

Ex: If you have invested In IIFL fud on 13th Dec at Rs 10/- per unit, that value
may go up to Rs 12/- after 6 months if that fund made profits.

9. On a daily basis, this fund activities are

A. Take subscriptions and accept new investors in to the fund and pay to
investors leaving the fund (if open ended fund).
B. Calculate NAV/Net Asset Value of the fund and units on a daily basis
based on change in market prices of the securities like shares.
C. Change the portfolio based on market conditions.
D. If open ended fund, they can continue forever. If closed ended fund, sell all
investments and return money to investors and liquidate the fund.

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Types of Mutual Funds:

Based on Based on Based on Based on Based on

Structure Asset Class Goals Risk Speciality
Open Ended Tax-Saving Low-Risk
Equity Fund Sector Fund
Fund Fund Fund
Close Ended Retirement Moderate- Thematic
Debt Fund
Fund Fund Risk Fund Fund
High-Risk Fund Of
Interval Fund Hybrid Fund Growth Fund
Fund Funds
Fixed Income
Fund

BASED ON STRUCTURE

➢ OPEN ENDED FUND: Open-end schemes are open for investors to enter or
exit at any time, even after the NFO. Although some unit-holders may exit
from the open-end scheme, wholly or partly, the scheme continues operations
with the remaining investors. The scheme does not have any kind of time
frame in which it is to be closed.

➢ CLOSE ENDED FUND: Closed-end funds have a fixed maturity. Investors

can buy units of a closed-end scheme, from the fund, only during its NFO. The
fund makes arrangements for the units to be traded, post-NFO in the stock
exchanges. This is done through a listing of the scheme in one or more stock
exchanges. Such listing is compulsory for closed-end schemes.

➢ INTERVAL FUND: Interval funds combine features of both open-end and

closed-end funds. They are largely closed-end, but become open-end during
pre-specified time periods. The gap between two successive transaction
periods is called interval period. The minimum duration of an interval period
is 15 days. Subscription and redemption are not permitted during the interval
period.

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BASED ON ASSET CLASS

➢ EQUITY FUND: The fund that invests in equity and equity related
instruments. Small Cap, Mid Cap and Large Cap are some examples of equity
fund where investment is made in shares of companies on the basis of their
market capitalization. The risk involved in these funds are higher, hence the
expectation of return by investors are also high.

➢ DEBT FUND: The fund that invests in debt and debt related instruments.
Some of the Debt schemes are; Liquid Fund, Money Market Fund, Overnight
Fund, Short- duration fund, Bond Fund, Gilt Fund etc. The risk involved in
these funds are less as compared to equity funds. Returns are lower but safer
instruments to invest.

➢ HYBRID FUND: These funds invest in a mix of equity and debt instruments.
This can be further categorized as conservative, balanced and aggressive
hybrid fund.

BASED ON GOALS

➢ TAX-SAVING FUND: Mutual fund offers tax-saving schemes which

provides tax benefit to the investors along with return. The investment made
in tax saving mutual funds are eligible for tax benefits under section 80C of
the Income Tax Act. Example of Tax Saving Fund - ELSS (Equity Linked
Saving Scheme).

➢ RETIREMENT FUND: The fund invests majorly in low-risk investment

option like govt. securities to ensure stable and steady return. Investors invest
money in retirement funds so that they can receive regular money as pension
after retirement.

➢ GROWTH FUND: Growth funds invests in diversified portfolio consisting

of stocks of high growth companies. The main objective of these funds is to
provide capital appreciation; thus, they provide little or no dividend. These
funds are high risk instruments with high return potential. Ex- Blue-chip Fund.

➢ FIXED INCOME FUND: These funds invest in safe assets like bonds,
debentures and money market instruments to provide regular cash flows at
defined interval to their investors in terms of interest and dividend.
Ex - Monthly Income Plan.
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BASED ON RISK

➢ LOW-RISK FUND: These are debt-oriented funds with low risk to safeguard
the invested money with an average return of about 6-7 %. Ex- Gilt Fund, Debt
Fund, Money Market Fund etc.

➢ MODERATE-RISK FUND: These funds provide a balanced composition of

investment in both equity and debt with moderate risk and return of about 8-
10%. Ex- Hybrid Fund, Conservative Fund, Balanced Fund etc.

➢ HIGH-RISK FUND: These funds invest majorly in equity and equity related
instruments with the major investment objective of growth and capital
appreciation. These involves high risk and tend to provide higher return if
market is in favour. Ex- Diversified Equity Fund, Focused Equity Fund, Sector
Fund, Small and Mid-Cap Fund etc.

BASED ON SPECIALITY

➢ SECTOR FUND: An open-ended equity scheme investing in a specific sector

such as bank, power, infrastructure, pharmaceutical, technology, real estate.
Sector funds are riskier as if the particular sector in which investment is done
doesn't perform well, loss will be significant.

➢ THEMATIC FUND: An open-ended equity scheme investing in line with an

investment theme. These funds invest across multiple sectors that are woven
around a common theme. For example, an infrastructure thematic fund might
invest in shares of companies that are into infrastructure, construction, cement,
steel, telecom, power etc.

➢ FUND OF FUNDS: An open-ended fund of fund scheme investing in an

underlying fund. The minimum investment in the underlying fund shall be 95
percent of total assets.

What are the liquid funds?

Liquid funds are money market mutual fund schemes in which you can
park your surplus funds for few weeks to few months. The yields of liquid funds
are usually higher than your savings bank account interest rates.

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What is money market funds?

A money market fund is a type of mutual fund that has relatively low risks
compared to other mutual funds and most other investments and historically has
had lower returns. Money market funds invest in high quality, short-term debt
securities and pay dividends that generally reflect short-term interest rates.

What is Overnight fund?

Overnight Funds are a type of open-ended debt scheme that invests in debt
securities maturing the next day. This means, the securities in the portfolio mature
every day and the fund manager uses the proceeds to buy new securities for the
portfolio maturing the very next day.

What is short duration debt fund?

Short term funds are debt funds that lend to companies for a period of 1 to
3 years. These funds mostly take exposure only in quality companies that have
proven record of repaying their loans on time as well as have sufficient cash flows
from their business operations to justify the borrowing.

What is Bond Fund?

A bond fund, also referred to as a debt fund, is a pooled investment vehicle

that invests primarily in bonds (government, municipal, corporate, convertible)
and other debt instruments, such as mortgage-backed securities (MBS). The
primary goal of a bond fund is often that of generating monthly income for
investors.

What is Gilt Fund?

Gilt funds are debt funds that invest primarily in government securities.
These funds have no risk of non-payment of interest or principal amount but get
affected by interest rate movements as the Government borrowing typically
happens to be for a longer duration.

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Q: What is NAV, how it is calculated? What Importance of this NAV
Calculation Funds?

NAV Stands for Net assets value.

All these funds like mutual funds, Hedge funds, P/E funds etc. calculate
the net asset value of that fund on regular basis like daily/monthly/quarterly and
report to investors can understand if the funds making profits or losses. This is
calculated as NAV= Assets- Liabilities

Ex: If Axis Blue-Chip Fund has assets (like Investments, Cash, and Receivables
etc.) Rs 100crore and liabilities of Rs 20crore (like Management Fee Payable,
Accrued Expenses), Net assets are 100-20=80 crore. So, if that fund is
liquidated/closed that day, fund will release Rs 80crore and that can be paid to
investors.

If an investor like Dhoni has 10% ownership in that fund, his NAV will be 8crore
(80cr*10%), if his investment in that fund is Rs 7crore (earlier invested), he made
a profit of Rs 1crore.

In mutual funds, they calculate the NAV per unit or share also. So, investors can
easily buy or sell at that value.

NAV per unit = NAV of the fund ÷ No. of units in a fund

Ex: if Axis Blue-Chip fund has 1 crore units, NAV per unit is 80÷1=80rupees per
unit.

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 Importance of NAV:

1. If NAV is increasing, investors can understand that the fund is making

profit. If NAV is decreasing, fund is incurring losses.

Ex: You have invested today in Axis Blue-Chip fund at Rs 10 per unit, that NAV
is Rs 12 per unit after 3 months, this means the fund made 20% return (2 rupees
profit for 10 rupees investment = 20% return)

2. Any Investment in the fund by investors will happen based on this NAV

Ex: If IIFL fund is launched today, all investors will pay Rs 10 per unit.
If that fund is making profits and NAV is increased to Rs 20 after 3 years, we
have to pay Rs 20 per unit to purchase that unit in 2025.

Calculation of NAV (example) Rupees in crores

Particulars Dec-22 Mar-23
Assets
Investments - 110
Cash 100 -
Receivables - 2
Total Assets(A) 100 112

Liabilities
Bank Loan - -
Management fee payable - 2
Other accrued expenses - 3
Total Liabilities(B) - 5

a) Net Assets (A-B) 100 107

b) No. of Units (Face Value per unit) 10 10
c) Per unit NAV(a/b) 10 10.7

Q: You have 10 units in that fund, you want to exit/redeem those units. How
much the fund will pay to you?

Units 10, per unit NAV 10.7, Amount Rs 107 (10*10.7)

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Mutual Funds-Few other Important Points:

Q. What is NAV, why important?

NAV stands for net asset value. This is calculated as (Assets – liabilities)

Ex: If a fund has 200cr assets and 20cr liabilities, net assets are 180cr. In case of
mutual funds, there are many investors so they don't prepare/update this NAV at
each investor level. So, they calculate the NAV per unit/share.
So, NAV per unit = NAV of the fund/No. of units in the fund

Assuming this fund has 10cr units, NAV per unit is 180/10=18. If an investor has
100 units, his NAV is 100*18- 180. He can decide to sell all units and get 180 or
sell 10 units only etc., that transaction is settled based on that day NAV.

Note: This NAV can be calculated using Balance sheet Approach as above or
Profit and loss account approach. In P&L approach, opening balance of NAV
plus net profit per unit of today is the closing NAV.

Ex: NAV per unit is 18, net profit per unit is Rs 2 for today, and closing NAV is
Rs 20 any capital activity like subscriptions and redemptions should also be
considered for calculating this

Q: If the Fund's NAV per unit is Rs 100, you have purchased 10 units, and
paid Rs 1000. NAV of the fund will be impacted due to this?

Particulars Before After

Assets (A) 11000 12000
Liabilities (B) 2000 2000
NAV (C=A-B) 9000 10000
No. of units (D=C÷100) 90 100
NAV per unit (E=C÷D) 100 100

NAV per unit will not change since the cash balance and no. of units both are
increased. All units are allocated based on today's NAV. So, no impact.

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Q: Fund had 10000 stocks of Apple, they announced 1:1 bonus issue. Fund
accountant not updated the quantity today is ex-date, any impact on NAV?

Particulars Before Ex-date After Ex-date

Quantity 10000 20000
Price 100 50
Market Value 1000000 1000000

If you have not updated the QTY to 20000, the pricing team/NAV teams will
take today’s market value, multiply with quantity and report the portfolio value
in the books. So, NAV will be incorrect if they use 10000*50 = 5lacs rather
than using 20000*50 = 10L.

Q: For management fee payable, entry was posted in Jan 2022 for 10cr, it is
paid in Feb 2022. Now accountant forgot to reverse the entry of payable,
recorded again expense (Management Fee Expense A/c 10 Dr To Bank A/c
10 Cr), what is the impact?

Since the liabilities are reported more and not reversed, NAV is reported less. To
correct this the entry will be
Management fee payable A/c Dr 10
To Management fee A/c 10

Note: Any increase asset (or income) will increase assets, net asset value. Any
increase in liability (or expense) will decrease, net assets.

Q: Whether the investors in mutual funds are always paid the NAV per unit?
Or do they add or deduct any charges etc.?

Generally, yes. However, mutual funds are allowed to deduct exit load charges if
applicable in that fund.in India, these exit load charges are allowed, at the
discretion of the fund, some funds charge these exit load charges. In most of the
funds, they collect the exit load charges if the investor wants to exit within one
year from his investment date.

Ex: you have 1 unit, nav per unit is Rs 100.the fund will pay you Rs 99, after
deducting the 1 rupee as exit load charges.

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➢ Journal entries
Unit Capital A/c Dr 100
To Bank A/c 99
To Exit Load Income 01

Since this is the fund level income, posted as income in the fud books (not fund
house/GP books)

Note: Entry load is banned by SEBI. So, the funds do not collect entry load but
exit load can be collected, so some funds collect from investors.

Q: What are the investment strategies/types of funds in mutual funds?

Equity Based Debt Based Hybrid Other

Funds Funds Funds Funds
Large Cap/Mid Long Duration Aggressive Commodity Fund
Cap/Small Cap Funds Hybrid Funds Like Gold
Short Duration Conservative
Sectorial Funds Index Funds
Funds Hybrid Funds
Money Market Balanced Hybrid Exchange Traded
Fund Of Funds
Funds Funds Funds (ETF)
Focused Funds Liquid Funds - REIT, INVIT

Equity Funds:

These funds invest in shares of listed companies. These are riskier

compared to debt funds, bank fixed deposits etc. since they can also give loss if
the share prices reduced in market.

Depends on where they are investing there can be many categories like;

➢ Large Cap Funds: Invest in top 100 companies in India by market cap
(market cap no. of shares in that company market price).

Ex: Reliance is biggest company in India by market cap with approx. 16lacs
crores market cap. If share price is 2000, company has 800cr shares then market
capitalization is 16 lac crores (2000*800)

➢ Mid Cap Funds: Invest in companies between 101 to 250th rank by market
cap.

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➢ Small Cap Funds: Invest in companies below 250th rank (251 to 5000,
assuming there are 5000companies in Indian stock exchanges).

➢ Sectoral Funds: It’s like banking funds-they invest in shares of that sector
companies like HDFC, ICICI etc.

➢ Focused Funds: Invest in less companies like 25-30 than investing in 60

companies (portfolio of companies in that fund is less)

Debt Funds:

They invest in debt/fixed income securities like debentures/bonds.

Investors will get interest at 6 to 10% general and get the principal back on
maturity like after 5 years so they are more secured/less risky.

Ex: If Reliance need money of 100cr, they can issue debentures of 1cr at Rs 100
per debenture at 10% interest/coupon rate, tenure is 5 years. Now a mutual fund
will buy 1 lac debentures and invest 1cr, they will get 10 lacs interest each year
(1cr* 10%) and get that 1cr back after 5 years.

If long duration fund invests in long term bond like 10 years its riskier since
company may default to repay after 10 years though that is good company today.
So, long term bonds, long term funds pay more interest/more returns.

If short term funds like money market, liquid funds etc. invest in securities having
less than 1 year maturity. So, less risk and low return.

Hybrid Funds:

• They invest in both types like shares and bonds.

• If they invest 50% in debt and 50% in equity it is balanced funds.
• More than 50% in equity, it is aggressive funds.
• More than 50% in debt it is conservative hybrid funds.

18 | P a g e
 Active vs Passive Funds:

➢ In active funds, fund manager decides what to buy and what to sell using the
fund money.
➢ In passive funds, they follow an index like Nifty 50. this index is developed
by stock exchange like NSE with top 50 stocks in India. So, if the NSE include
Zomato and remove Wipro after 2 years, this fund also does the same.

These passive funds are more popular now for below reasons;
1) They have top stocks in the portfolio so we can expect consistent return in
long term
2) Expenses are less since no research and active management is there in these
funds (most of the passive funds charge management fee around 0.1 % to
0.5%)
Popular examples for passive funds are: A) Index Funds, B) ETF

Q: Difference between index funds and ETF?

Details Index Fund ETF

Money of the fund is invested in index Same as index fund, also this is traded
Meaning stocks like Nifty 50 stocks like a stock where price changes in real
time
HDFC launches Nifty50 fund, invest Portfolio is same like index fund. Units
money in to all 50 stocks in that index. of the fund is traded in NSE/BSE where
Example
If exchange remove one stock and add investors can directly buy/sell there.
new stock, this fund also does the same
More, fund house will arrange money Less, these are traded in exchange.
Liquidity when investor need, settlement happens Investors can buy/sell there only
at NAV of that day

19 | P a g e
Private Equity Fund:

P/E funds works differently and these funds try to generate more returns to
investors by investing in risky assets like shares of a start-up company or real
estate assets or infrastructure assets etc.

When they want to take more risk to generate returns, retail investors like
employees/small business etc. are not suitable to raise the money these kinds of
investors cannot afford to make huge losses if the investment made by the funds,
are a failure.

So, these funds target the wealthy investors like HNIs, Institutional investors,
Sovereign wealth funds etc. to pool the money. This will help the fund to raise
more money than 100 crore/1000crore etc. and the fund can invest any
asset/business.

Ex: If KKR pool the money from Govt. of Dubai/investors like Ambani to the
extent of Rs 5000 crores, they can buy a company like Big-bazaar (future group)
or they can buy major stake like 10 to 80% in a start-up company like
Flipkart/OYO rooms etc.

These funds can invest this money pooled from investors into any asset/business
(legal in that country) without many restrictions since these investors in the fund
are accredited investors (investors with more money and who can take risk. Who
can understand the risk?)

While making investments, these funds follow different approach than a

traditional fund like mutual fund. So, they can try to generate more return like
20%+ per year. Those features are like:

• Try to invest more money in a company/asset so they can get more stake
ownership like 5% to 95% ownership.
• This will help the fund to involve in the decision making in that company
by taking a seat in board (Board of Directors of that company) etc.

Ex: If KKR invested in Paytm Company, they will appoint one person/more from
their side as directors, so they know the decision taken in that company, this fund
representatives/directors can try to implement some decisions that are favourable
to that fund house/fund.

20 | P a g e
 • Since they invest more money, they will also continue in that
investment/company for long term like more than 5 years. That will help
them to develop the performance of the company in a meaningful way. So,
they can make good profits when they exit from that investment.

Ex: If KKR Invested in Flipkart at Rs 10 per share in 2015, they may sell the
shares at Rs 100 per share in 2020/2022. Since the company operations like sales
are increased significant now.

If they want to invest in a business/asset for long term like more than 7 years,
they cannot allow investors in the fund to exit/redeem their investment in short
term like after a month.

So, these funds launch (Mostly) closed ended funds, where the life time of the
fund will be around 10 years.

Ex: JP Morgan launches a P/E fund in 2022, they will keep the life time as 10
years which means they will return the money to invest in 2032 the operation of
the fund in these 10 years will be (life cycle of a P/E fund).

• 1st year – Launch period – Target the Potential investors, raise money,
register the fund etc.
• Up to 4 years – Investment Period – do the research and invest in 1 or 2
companies in 1st year, few in 2nd year etc.
• 1 to 8 years – Growth Period - Once investment made, try to increase the
valuations, increase the brand image of the company so easy to sell at good
valuations etc.
• 7 to 10 years – Exit Period – see the right time to sell each investment and
exit, sell can be in IPO/sell to other P/E fund etc.
• 10th year – Liquidate the fund (each fund registered separately, liquidated
after the sale of investments)

Generally, these funds keep a condition that the funds life time can be extended
for up to 2 years if they are not able to sell the investments in time. They cannot
extent beyond that time.

21 | P a g e
Launch of a P/E fund:

If a fund house like Black Stone want to launch a P/E fund, they have to
identify the potential investors (Wealthy investors), have meetings with them to
explain about the fund and make them invest.

All these marketing/reaching out to investors will happen in Private/Confidential

mode rather than advertising in public/media etc. or investment strategy of that
fund, risks and expected returns in that fund etc.

Based on interactions with investors, these fund house/AMC’s like KKR can plan
other things like how to register the fund, where to register the fund etc.

Most of these funds are registered as limited partnership entities where all the
investors and the fund manager are considered as partners to launch and register
these funds, these fund houses may see the below issues in most of the cases

• If international investors are coming in to the fund, there can be some

regulatory issues like restrictions to those investors to invest in one
country.

Ex: An Investor from Russia may not be allowed to invest in America/American

funds due to restriction/sanction imposed by American govt.

• Tax issues like the same investor may need to pay tax in more than one
country (Indian investor may need to pay tax in India and in America, if
the fund/investment is in America)

All these issues will be taken care while planning the structure of the fund like
the form in which the fund is registered like as company/partnership/trust or
where the fund is registered like America/other country etc.

If the fund is registered and investors are accepted in those funds, they can start
the operation like research on investments and make investments etc.

22 | P a g e
Key terms – Launch of P/E fund

• LP-Limited Partnership
• LP’s-Limited Partners
• GP-General Partner
• LPA-Limited Partnership Agreement

LP-Limited Partnership: These P/E funds or Hedge funds are registered as

Limited Partnerships (generally). This means all investors in the fund and fund
manager are the partners in the fund, and their liability is limited to
investment/commitment.

Ex: If a fund/any business is registered as partnership (other than limited

partnership), Partners will have unlimited liability. That means any excess losses
over and above the capital can be recovered from partners. If capital in the
business is 10 crores, bank loan is availed for 10 crores, bank can recover the loan
amount from partners from their personal assets if the losses are more in that
business and there are no assets to sell in that business.

If that business is registered as limited partnership, like company,

partners/investors in that business will have limited liability to the extent of their
capital. Other format used to register these funds is LLC (Limited Liability
Company), however most of the funds follow LP structure.

If KKR launched P/E fund to invest in Indian companies, they can register the
fund as “KKR India Venture Capital Fund LP”. This fund /limited partnership
will be managed for 10 years and liquidated once the tenure of the fund is over.
If they launch another fund, it can be registered as “KKR Asia Fund LP”.

LP’s-Limited Partners: These are investors in the fund like HNIs, Institutional
Investors etc... These people commit/invest some amount in the fund, there
liability is limited to that extent. These LP’s will not participate in the decision
making in the fund. They only invest when fund manager/fund house ask to invest
and pay the expenses in the fund and take profits/losses on their investment.

Ex: If MS Dhoni and Amitabh invested in the fund launched by Kotak/JP

Morgan, they are limited partners.

23 | P a g e
GP-General Partner: GP is the main partner in the fund who takes all decisions
like where to invest, when to invest etc. This partner is from the fund house like
KKR/JPM.

Ex: If the fund is launched by KKR, 4 external investors invested Rs 4000 crores,
there will be one internal investor (Investor from the fund house like KKR) also
in the fund, that person will manage the fund (GP=Fund manager).

This is common practise in the industry to have investment from general

partner/person from the fund house since that will increase their responsibility in
the fund to find good investments and manage the fund with responsibility. As
per the limited partnership rules, this GP who takes the decision should have
unlimited liability though other partners (LP’s) will have limited liability.

Ex: If GP committed or invested Rs 10 crores, his liability can be 100/1000 crores

also if the fund has unsettled liabilities after selling that fund assets. If the fund
has commitments of Rs 100 crores, taking a loan for 400 crores, losses in the fund
can be more than 100 crores. In this case after selling assets in the fund and
settling liabilities, there can be still pending liabilities, GP should pay that from
their personal assets to avoid this problem, these fund houses like KKR register
a separate company as GP like “KKR GP LTD, KKR GP 1 LTD etc.”, and appoint
that company as GP.

If the capital/net assets in that GP is 1 crore, any court/bank etc. can recover
maximum up to that amount only so fund house is not in trouble even if a fund
incurs huge losses beyond the capital in that fund.

Limited Partnership Agreement: When a fund is registered as Limited

Partnership, all investors in that fund/LP are partners. They enter into this LPA
which will have all details like;
• Tenure of the fund • Any expenses cap like
• Management fee, Incentive fee maximum amount that can be
(Waterfall provisions) rates paid by investors in that fund.
and how that need to be paid. • Rights and responsibilities of
• When the financials of fund investors/partners, can they
will be sent to investors transfer their stake to others
etc.
This is important for fund accounts also to accrue different expenses and to know
due dates for financial reporting etc.

24 | P a g e
Structure of P/E funds, Master/Feeder Structure/Standalone funds:

These P/E funds are generally register as limited partners where

these investors like HNI’s are limited partners and fund manager/decision making
party is GP registering one fund/one limited partnership and accepting all
investors in to the same fund and making all investments from the same fund is
called as standalone fund.

Ex: ICICI launched a fund in Mumbai with name “ICICI India advantage
fund 4 LP”, accepted by 3000 crore commitments from all Indian investors,
invested all that money in 10 Indian companies, they have only one fund/one legal
entity. They don’t have master/feeder etc.

However, as mentioned above having international investors and international

investments are common in these funds so they may find issues with

• Regulatory approvals (an investor from North Korea may not be allowed
to invest in American company etc.),
• Tax issues (I\investor from Singapore in Indian fund may need to pay tax
in Singapore and India) etc.

To avoid these issues, one of the common routes these funds take is register
multiple entities/funds/companies in different countries. So, the net tax paid by
investors/that fund is less and regulatory approvals can be available easily.

Master/Feeder:

A fund having most of the investors, decision making (General

partner is part of that fund) in that fund is generally considered as master fund.
This fund is generally registered in home country (Country where the decision
makers/GPs/fund house located), also called as “ONSHORE FUND”.

Ex: If KKR launched a fund in America to make investments across the globe,
they will register that fund is America (mostly in the state of Delaware), most of
the money will be raised from domestic (America) investors, appoint one of their
companies “KKR GP LTD” as GP/fund

Feeder fund is as fund that is used to collect money from foreign investors
and send/feed that money in to master fund.

25 | P a g e
 Ex: If above KKR fund also have international investors like 1 investor from
Singapore and 1 investor from India, they can keep both these investors in a
feeder fund, register that fund in Cayman Islands.

This feeder fund is also (Generally) an offshore fund since they are registered
outside the country (any fund outside America is offshore fund for an American
fund).

Note: Some times, a fund can launch a feeder within country also, that is domestic
feeder. So, feeder can be domestic/offshore.

Example: KKR Asia Fund LP (Mater Fund)

Partner
Investor Name Commitment Liability Comments
type
Trump 500 LP Limited-
George Bush 400 LP Limited-
New-York Pension fund 1000 LP Limited-
KKR (Cayman Islands) 500 LP LimitedFeeder is LP in master
Asia fund LP like any other investor.
KKR GP Ltd 100 GP Unlimited -
Total commitments/ 2500
fund size

Example: KKR (Cayman Islands) Asia Fund LP

Investor Name Commitment Partner type Liability Comments

Dhoni 200 LP Limited -
Singapore Govt. 300 LP Limited -
fund (GIC)
Total 500

Note: Dhoni name will not be there in master fund. He is an investor in feeder
and that feeder is investor in master.

26 | P a g e
Blocker Entity/Blocker:

This is an entity to save tax at an investment level.

Ex: If master fund (KKR Asia fund LP) wants to invest in Indian company like
Oyo rooms, they can register a separate entity like a company in Mauritius and
that Mauritius company (Name- KKR Asia (Oyo Rooms) ltd) can invest in to
Indian company Oyo Rooms etc. for govt. of India records, money came from
Mauritius, not from America so it can be tax exempt.

Note: Some times, feeder is also considered as blocker since that is also
blocking/reducing tax liability to investors. However, most common usage of that
term is for the entity registered to block tax liability at investment level (Not at
investor level).

So, Cash flow movement will be as below:

• International investors like India and Singapore/Dubai investors invest in

money in feeder fund in Cayman Island/other tax haven entity.
• That feeder fund invest money in to master fund in America.
• If that American fund/master fund investing in American company like
Google/Apple, no blocker required. If that master fund is investing in to
other country company like Oyo Rooms in India, to avoid tax in India, they
can register a blocker entity in Mauritius country. So, master fund invest
in blocker, blocker invest in portfolio company like Oyo Rooms.

Note: Generally, this blocker entity activity is just to receive money from master
and invest in to a company. Separate blockers will be created for separate
investments, so no other activity there. So, they don’t prepare separate financials
for blocker in the schedule of investments (SOI) prepared as part of financial
statements, they separately disclose the fact that investments are held through
blocker.

27 | P a g e
Close/First close/2nd Close/Final Close:

If a P/E fund finalises the list of investors or new investors want to invest
more, fund can announce 2nd close/final close etc.

Ex; ICICI announced first close of its P/E fund (India advantage fund) where they
have raised Rs 1500 crores, same fund announced 2nd close after 6 months, raised
Rs 1000 crores. So, total fund size became 2500 crore most of the funds will have
only one close. Other funds can have 2 or 3 closes, 3rd close will be final close in
most of the cases.

Note: If the fund keep takes new commitments and expand the fund, it is difficult
to invest that money and close the fund the fund in time. So, they keep all these
closes with in 12 or 18 months from the launch date (that period is called as
commitment period).

Vintage Year:

This is the first year of a P/E fund.

Ex: ICICI launches 2 funds in 2007, Vintage year of those funds is 2007.

If KKR is managing 100 funds, they may have 10 funds with vintage year as
2020, 20 funds with vintage year as 2021 etc. they can use this word like all funds
with 2020 as vintage year need to be extended for 2 years due to Covid impact
etc.

28 | P a g e
Cash Flows in a P/E Fund:

• These P/E funds generally invest in illiquid assets. So, they launch these funds
as closed ended funds.
• This means money invested by investors is locked for the life time of the fund
like 10 years, fund manager has no obligation to return the money to investors,
even if they request the redemption of their investment in 2nd year/3rd year
etc.
• The fund manager obligation is to return the money by end of the life time like
after 10 years at the time of launch. They don't need to collect all the money
from investors, since it will take time to invest that money. So, they collect
only commitments from investors and then call and collect money from each
investor when they need (like to invest that money).
• Same way, when the fund has money on sale of investment/when the fund
received income like dividend, they will distribute that money to investors.
• Generally, fund collect money from investors in the first 4 years and distribute
money in the last 4 years. Investors should plan their cash flows accordingly
to pay when the fund call/ask money and take money when fund distribute.
• If an investor failed to send money in time, he is called as default/delinquent
investor, fund can collect delinquent interest like 8% per year.
• If an investor continues to default, GP/Fund Manager can find another investor
in that place and transfer the stake to that person.
• Same way, if an investor wants to move out of the fund, they can request GP,
if any suitable investors are there, they can transfer the stake to other investors.

Commitments:

This is the amount an investor agreed to invest in a P/E fund or VC (venture

capital) fund

Ex: If KKR launched a P/E Fund and Rattan Tata committed Rs 500 crore, he is
ready to invest Rs 500 crore when the fund need money fund may collect 10% of
that committed amount in the 1st year and 30% in 2nd year etc.

29 | P a g e
Q: Commitment amount includes the management fee payable by investor
to that fund or maybe that is in addition to this commitment?

Generally, commitment includes management fee. If Rattan Tata

committed Rs 500 crores to a fund, total money he needs to send to that
fund/invest in that fund is Rs 500 crores fund manager can plan like how much
money to invest in company/how much money for expenses etc. However, in
some funds, this commitment is excluding the management fee (fee outside the
commitment).

In that case TATA might invest Rs 500 crore for investments (fund invested in to
BYJUS, INS card, First-Cry etc. So, his money is used to invest in that) and
common expenses like audit fee in the fund, custodian fee in the fund etc. On top
of that, he paid Rs 80 crores towards management fee to the GP/Fund manager
for managing his investment. So, total invested by him in the fund is Rs 580
crores.

Capital Call Notice/Drawdown Notice:

When the fund need money to invest or to pay expenses etc., they call from
each investor in the fund in proportion to their ownership.

Ex: Total commitments in the fund are Rs 100 crores, Dhoni committed Rs 10
crores, and his ownership is 10%. If the fund needs Rs 25 crores to invest in Ola
cabs shares, they will call Rs 2.5 crores (10% of 25 crore) from him; generally,
these funds will give 15 days’ notice so investors/Limited partners can arrange
the money by that time.

Distribution Notice:

When the fund has money since they received income like dividend/rent or
they sold investments, they will distribute that money to investors for distributing
the money, they issue this distribution notice if there is a capital call and
distribution, they can call only net amount from investors.

Ex: Dhoni need to pay Rs 2.5 crore to invest in Ola and the fund has Rs 1 crore
to be paid to Dhoni as income on one investment, the fund can made net capital
call for Rs 1.5 crore.

30 | P a g e
Contribution: When the investor send/pay that money to fund, it is called as
contribution.

Distribution: When the fund has money, they pay that money to the investors, it
is distribution.

Many types of distributions are there:

• Income distribution: When fund receives income like interest, they will
distribute that money to investors.
• Capital distribution: When an investment is sold, that will be distributed
to investors
• In kind distribution: When the fund distributes other than cash it is in
kind distributions.

Ex: Carlyle fund invested in SBI Cards shares, when that company went for IPO
(Initial Public Offer), this fund can transfer 100 shares to each investor in the fund
and these investors can directly sell the shares in the stock exchange when they
need money. Fund will not sell and then pay that money to investors. This can
happen when the fund has to liquidate the fund. So, they cannot wait for good
time and price to sell the shares or if the shares are available in stock exchange.
So, investor in the fund can sell them when they need etc.

Recallable Distribution:

This is a portion of distribution amount an investor has to contribute again

to the fund, if the fund says it is recallable distribution at the time of distributing
it.

Ex: Deepika committed Rs 100 crores to the fund, paid already Rs 50 crores in
2020. In 2021, fund distributed Rs 25 crores to her (on sale of an investment) and
mentioned Rs 10 crores in that is recallable distribution. This means, out of that
Rs 25 crores, she can spend Rs 15 crores anywhere but she has to plan to invest
Rs 10 crores again in the fund when the fund asked her to invest.

This is not normal in all the funds. However, if the GP feels the market conditions
are good to invest more money, so they can make more profit etc., they can use
this option. However, fund should have this condition in LPA and inform the
investors in advance while distributing to them so they can plan and have this
money available to invest in fund when the GP asked them to invest.
31 | P a g e
Unfunded Commitment/Remaining Commitment:

Unfunded Commitment (UFC) = Commitment - Contributions

If Katrina committed Rs 100 crores to ICICI fund, already paid/contributed Rs

50 crores, the UFC is Rs 50 crores.

Normal distributions made by the fund to investors will not impact this UFC, that
distributed amount is investor money. GP/fund cannot recall if it is a recallable
distribution that will increase the UFC since investors have to invest that money
again in the fund.

Ex: If the fund paid Rs 20 crores to Katrina and mentioned Rs 10 crores is

recallable, then UFC is UFC = Commitment - Contributions + Recallable
Distribution (100-50+10=60 crores)

Original unfunded commitment is Rs 50 crores and recallable distribution added

to it is Rs 10 crores so total UFC is Rs 60 crores

GP will ensure the UFC is not exceeding the original commitment of investor so
it is easy for the investors to arrange money in time and plan their cash flows.

Ex: If Katrina committed Rs 100 crores, her UFC at any point of time will not
exceed Rs 100 crores.

Calculate Capital Call to be made from investors from the below details?

Fund Name : Godrej Office Fund LP

Fund size : Rs 5,000 crores
Investors : Allianz Insurance Company, Rohit, Deepika

Investor name Commitments

Allianz Insurance Company 3,000
Rohit 1,200
Deepika 800
Total 5,000

32 | P a g e
Q: In June 2022, fund decided to invest Rs 3,000 crores Bangalore based IT
park in Maratha Halli. How much they can call from Allianz?

Allianz's ownership in the fund is 60% (3000/5000*100 = 60%) since they

committed Rs 3000 crores out of total 5,000 crores. So, fund will call Rs 1800
crores from that company out of Rs 3000 crores they need now 3000*60% = 1800
crores.

Q: What are Unfunded Commitments in that fund after this capital call?

Commitment’s 5000
Contributions made 3000
UFC or Remaining Commitments 2000
All investors UFC is Rs 2000 crores how much is Deepika’s Unfunded
commitment?
Deepika commitment 800
Total commitments in the fund 5000
Her ownership 16% (800/5000*100)
Total UFC in fund 2000
Deepika’s UFC 320 (2000*16%)

Q: Assuming this fund sold this investment in 2027, distributed Rs 8,000

crores to investors, any change in UFC amount of Rs 2000 crores?

No, since any distribution made to investors is their money, they have no
obligation to reinvest that money. So, remaining/unfunded commitment will not
change. If Rs 1,000 crores out of that distribution is marked as recallable
distribution at the time of distribution that will increase the UFC since that should
be invested by investors again when the fund calls that money to reinvest. So,
UFC will be 2000+1000= 3000 crores.

Management Fee:

This is the fee paid by investors to the GP/fund house for managing their money,
investing their money in to assets and generating returns different funds in the
industry follows different practices to charge this fee like;

• Mutual Funds - Generally charge fee based on NAV in that fund

• Hedge Funds - Generally based on NAV of the fund
• P/E Funds - Mostly on commitment.
33 | P a g e
However, these P/E funds have different cash flow pattern than other type of
funds. So, there are different types of fee arrangements in this industry. The fee
method is decided based on negotiations between the GP/investors at the time of
launch. These negotiations will be based on

1. Efforts of the fund manager.

2. Investment strategy of the fund that decides the efforts and skills of
that fund manager/team.
3. Influence of the investor like capacity to invest more money/less.
4. Track record of the fund manager/fund house that influences the
expected return in this fund etc.

Most common types of management fee methods followed in the industry are;

1. Commitment-based fee 3. NAV on the fund based

2. Invested capital/Cost of the 4. Switch based/Conversion method
investments 5. Fixed amount per year etc.

Q: Is this management fee collected in advance or in arrears in P/E funds?

Industry has both the practices, most of the funds follow arrears basis
If a fund collects fee in Jan for Jan to March period, it is fee collected in advance
If the fund collects in April for Jan to March quarter it is fee collected in arrears

Q: This fee is an expenses or income in the fund books? Is it recognised when

actual payment is made or an accrual basis?

Fund is managed on behalf of investors by the investment manager/fund

house. If ICICI launches the fund, they will collect management fee from the
fund/investors. That is charged as expense in the fund books, collected from all
investors in the fund and then paid to the fund house like ICICI. These funds,
books are prepared on accrual basis. So, these expenses are also accrued even
though they are not paid.

34 | P a g e
Ex: If ICICI launched a fund, if there are two investors, their investments is
reported as capital in the fund books. Any income based on investment made is
considered as income in that fund and expenses to manage the fund like
management fee, audit fee is considered as expense. Net profit is allocated to
owners of the fund /investors and paid to them when they are leaving the fund or
when the fund is liquidated after completion of term like 10 years.

Investors Name Amount

Dhoni 10
Amitabh 10
Total Investment 20

ICICI India Advantage Fund LP - Balance Sheet

Assets Amount
Cash/Bank 20
Total Assets 20

Liabilities Amount
Other Liabilities 0
Capital 20
Total Liabilities and Capital 20

Profit and loss account of the fund for the period 1st Jan to 31st Dec, 2022

Dividend 1
Unrealised gain 10
Management fee -2
Audit fee -1
Other expenses -2
Net profit 6

Investors accounts (Partner Capital Statement) – Amitabh

Contribution 10
Net profit 3
Closing Balance/NAV 13

35 | P a g e
 1. Commitment Based Fee

Fund Name: Softbank Vision fund

Fund Commitments: 8,00, 000 crores
90days (31+28+31)
Investors Commitment Fee rate Yearly fee Jan to March
Saudi Govt. 4,00,000 1.5% 6,000 1,479.45
Khatar Govt. 2,00,000 1.75% 3,500 863.01
Others-Corporate 50,000 2.00% 1,000 246.58
Softbank Group 1,49,900 0% 0 0
Softbank GP 100 0% 0 0
Total 8,00,000 10,500 2,589.04

Journal Entry:

Management fee Dr 2,589.04

To Management fee payable 2,589.04

Note: Cap call notice will be sent to each investor to Saudi govt., it will be sent
for 1,479.45 crores. In this commitment-based method, each investor is charged
the fee on their commitment from the day 1 till the end of the fund’s life time.
This is most commonly using method in the industry, even if the fund manager
did not invest all the money, they are incurring expenses like salaries to research
staff to find out the investment opportunities so they need to collect this fee and
charging that based on commitment will give them more amount.

2. Cost of the Investment /Invested Capital-Based Method

In this method, fee is charged only on the amount invested by the fund, not on
commitments this is beneficial to investor since the fee amount/expense will be
less to them.

Ex: If Amitabh committed Rs 100 crores on 1 st Jan,2-22, only invested Rs 20

Crores in that year, fund will charge fee on those 20 crores only.

36 | P a g e
 Example:

Date Amount Invested in

01-01-2022 1,000 BYJU’S
02-01-2022 5,000 OYO ROOMS
03-01-2022 8,000 BLINK IT
Total Invested capital 14,000

Invested
Fee
Commit Owner capital Fee Fee-Jan Feb-
Investors 28 days
ment ship share - rate 31 days cap
JAN
Saudi Govt. 400000 50% 500 2% 0.85 3000 4.6
Khatar Govt. 200000 25% 250 2% 0.42 1500 2.3
Others-Corporate 50000 6.25% 62.5 2% 0.11 375 0.58
Softbank Group 149900 19% 187.375 0% 0.00 1124 1.72
Softbank GP 100 0.01% 0.125 0% 0.00 0.75 0.00
Total 800000 100%

Q: is this invested capital is always advantage to investors since they will pay
less fee compared to commitment?

Fee will be less to them since these funds will take more time to make
investments also this invested capital will be less towards end of the fund’s life
time.

Ex: If the commitments in the fund are 1000 crore, they may invest only 100
crores in 1st year by 2nd year fee is charged only on that amount. After 7 years if
the fund sold investments worth of 200 crores fee is also collected on 800 crores
only (invested 1000 crores by that time less 00 crore worth of investments now
sold)

However, fund house may try to invest all the money in quick time to get more
fee their investors may miss an opportunity to get best returns since the fund
manager did not spend more time to evaluate the investment proposal and they
have not negotiated the deal. So, investors and fund house need to look at various
aspects before deciding the right method in that fund to charge the fee.

37 | P a g e
Q: Can this method allow the fund house to earn more fee if they take
leverage (Like bank loan) and invest more money?

Yes, most of the fund houses agree for this method if investors are
accepting for leverage like they can take loan on funds name and invest more
money.

Ex: if the fund investing in to real estate, they can collect Rs 1000 crores from
investors take Rs 4000 crores loan and invest all 5000 crores for fee calculations
5000 crores is considered as invested capital so fee is 5000*2%=100 crores.

Any gain/loss on that invested capital also belong to investors since that loan is
taken on funds name.

3. NAV Based Fee

NAV means Net asset value; NAV=Assets-Liabilities

If a fund has 100 crores assets (Cash + Investments + Receivables) 20 crores

liabilities (Bank Loan + Accrued Expenses + Management Fee Payable etc.)

NAV is 100-20=80 crores, Fee will be 80 crores * 2% = 1.6 per year

4. Switch Based Method/Conversion Method:

In this case fee base will be changed after some time like 4 years
Ex: From 2022 to 2026 fee will be charged on commitment basis and 2026+ to
2031 fee will be charged on invested capital basis this will allow the fund house
to take time and invest money in 4 years till that time fee is paid on commitments
and from there fee is paid only on invested capital.

5. Fixed Fee Method:

In some funds fee is collected like 1 crore per year etc. or 1 crore in 1st year
0.9 crore in 2nd year 0.8 crore in 3rd year etc. that will be mentioned in LPA.

38 | P a g e
Exceptions in Management Fee

These Investors/GP’s negotiate certain terms mainly based on efforts of the GP

or risk taken by investor.

1. Step Down Method/Adjustment:

In this case the fund will charge lower fee over a period. If the fund manager
efforts are expected to be less in the later part of the fund’s life time.

Ex: if the fund is following fund of fund method the GP efforts are more in first
4 years to find the investment opportunities later the efforts can be less so they
can agree the fee rates like below

Year Fee rate terms Effective rate

1 to 4 Normal rate 2%
5th year 75% of previous year 1.5%
6th year 75% of previous year 1.125%
7th year 75% of previous year 0.84375%

2. Tier Based Fee:

Fee from investors will be different mainly based on the amount they invest

Investment by investor Fee rate

Up to 100 crores 2%
Above 100 to 500 crores 1.75%
Above 500 crores 1.5%

3. Side Letters

LPA terms applies to all investors in the fund. If fund want to give some exception
to one or set of investors, they can enter in to separate agreement/side letter with
them.

Ex: If Carlyle has only one fund in 2022, they have charged 2% fee to all investors
in 2023 they launched 2nd fund if an investor from fund 1 also invested in fund 2
and they can give 0.25% discount/lower rate in fund 1 also. For this reason, they
have issue side letter to those investors in fund 1 and charged lesser fee.

39 | P a g e
 4. Fee Free Investors

Some investors in the fund will not pay fee they should be excluded from fee
calculations.

Ex: Below categories of investors will not pay fee

a) General Partner Carried interested partner
b) Employees of the fund house (Goldman Sachs employees in gold
man funds)

Fund Name Blackstone India Fund LP

Fee base Commitment basis

2020 2025
Investor
Commitment Fee Fee
Name Fee rate Fee rate
Amount Amount
Trump 200 1.5% 3 1.13% 2.25
Amitabh 100 1.75% 1.75 1.31% 1.3125
Saina 50 2% 1 1.5% 0.75
Total 5.75 4.3125

Incentive fee Calculations, Carried interest/Carry waterfall provisions

Performance fee:

Q: Is this mandatory expense like management fee should investors pay this
incentive fee even if the fund makes losses?

Management fee is payable by investors even if the fund is making losses.

This is mainly paid towards day-to-day expenses of the fund house (some portion
can be profit).

This performance or incentive fee is only payable by investors if a fund is

making profits. This is paid as a share in profits like 20% of profits paid to fund
house. This is common in P/E funds and Hedge fund but not common in Mutual
Funds.

40 | P a g e
Q: Why is this performance fee paid?

This will motivate the fund house/fund manager to try and generate more
returns to investors. If they can see more earning capacity in that fund they can
deploy best minds (more experienced and qualified people) to manage that fund
use best technologies etc... Investors will be ok to share the profits if they see
more profits in that fund if they agree for these profits sharing.

Q: How is this incentive fee % is decided?

Like management fee based on negotiations between LP’s GP’s these % of

profit sharing/incentive fee is decided in most of the cases 20% of the profits in a
fund are paid to fund manager/GP/fund house for their efforts to generate more
returns to the fund/investors to get best returns in the fund and make fund manager
involved in the funds operations this industry also has another practice like GP
also invest in the fund along with other investors. Generally, around 1 to 10%
amount in the fund is invested by GP (on this amount GP is treated like other
investors GP also will get return on that investment).

Q: What are different methods/practices followed in P/E industry to share

the profits/to pay this incentive fee?

Provisions in LPA which are explaining these incentive fee provisions are
called as waterfall provisions in P/E funds cash flows distributions/cash flow
patterns are different from other funds (they collect money over a period of 4
years and then distribute to investors over a period of 4 years). These waterfall
provisions in LPA define the hierarchy of cash flow distribution like who will
get the cash first out of investors and fund manager/GP

There are two types of waterfall methods in the industry they are

• European waterfall method

• American waterfall method

41 | P a g e
American Waterfall Method:

In this case GP/fund house can take incentive fee based on deal-by-deal profit.

Deal means investment this means fund manager can take incentive fee on profits
made on one investment also they don’t need to wait for profits made at fund
level/whole fund.

Ex: KKR fund collect Rs 100 crores from investors invested 50 crores each in
flip kart Paytm. If they sold flip kart after a year for Rs 70 crores there is a profit
of Rs 20 crores so the fund manager/GP can take incentive fee on that profit.

European Waterfall Method:

This is commonly accepted method; this is favourable to investors

(American method favourable to GP). In this method GP/fund house can take
profits share. Incentive fee only on profits at FUND LEVEL/Whole fund basis.
This means after considering the investments in to all if there is a profit them GP
can take incentive fee.

Ex: If fund invested 50 crores each in Flipkart and Paytm if they sold Flipkart for
70 crores, they can’t take incentive fee since they are yet to get 100 crores
investment made in to all investments, they can take incentive fee only.

1. If flipkart itself is sold for more than 100 crores they are able to recover all
investments related money of Rs 100 crores.
2. Only after selling other investments if the total sale proceeds of flip kart
plus Paytm is above 100 crores then the GP can take incentive fee.

So, investor has advantage in this fund they can only pay incentive fee once they
got all their invested money/principal back

42 | P a g e
While negotiating these methods or cash flow hierarchy distribution GPs
and LPs consider many points like

1. Investor will feel safe if they got their principal amount/invested money
back so they ask priority for that principal repayment. So, these waterfall
methods also will keep this provision like all money in the fund/distributed
money in the fund will be considered as principal to investors till that is
paid to investors.

Ex: By selling flip kart for Rs 70 crores profit all those 70 crores is considered as
principal repayment to investors for this waterfall provision reasons

2. Investors will compare the return they got in a fund with return they can
get in alternative investments like investing in fixed deposit/government
bond/shares etc. so they will negotiate with GP that the incentive can be
paid only if the profits are over and above certain % like 8% per year.

So, these waterfall provisions will keep the second level like the fund should pay
8% per year/some % per year to investors if there is excess cash then it can be
shared.

Ex: if investor invested Rs 100 crores in a fund paid back Rs 107 crores in a year
then no incentive fee. If fund pays Rs 120 crores investor will be considered as
principal 8 crores as minimum return/preferred return and balance 12 crores will
be shared between GP and LP.

3. Any excess cash in the fund after distributing the money for principal
preferred return can be shared between GP and LP in agreed ratio like 20%
to GP and 80% to LPs

Note: In some funds GP will negotiate catch up as 3rd stage of waterfall where
some portion of cash after principal and prefer return is paid to GP and then the
profits sharing can be done.

43 | P a g e
 Assuming the fund is following the European method the cash flow
distribution is as follows:

Fund Name : Motilal Oswal India business excellence fund IV

Fund size : 4000 Crores
Investors : Amitabh, Saina, Sindhu, Deepika, Kohli.
Investments : Parag Milk, MRS Bector foods, Cycle Agarbathi

Assuming the fund is launched on 01-01-2020 collected all money on same day
sold all the investments for 6020 crores after paying liabilities like management
fee etc. they have 6000 crores the distribution is as below

Assume the hurdle rate is 10%. So, preferred return payable is 400 crores as 31-
12-2022 (the date of distribution)

Cash
Details Amount Paid Balance Comments
available
Principal 4000 6000 4000 2000 -
Preferred Return 400 2000 400 1600 -
Catch-up – 20% of 20% on 400 Crores -
80 1600 80 1520
Preferred return Preferred Return
Profit Share GP - 20% 1520 304 20% on 1520 crores
Profit Share LP – 80% 1216 80% on 1520 crores
Total 6000

Key Terms-Waterfall

Waterfall Provisions:

These terms in LPA defines the cash flow distribution hierarchy in a P/E fund
based on negotiations between the GP and LPs (investors) these terms are
finalized and included in LPA most commonly followed hierarchy of these cash
flow distributions is

• Pay 100% principal to investors

• Pay preferred return like 8% per year on that principal to investors
• Take 20% or 25% of preferred return as catch up by GP
• Share the remaining cash in 20:80 ratio between GP and LPs

44 | P a g e
Hurdle Rate:

This is the rate at which a fund should generate profits. So, the GP will get
eligibility for the carry

Ex: If hurdle rate agreed is 10% that fund should generate 10% return per year if
not GP will not get the carry/incentive fee this is NOT GUARANTEED
RETURN/PROMISED return to investors this rate is only ELIGIBILITY
CRITERIA to be fulfilled by the GP/fund house to get that carried interest Most
common rate in international funds is 8% per annum (year) in Indian funds most
of the funds follow 10%.

Q: What is Soft-hurdle rate and Hard-hurdle rate?

Hard-Hurdle
Particulars Soft-Hurdle rate Comments
rate
Principal 100 100
Sale Proceeds/NAV 109 109
Preferred Return Payable 8 8 at 8%
Carry to GP is 9*20%=1.8 crore 1*20%=0.2 crore

• In soft hurdle rate once the return is above the hurdle rate all profits can be
shared between GP and LP so this is more beneficial to GP.
• In hard hurdle rate profits, which are over and above the preferred return is
only considered for distribution to GP.

In the above example Rs 100 crores principal and Rs 8 crores preferred return
goes to investors. Balance amount of Rs 1 crore is shared between GP and LP so
GP will get 0.2cr (1cr*20%). This is in favour of investors; this is most commonly
used in the industry.

Preferred Return:

Preferred Return = Principal Outstanding * Hurdle Rate

This is the amount calculated using the hurdle rate. If a fund used investors’
money for more time like 5 years/7 years etc. there will be more preferred return
payable so the chances of receiving carry will become less.

45 | P a g e
 Ex: If an investor paid/contributed Rs 100 crores to the fund preferred
return payable will be as below

Principal Total Hurdle Preferred Closing

Year
Outstanding Outstanding Rate Return Balance
2020 100 100 10% 10 110
2021 100 110 10% 11 121
2022 100 121 10% 12.1 133.1
2023 100 133.1 10% 13.31 146.41
So, if the fund can give some principal or all amount back to investors soon
preferred return payable will be less.

Q: Calculate preferred return based on below example?

Fund Name : Motilal Oswal India Business Excellence Fund IV LP

Fund Size : Rs 4500 crores
Investors : Saina Sindhu Sharukh Amitabh
Investments : Dixon Technologies AU Small Finance Bank Cycle Agarbathi
Hurdle Rate : 10%
Vintage Year: 2022

Contribution Op. Total Hurdle Pref. Cl.

Date Investments
/Distribution Bal O/s Rate Return Bal
Dixon
01-01-2023 500 0 500 10% 50 550
Technologies
AU Small
01-01-2024 1500 550 2050 10% 205 2255
Finance Bank
01-01-2025 Cycle Agarbathi 2500 2255 4755 10% 475.5 5230.5
4500 730.5

Q: If the fund sold all investments and has sent cash of Rs 6230.5 crores what
is the carry payable to GP assuming profit share is 20% of remaining cash
after principal and preferred return?

There is excess of Rs 1000 crores (6230.5-5230.5 towards principal and

preferred return). GP can take 20% of it as carry (Assuming no catch-up
provision).

46 | P a g e
 Example:

Fund Name : Kotak Pre IPO Fund

Fund Size : 1500 crores
Investors : Ramdev Agarwal Damani Apple Singapore Pension Fund
Investments : Cred Policy Bazar First Cry
Vintage Year : 2021
Hurdle Rate : 10%
Catch up : 20% on preferred return

Date Investment Name Investment Amount

01-01-2021 Cred 300
01-01-2022 Management fee Policy Bazar 600
01-01-2023 First cry Fee/other expenses 600

Contribution Op. Total H. Pref. Cl.

Date Investments
/Distribution Bal O/s Rate Return Bal.
01-01-2021 Cred 300 0 300 10% 30 330
01-01-2022 Management fee 600 330 930 10% 93 1023
Policy Bazar
01-01-2023 First-cry Fee/other 600 1023 1623 10% 162.3 1785.3
expenses
Total 1500 285.3
Assuming fund sold an investment (Partial sale) in 2024 calculation will be
01-01-2024 Distribution-partial -400 1785.3 1385.3 10% 138.53 1523.83
sale – policy bazar
1100 423.83

Assuming remaining investments are sold for Rs 5000 crores how this
waterfall distribution will be made in this fund
Details Eligibility Cash Available Paid Balance
Principal -O/s 1100 5000 1100 3900
Preferred return 423.83 3900 423.83 3476.17
84.77
Catch up 3476.17 84.77 3391.40
(423.83*20%)

Profit share – GP 678.28 (3391.4*20%)

LP Profit share 2713.12 (3391.4*80%)
Carried Interest 763.05 (678.28+84.77)

47 | P a g e
Catchup:

This is a provision in waterfall provisions that allow the fund manager/GP

to take a portion of remaining cash after paying principal and preferred return to
investors.

Ex: If a fund has principal (100 crores), Preferred return (8 crores), Outstanding
as Rs 108 crores the fund will have 1 crore balance if the total sale proceeds/cash
available in the fund before distribution is Rs 109 crores.

If the GP takes 20% of that remaining 1 crore, he will get 0.2 crore (20 lacks) as
his share if the efforts of that GP is more to generate that 9-crore profit in catch
up they can agree for 20% or 25% of preferred return as their share (GP/Fund
House share) so they are also happy like investors (investors got preferred return
and GP got Catchup) so they can share the remaining cash in the last stage of
waterfall like 20:80 ratio. This Catchup is calculated of Preferred return
(Preferred return paid to investors is their money that amount is not collected
from investors. This Catchup is paid from any excess money after preferred return
payment).

If preferred return paid is Rs 100 crores catch up will become 20 crores if

preferred return is 8 crores Catchup is 1.6 crores (8*20%). So, in the above case
catch up eligibility is 1.6 crores remaining cash after prefer return payment is only
1crore (109-100-8=1 crore) so all that 1 crore is paid to GP if no catchup GP will
get 0.2 crore if Catchup is there the GP share is 1 crore.

Claw Back:

This Provision gives a right to the LPs to pull back excess carried interest
already paid to the GP in a fund.

Ex: A fund is following American waterfall method which means the GP can take
carried interest if the profits are made on one investment also when it is sold.
Fund has two investments they sold OYO rooms for 1000 crore made 600 crore
profits so GP took carried interest (Assume 100 crore). Next investment they sold
after 3 years (Cred) and made loss of 600 crore. So total profit in the fund is Zero
in this case the carried interest/carry already paid to GP 100 crores can be pulled
back or clawback by LP’s.

48 | P a g e
 Q: Catch up 20% or 25% what is better and why it is either 20% or 25%
only?

Investors Investment : 100 crores

Net sale proceeds : 200 crores (Sold for 250 crores liabilities like
payables settled for 50 crores)
Net profit : 100 crores

Method -1 Method-2 Method-3 Method-4

Bal. Bal. Bal. Bal.
Principal 100 100 100 100 100 100 100 100
Pref. return 8 92 8 92 8 92
Catch-up
1.6 90.4
20%
Catch-up
2 90
25%
GP share 20 18.4 18.08 18
LP share 80 73.6 72.32 72
Carried 19.68 20
20 18.4
(18.08+1.6) (18+2)
Profit 100 100 100 100
% Of Profit 20% 18.4% 19.68% 20%

Note: If catch up is 25% on preferred return GP can have 20% share in overall
profits as mentioned in method 4 most common method is 3rd method in that case
GP share approx. 19.6% of overall profits.

Q: Which terms are favourable to GP/LP?

Types GP LP
Carried Interest Yes -
Hurdle Rate - Yes
Soft Hurdle rate Yes -
Hard Hurdle rate - Yes
Catch up - 25% Yes -
Catch up - 20% - Yes
Claw back - Yes

49 | P a g e
Investments made by P/E funds or Investment strategies of P/E funds

Q: Is there any restrictions on P/E funds?

No any legal business in that country can be owned/funded by them. In

India their investments include…
• Investments in to Real Estate like Shopping Malls/Apartments etc.
• Infrastructure like Roads/Airports/Seaports
• Sports franchises like IPL teams
• Education like BYJU’s
• Games like MPL
• Fintech Companies like Paytm etc.

Since investors in these funds are accredited investors this investment strategy
decides where the fund will invest or how that fund will try to manage the
investments and give returns to investors.

Ex: If Sequoia capital is launching a fund today and informed the investors that
is Venture Capital fund, they will invest the money in that fund in to start-up
companies which means risk is high in the fund investors can expect more returns
also.

Q: What are the popular investment strategies followed by these P/E funds?

To give more returns to investors than traditional mutual funds these funds
take more risk and find new assets/categories like invest in start-up company
shares etc.
Based on the popular investments they made those strategies are as below (more
popular strategies)

1. Venture Capital
2. Fund of funds (FoF)
3. Real Estate
4. Infrastructure
5. Credit
6. Distressed/Special situations funds
7. Pre-IPO
8. Mezzanine
9. Leveraged buyout (LBO)

50 | P a g e
Fund of Funds:

In this case one fund will invest in to other fund/funds rather than directly
investing in to company/asset

Ex: If Navi Company launches an international fund of fund in India they will
invest in to a fund launched by JP Morgan or Goldman Sachs in America. (One
or more funds they can invest)

This is popular strategy in MF/PE/HFs due to below reasons:

1 More diversification- each main fund will invest in to one or more underlying
funds these underlying funds will invest in to more stocks/assets so number of
investments that a fund invested is more so risk is diversified (one or two
portfolio companies are failed no major risk to investors)
2 Use the expertise of different asset managers-if Goldman Sachs launches a
fund they can invest in to black stone funds for real estate KKR funds for
buyout etc. since these companies are specialised in the investments in to these
categories it is good to use their expertise

Main fund Underlying Fund Portfolio Companies

NAVI NASDAQ fund JP Morgan Blue-chip
Apple Microsoft Facebook
etc. fund

Venture Capital Strategy:

In this strategy these venture capital or private equity funds invest in to

start-up companies.

Start-up means a company having an innovative business idea and it is newly

started.

Since the business model is not tested earlier it is difficult to predict the success
or failure of the business. so, this strategy is risky and investors who aim for huge
returns and ready to take that extra risk can invest in these funds related to funding
of start-ups the common hierarchy of funding is as below;

51 | P a g e
 Amount
Year Word Meaning Example
(Approx.)
Boot Personal money like Zerodha is Boot Strapped
1st year 10 lacks
Strapping savings start-up (Kamath Owner)
Rattan Tata Rakesh
Below Angel Individuals like
50 lacks Jhunjhunwala Bollywood
2 years investors Rattan Tata
celebrities etc.
Below Venture Mostly pooled money 1 to 20
Sequoia Accell partners
5 years Capital from investors crores
5 to 10 Private Pooled money from
100+crores Softbank Blackstone etc.
years Equity investors
Above
Public
10 100+crores Softbank Blackstone etc.
issue/IPO
years

Real Estate Strategy:

In this strategy these funds invest in to assets like shopping malls office
parks hotels resorts apartments etc. they get rental income and appreciation in the
property if they want consistent income and less risk investment can be made in
completed and rental yielding assets like office parks where companies starting
their office in India like Goldman Sachs/amazon/state street etc. can pay the rent
to them consistent increase in the rent can generate revenue for them.

If these funds are OK to take more risks but aiming for more return like 20% +
they can tie up with builders like DLF/Nitesh estates/Purvankara/Prestige etc. and
complete the projects like Villas/apartments etc. which can give more return.

Black stone is known for more real estate investments across the globe they own
Nexus malls chain India and they were major stake holders in Hilton hotels earlier
to run these funds these fund managers take help of different professional or
professional firms like asset managers property managers etc. and they pay
professional fee to them for taking their services.

• Asset managers help these real estate funds to get the tenants negotiate
rental terms and conditions etc.
• Property managers help to maintain each property like shopping mall like
gardening maintaining facilities like lifts etc.

52 | P a g e
All these fees paid to them are accounted as expenses in the books of this real
estate fund.

One of the practices followed by these asset managers to get the tenants to new
properties like office park/shopping mall is to give also rent-free period like 6
months or 12 months and agree for rental contract for 10 years so business-like
shops need not worry about rent expense and low income in initial time.

These kind of rental terms and conditions and type of revenues in these funds also
attract different accounting treatments based on local GAAP like US GAAP or
fund accounting GAAP (certain common practices are accepted due to nature of
that business).

Ex: If the fund entered in to rental agreement with Bigbazzar for 10 years first 6
months’ rent need not be paid by Bigbazzar then the fund will report rental
income for all the time of 10 years including 6 months’ rent-free period by straight
lining the rent.

Rent per month 100000

Contract term 10 years/120 months
Rent free period Jan to Jun 2022 6months
Effective rent 114 months* 1 lac = 114 lacs

The fund will recognise that 114 lacs in 120 months. So, 95000 per month

Entries in fund books from Jan to June 2022 are;

Rent free adjustment (Asset) Dr 95000

To Rental income 95000

In 6 months, asset is created for 570000 (95000*6)

July onwards it will be reversed so that asset will become zero by end of contract
120th month if the fund receives Rs 100000 as rent in July entry will be

Bank a/c Dr 100000

To Rental Income 95000
To Rent free adjustment (Asset) 5000

53 | P a g e
Property Accounting:

Most of the real estate funds first prepare the financials are property level
like each hotel/shopping mall separate TB for that and then consolidates the
financials at fund level and send consolidated fund level financials to investors.
In these cases, each property is registered as a separate company/SPV (Special
purpose vehicle) and treated as independent entity these funds are called as real
estate funds or PERE (Private Equity Real Estate) funds.

Loan/Borrowing Facility Related Reporting:

These funds take loans to invest in the properties (generally) so these banks
will ask reports like projected rent revenues of the properties owned by the fund
for next 12 months/5 years etc.

These bankers as for financial statements in their format on a regular basis like
monthly/quarterly so they can assess the financial condition of the funds to repay
the loan and pay the interest in time they also expect these fund accountants to
prepare some documents/calculate the ratios like interest coverage ratio
(EBIT/Interest expense) debt equity ratio (Debt/equity (Capital + Reserves)) etc.
These funds also use to separate software’s than other funds like Yardi (Other
funds use software’s like Investran Geneva E-front etc.)

Property Accounting and Consolidation:

Generally, these funds register each real estate asset as separate legal entity
like a company and prepare the trial balance separately to prepare the fund level
financial statements they consolidate all these TBS of properties like 10 TBs if
that fund own 10 shopping malls. That consolidated financials need adjustments
like eliminate intercompany balances due from and due to balances between those
companies etc.

Q: What are REITs?

Real estate investment trust is an exit option to the P/E funds. if black stone
invested Rs 2000 crores in two office parks they may not be able to find the buyers
in market easily for that amount so they can use REITs and sell the shares/units
to retail investors/other investors. Process is

54 | P a g e
 1 Transfer the assets like shopping mall/office park (commercial real estate)
to a trust.
2 Issue units/shares to public by dividing that asset value in to small value
shares/units.

(Ex: convert Rs 2000 crores worth property in to 20 crore shares/units at Rs100

per unit. Any investor having Rs 10000 can buy 100 units in IPO.)

3 Same as IPO process list these units/shares in the exchange like NSE/BSE
4 Investors can buy/sell units in the exchange at ongoing price. If that
property market value is increased it will trade at premium like Rs 110 per
share/unit
5 Investors can sell to others in the exchange so they have liquidity
6 REIT will pay dividend to investors at regular intervals like quarterly from
rental income.

Note: These REITs are suitable for retail investors so they belong to mutual fund
category. Real estate funds belong to P/E category so wealthy people can only
invest.

Leverage Buy Out (LBO):

In this case the fund will acquire the company/asset with help of
leverage/borrowing. This is risky since the fund can make huge loss if the deal is
a failure the debt burden can spoil the reputation of the company on other side if
they make profit and return % can be very high to investors.

Particulars No Leverage With Leverage

Purchase – Trident Hotel 585 585
Capital/Investors Money 585 100
Borrowed Capital 0 485
Sale after 3 years 1000 1000
Profit 415 415
101.85
Less: Interest 0
(485*7%*3)
Net Profit 415 313.15
Investors Capital 585 100
Return 70.94% 313.15%

55 | P a g e
So, leverage buy can help to increase the returns if executed the deal as per the
calculations. If failed all the money of investors will be lost. So 100% loss to
investors there may be pending bank loans so reputation loss due to insolvency
proceedings etc.

Infrastructure Funds/Infrastructure Strategy:

Infrastructure funds invest in airports highways sea ports gas pipe lines
broadband cables etc. in this case these funds will get the revenue like toll charges
parking charges rents (if any structures allowed like in airports shopping malls)
etc. these funds will get a right to operate public assets like airports for some time
like 10 years they have to recover their investment and return from toll charges
parking fees from airlines like indigo etc. if they predict the traffic in that road
correctly and bid for the right price fund will make profits.

InvIT: This is one of the exit routes for P/E fund or any other investor invested
in infra-assets like telecom towers/roads airports etc. (this is not an investment
strategy. strategy is infrastructure).

Ex: If KKR invested in highways Rs 10000crores not easy for them to sell those
assets when they need money. Same way if Reliance Company 95% invested
more money in broad band cables/telecom towers difficult for them to find that
much capital. So, they can sell these assets to public by converting those assets
in to securities Rs 10000 crores worth of asset can be converted in to 100 crores
InvIT Units at Rs 100 per unit. Any investor can buy these units at IPO stage or
in stock exchange income from toll fee etc. is paid as dividend to investors. if
they need money they can sell to other investors since they are listed in
exchanges.

Mezzanine funds: These funds invest in to securities that are having debt and
equity features. They can invest in to convertible securities warrants etc. so they
can get fixed interest and also equity appreciation when the securities are
converted

Credit funds: They invest in bonds/debentures ate rather than shares so less risk
compared to other funds

56 | P a g e
Valuation of investments and disclosures related to valuations:

All these funds like mutual funds/P/e funds or hedge funds will report the
investments at fair market value (that day /balance sheet day's market value). So,
they have to find out market value to prepare the financial statements (whenever
they prepare like daily/monthly/quarterly etc.) for some assets it is easy to know
the market value since there is active market like stock exchange

Ex: If a mutual fund/other fund invested in Tata motors stock it is easy to know
that day value since these stocks are traded in BSE/NSE. if the fund purchased
shares at Rs 100 and today’s market value is Rs150 they can report 50% gain in
the books knowing the market value of some investments is difficult since that
asset/company shares has no active market or they do not have similar
companies/assets in the market to compare and know whether market value is
increased or decreased.

Ex: If KK fund invested in CRED company shares or MPL shares it is difficult

to value that shares since similar company shares price is also not known
investors in the fund would like to know the value of all assets and profit on that
investment, they would also like to know how the assets are valued so they can
understand if the profit/loss reported may change in the future or it is more
accurate. so, to disclose these valuation sources to investors and make them
understand the risk in the fund they Use FAIRVALUE HEIRARCHY
disclosures as below

Level 1: If an asset is valued using active market value

Ex: KKR VC fund invested in Paytm shares that company shares are available in
stock exchange market value of that investment is reported as 1000 crore since
the company has 2 crore shares and each share is considered at Rs500 based on
that day market value.

Level 2: If an asset owned by the fund has no active market like stock exchange
however similar asset/shares are traded in the market recently

Ex: A fund invested in forward currency contract to buy 1 crore dollars at Rs 75

per dollar. They want to know if that contract is giving profit or loss today. They
can check with a bank like Citi bank on today rates for USD to INR conversion.
If they say it is Rs 70 today then the fund can report rs5 profit 100 since they
agreed to sell at Rs 75 and today it is only Rs 70.
57 | P a g e
Ex: If a fund invested in shopping mall, they can use the value of similar mall
purchased/sold in that month as reference.

Level 3: If the fund invested in a start-up company like Cred/Yulu bikes etc they
may not know today market value. They have to calculate the market value using
discounted cash flow method/other method that will be considered as level 3.

If the trips of these bikes are increased in the recent years and revenue is gone up,
they can value the asset at better price like 10% appreciation in the value and
repot that as gain (earlier the value is 100 crores now it is 110 crore)

If a fund reported more investments in level 3 risk is more so they have to give
more additional details to investors like the source for these calculations (if they
used discounted rate of 10% how they decided/factors influencing that etc.).

DCF Method (Discounted Cash flow Method)

As on 1.1.2022

Invested 100000
Sold on 12.31.2022 120000
Profit 20000
Return 20%

If my expectation is 20% return when I know a share/asset will give me 1.2 lacs
in 12 months I am ready to pay 1 lack today. If an asset will give me 144000 after
24 months/2 years I am ready to invest Rs 100000 today since that is giving 20%

Opening Balance 20% Closing balance

100000 20000 120000
120000 24000 144000

There are many methods to value the investments most commonly used method
is DCF.in this case they project the Values/income of that asset for the future
convert them in to present value that is the value of that business.

Ex: If my expected return is 10% if an asset will give be Rs 110 after 1 year I am
ready to invest Rs 100 today.

58 | P a g e
Portfolio of Investments – Example Case for Fair Value Hierarchy

Company Security Source Level

Flipkart Common stock/equity share Calculated Level-3
Amazon Common stock/equity share Stock exchange Level-1
Forward Currency Reference from
Derivative/Forward contract Level-2
Contract banks

Financial Reporting of P/E Funds

Post the entries for the below fund and prepare the financial statements

Fund Name : Carlyle Buyout Fund

Vintage Year : 2021
Commitment/Fund Size : 160000Crs
Investments : HDFC Bank, SBI Cards, PNB, IIFL
Frequency of Fin Reporting : Quarterly
Investors : Singapore Pension Fund Govt. of Norway Fund
Canadian Pension Plan EPF.

Journal entries from Jan to March 2021

1. Post all bank statement entries

There may not be any bank payments or receipts in the first year/Quarter so no
entry.

2. Post all adjustments entries since books are prepared using accrual
basis

Q.(A): Any entry for launch of fund and taking commitments from
investors??

No since only commitments are received no cash flow.

59 | P a g e
Q.(B): By quarter end all expenses or income of the fund need to be
accrued??

Management fee to be accrued from Jan to March.

Commitments : 160000
Fee rate : 2%
Commitments - Non fee payments : 10000
Fee can be charged on : 150000
Per year fee : 3000
No of days : 90
Fee for Jan to March : 739.73 (3000*90/365)

Journal Entry:

Management fee a/c Dr 739.73

To management fee payable 739.73

Entry-all other expenses accrue:

Custodian fee A/c Dr 7

Audit fee A/c Dr 7
Tax consultant fee A/c Dr 8
Fund administrator fee A/c Dr 15
RTA fee A/c Dr 1
To custodian fee payable 7
To audit fee payable 7
To Tax consultant fee payable 8
To Fund admin fee payable 15
To RTA fee payable 1
(Being fee payable for Q1 2021 accrued)

60 | P a g e
Syndicate Expenses Invoice is Received from Fund House:

If the fund house like Carlyle paid common expenses on behalf of all funds
like travel expenses related to investments registration of the funds legal fee paid
for opinion on investments etc., they record those expenses as syndicate (pool of
expenses) and they raise the invoice to each fund based on allocation.

Ex: If fund paid 20cr for investments in Byjus company (like travel
expenses/lawyer fee etc.) they will allocate 5cr to calycle buyout fund if that fund
invested 250cr and all funds together invested 1000cr (this fund share is 25%).

Entry - for syndicate expenses (example taken is legal fee)

Legal fee a/c Dr 5

To Due to Affiliates 5
(Being amount payable to fund houses recorded as liability)

61 | P a g e
Statement of operations (SOO) for the period Jan to March 2021

Details Amount
Interest income 0
Dividend income 0
Other income (interest on late payments etc.) 0
Management fee -739.73
Professional fee-other -38
Legal fee -5
Realised gain/loss on investments 0
Unrealised gain/loss on investments 0
Realised gain/loss on forex transactions 0
Unrealized gain/loss on forex transactions 0
Net profit/ (Loss) -782.73

Statements of assets and liabilities (SOA) as of 31-3-2021

Assets Amount
Investments 0
Due from affiliates 0
Cash and cash equivalents 0
Receivable 0
Capital contribution receivable 0
Total assets 0

Liabilities Amount
Bank loans 0
Management fee payable 739.73
Other accrued expenses 38
Due to affiliates 5
Total Liabilities 782.73
Capital 0
Reserves and surplus (accumulated profits) -782.73
Liabilities and capital 0

Alternative presentation
Assets 0
Liabilities -782.73
Net assets -782.73

62 | P a g e
(Note: if fund is liquidated today investors need to pay money to the fund
782.73cr fund can pay that money to creditors like fund manager auditor fund
admin etc.).

Q: Can NAV of a fund can be negative?

• In P/E Funds that can happen when contributions are not yet received.
• In Mutual funds or Hedge funds they collect money at the time of launch
and then invest money. So negative NAV is not possible.

Journal entries for April to June 2021

Assuming the fund finalised an investment opportunity (HDFC Bank) they

have decided to call 5000cr in April 2021 they have included any pending
receivables from investors (payable to the fund) and called all that together.

Capital call to be made for Amount

Investment -HDFC Bank 5000.00
Management fee-Q1 739.73
Other accrued expenses 38.00
Due to affiliated 5.00
Total money called from investor 5782.73

Capital Contributions Receivable A/c Dr 5782.73

To Capital A/c 5782.73
(Being capital called from investors)

If all investors pay that money by 15th April (amount called on 1st April)

Bank A/c Dr 5782.73

To Capital Contributions Receivable A/c 5782.73
(Being cash received from investors against the call made)

Investment made in HDFC shares

Investment in Shares Dr 5000
To Bank 5000
(Being Investments Made)

63 | P a g e
All other expenses related entries will be like management fee custodian fee
etc.…

Management Fee Payable A/c Dr 739.73

Custodian Fee Payable A/c Dr 7
Audit Fee Payable A/c Dr 7
Tax Consultant Fee Payable A/c Dr 8
Fund Admin Fee Payable A/c Dr 15
RTA Fee Payable A/c Dr 1
Due To Affiliates A/c Dr 5
To Bank A/c 782.73
(All accrued expenses in the fund are now paid)

HDFC Bank announced dividend this funds portion is 50cr

Dividend Receivable A/c Dr 50

To Dividend Income A/c 50
(Being dividend declared by a company is accrued on ex-date)

By the end of the quarter investment value is increased by 200cr

Investment in Shares A/c Dr 200

To Unrealised Gain/Loss on Investments A/c 200
(Being investment value increased in the market)

Fund invested Rs 50000cr in to PNB Housing finance in June 2023

Capital Contributions Receivable A/c Dr 50000

To Capital A/c 50000
(Capital Call Made)

Bank A/c Dr 50000

To Capital Contributions Receivable A/c 50000
(Money Received from Investors)

Investment in shares A/c Dr 50000

To Bank A/c 50000
(Investment made by the fund)

64 | P a g e
Assuming the market value is decreased by 100cr by end of June

Unrealised Gain/Loss on Investments A/c Dr 100

To Investment in Shares A/c 100
(Investment Value Is Decreased)

All other expenses related entries will be common in each month/quarter like
management fee custodian fee etc.…

Management Fee A/c Dr 739.73

To Management Fee Payable A/c 739.73

Custodian Fee A/c Dr 7

Audit Fee Expenses A/c Dr 7
Tax Consultant Fee A/c Dr 8
Fund Administrator Fee A/c Dr 15
RTA Fee A/c Dr 1
To Custodian Fee Payable A/c 7
To Audit Fee Payable A/c 7
To Tax Consultant Fee Payable A/c 8
To Fund Admin Fee Payable A/c 15
To RTA Fee Payable A/c 1
(Being Fee Payable for Q2 2021 Accrued)

Management Fee Payable A/c Dr 739.73

Custodian Fee Payable A/c Dr 7
Audit Fee Payable A/c Dr 7
Tax Consultant Fee Payable A/c Dr 8
Fund Admin Fee Payable A/c Dr 15
RTA Fee Payable A/c Dr 1
Due To Affiliates A/c Dr 5
To Bank A/c 782.73
(All accrued expenses in the fund are now paid)

65 | P a g e
Statement of operations (SOO) for the period April to July 2021
Details Amount
Interest Income 0.00
Dividend Income 50.00
Other Income (Interest on Late Payments etc.) 0.00
Management Fee -1479.46
Professional Fee-Other -76.00
Legal Fee -5.00
Realised Gain/Loss on Investments 0.00
Unrealised Gain/Loss on Investments 100.00
Realised Gain/Loss on Forex Transactions 0.00
Unrealised Gain/Loss on Forex Transactions 0.00
Net profit/ (Loss) -1410.46

Statements of assets and liabilities (SOA) as of 31-7-2021

Assets Amount
Investments 55100.00
Due from affiliates 0.00
Cash and cash equivalents 0.00
Receivable 50.00
Capital contribution receivable 0.00
Total assets 55150.00

Liabilities Amount
Bank loans 0.00
Management fee payable 739.73 (Q1 paid and Q2 pending)
Other accrued expenses 38.00
Due to affiliates 0.00
Total Liabilities 777.73
Capital 55782.78
Reserves and surplus (accumulated profits) -1410.46
Liabilities and capital 55150.05

Alternative presentation

Assets 55150.00
Liabilities 777.73
Net assets 55927.73
Capital and reserves 54372.27

66 | P a g e
General ledger: Unrealised Gain/Loss on Investment

Particulars Amount Particulars Amount

To Investment in shares 100 By Investments 200
To P&L a/c 100
Total 200 Total 200

Other journal entries in fund books:

If the fund sold an investment and distribute money to investors

Investments is sold:

HDFC Investment 5000

Unrealised gain reported already 200
Market value /Fair value reported in book 5200
Sold for 7000

Entry:

Bank Dr 7000
To Realised gain/loss on investments 1800
To Investment in shares 5200
(Being investments sold for 7000cr recorded)

Alternative entry for the same transaction:

1. First, we can reverse any unrealised gain or loss

Unrealised gain /loss on investment Dr 200

To investment in shares 200
(Being unrealised gain related to sold asset reversed now)

2. Due to this entry, asset is now reported at cost of 5000cr, and if this is sold
for Rs 7000cr, gain is Rs 2000cr, then the entry is

Bank Dr 7000
To Investment in shares 5000
To Realised gain/loss on investments 2000
(Investment sold is recorded, realised gain is accounted)
67 | P a g e
3. If that money is distributed to investors

Capital Dr 7000
To Distribution payable 7000
(Being the distribution made to investors)

4. On accrual basis, if there is carry payable in the fund (NAV is greater

than principal and preferred return)

Carried expenses Dr 2174.45

To carried interest payable 2174.45
(Based on LPA terms, carry payable as of today is accrued)

5. May be after 7 years, all principal and preferred return is paid to

investors, there is excess cash and carried interest is now paid to GP,
500cr

Carried interest payable Dr 500

To Bank 500

TDS / WHT related entries: Tax Deducted at Source (TDS)/Withholding Tax

(WHT) means while making payments by a company/fund etc. to any
professional services provider like auditor / fund house etc. the fund should
deduct income tax at certain rate like 10% and pay to government.

Ex: If fund is paying 10 lacs as audit fee to KPMG and 1 lac to government.
KPMG Company will adjust this amount while enjoying their income tax to
government.

Entry in the fund books is:

Audit fee Dr 10 lacs
To TDS/WHT payable 1 lacs
To Bank 9 lacs
(Being audit fee expenses and TDS payable is accounted)

After some like and of the month, this fund will pay that amount to government.
So, the entry is;
TDS/WHT payable Dr 1 lacs
To Bank 1 lacs
(TDS deducted on audit fee is now remitted to govt.)
68 | P a g e
Master feeder entries:

Q: When fund called money from feeder along with other investors, any
separate entry in master books??
No. separate entry;
Capital contributions receivables Dr XXX
To capital o/s the entry XXX
When master asks money, feeder also asks/call money feeder's investors (if Dhoni
invested inn feeder registered IIN Cayman, that feeder fund will send cap call to
Dhoni) 1. Master fund in America

Q: Carlyle Buyout fund paid legal fee of 10cr on behalf of Carlyle vs fund.
What is the entry in both the funds?

In VC Funds:

Legal expenses a/c Dr 10

To due to affiliates 10
(Being legal fee accrued and payable recognised)

In Buyout Fund:

Due from affiliate Dr 10

To Bank 10
(Being legal fee paid on behalf of another fund recognised as receivable)

If a fund has any foreign currency transactions or assets, gain/loss due to change
in forex rates can happen if an Indian fund invested 80cr in US Company in June
2022, when conversion rate is Rs 80 per USD, then conversion will be as below:
Indian Rupee (INR) 80cr
Exchange Rate 80
US dollar purchased at 1USD=800INR

Invested in US Company Tesla is 1cr USD as of 30th September, when books are
prepared, these rates are:

Market value of investment 1cr USD (no change)

Forex changes 82 per USD
Value of asset in INR 82cr

69 | P a g e
This gain of 2cr came due to change in forex rate, asset price in America is not
changed so this is not unrealised gain, and it is forex gain

Investment in shares Dr 2
To unrealised gain-on assets due to forex changes 2

Common Points -Financial Statements Preparation

Q: What is the frequency to prepare these financial statements?

IN PRIVATE EQUITY FUNDS:

Monthly /Quarterly-Unaudited financials (disclosures will be less in these

unaudited financials) year end -audited financials, audit firms like KPMG will
review these financials and provide audit report. Disclosures are more in yearend
financials half yearly financials or/and year end audited financials.

IN HEDGE FUNDS:

Mostly prepared monthly, these are unaudited financials and year end
financials which are audited these are decided at the launch time and included in
LPA in Hedge funds and private equity. In MUTUAL FUNDS it is regulatory
requirement to calculate NAV daily.

Q: What are the sections in the financial statements that are sent to
investors?

• Statement of assets and liabilities (SOA) - Balance sheet

• Statement of Operations (SOO) - Profit and loss a/c
• Schedule of investments (SOI) - Details of investments made by the funds
• Statement of changes in partners’ capital (SOC) – Details of Partners Capital
Opening Balance, Net Profit/Loss Allocated, Closing Balance (NAV) etc.
• Cash flow statements - showing the source of cash to that fund, application of
cash/cash outflow details.
• Notes to accounts /foot notes -details about all risks in the fund, more
information about numbers in SOA/SOO etc... Fair value hierarchy (level 1,
level 2, and level 3), financial high lights (FHL's) etc. are important.

70 | P a g e
Along with these funds also send below details /documents;

1. Partners’ Capital Statements(P-CAP), this will have individual partner

details, sent to only that investor like that investor opening balances,
allocated profit/loss to that party, closing balance /NAV of that investor,
return/profit of that investor from the inception/start of the fund etc.
2. Market lookout/management summary -explaining how that fund is
performing, expected returns/challenges in the coming period etc.
3. Audit report if that is year-end financials.

Q: What is GAAP (Generally Accepted Accounting Principles) these funds

follow?

Depends on where the funds are registered, they follow local GAAP like us
based funds follow US GAAP, Europe based funds follow IFRS or local GAAP
like UK GAAP/Luxembourg (Lux) GAAP etc.
• If the master is registered in US, that funds follow US GAAP
• If master is in Luxembourg, those financials are prepared using Lux GAAP
etc.

71 | P a g e
Q: What is NAV life cycle or steps followed to prepare the financial
statements?

Like any other company financial statements preparations, these funds also
follow the below steps (few additional steps will be there due to outsourcing of
work to funds admins etc.)

1. Post all bank related entries like capital received from investors, investments
by the fund, expenses paid, and incomes received etc. each fund like master
and feeder will have separate bank accounts.
2. Post all adjustment entries like increase or decrease in investment value,
expenses payable/accruals like management fee payable audit fee payable etc.
Incomes earned but not received like dividend receivable any related parties
payable/receivables etc.
3. Once all entries are posted, general ledger will be ready, after
reviewing/checking those GLs for accuracy, they can be closed (GL close all
numbers will reflect in trail balance).
4. This TB and supporting calculations like management fee calculations,
incentive fee calculations etc. Will be included in the monthly pack /quarterly
pack and sent to fund house for review (if state street prepared Blackstone
fund financials, black stone will review and then send to investors as they have
to send to investors)
5. Once the TB is approved, fund administrators will prepare the financial
statements like SOA/SOO/SOI etc. Before that they prepare allocation, file
which will allocate the fund level income and expenses to each investor. So,
they can finalise NAV of each investor of those.

72 | P a g e
Q: Do they prepare one set of financials for master and feeder investors like
consolidated or separated sets?

Depends on the structure it is decided commonly, separate set for master and
feeder. Feeder investors will receive feeder financials plus master financials since
only feeder books will not give full details like where the money is invested like
company name, country name etc. In feeder books, investments in master are
shown in one line item in balance sheet in case of real estate funds where each
property like parks/shopping malls is separately registered, they do consolidation
at fund level and that consolidated financials are sent to investors

Fund name Warburg India fund LP

Commitments 16000cr
Investors Provident Fund of India, Singapore Pension Fund
Vintage year 2022
Reporting cycle each quarter end (31st Mar, 30th Jun, 30th Sept, 31st Dec)

Post the journal entries for Jan to march 2022 and prepare financials statements.

73 | P a g e
Few terms related to financial reporting

Escrow account: This is the cash in restricted account for the fund.

Ex: If the fund sold an investment for 1000cr, buy might pay 950cr immediately
and deposit 50cr in separate bank account fund can be using that money only after
fulfilling some CONDITIONS after a period like 6 months, governments also
keep like this to release money to road contractor etc., after 3 months by
ensuring there is no damage to the roads completed by that contractor.

Management offset: At times, the direction of GP, funds may offset/reducing the
management fee in a fund.

Ex: Fund life time is 10 years but extended 2 more years since the investments
are not sold, so GP may not charge fee for these 2 years or the fund got some
additional income like placement fee (fee paid by another fund house to this fund
for placing investors’ money in that fund, assume you have invested in KKR fund,
they invested that money in JPM fund, JPM pays placement fee to KKR) so that
fund (KKR) reduces the fee to the extent of that additional revenue.

Broken Deal /Dead Deal: Deal means a fund making investment in to a company
/asset. Sometimes these investments are failed in last minute due to failed
negotiations on price etc.… all the cost incurred till that time is considered as
broken deal cost and accounted as expense in the fund.

Ex: KKR team travelled to India, met Byjus team to negotiate on valuations to
make investment. They have incurred 10cr expenses finally they decided not to
invest so accounted that 10cr as broken deal cost (if success, this cost is included
in cost of investments)

Due Diligence Cost: Before taking any major stake in a company, these funds
conduct extensive research like understand the financials of that company,
discuss all potential risks for that business including any court cases pending on
that company etc. this is due diligence.

Financial Highlights: All funds (MF/HF/PE) need to report certain financial

highlights in the books (financial statements). So, investors can compare 2
different funds. Commonly reported FLHLS (financial highlights);
• IRR- Internal Rate of Return
• Expense Ratio
74 | P a g e
IRR-This is the time weighted return calculated to report the performance of the
fund.
FUND-A FUND-B
Date Cash flows Date Cash flows
01-01-2022 -100 01-01-2022 -100
01-01-2023 10 01-01-2023 0
01-01-2024 110 01-01-2024 120
10% 9.6%
In the above case, first fund paid 10cr at the end of the 1st year (2022) and then
10cr in the 2nd year so return is 10% other fund paid same amount of 20cr
return but cash flows are paid late (in 2nd year) so IRR is 9.6%

Other definition used for IRR is the rate at which inflows and outflows are same.

Ex: If you invest in the Fund-A on 01/01/2022 100cr, that fund gave you back
110cr on 01/01/2024, then IRR is 10%. So, if we discount future cash flows to
today date at 10 % inflows is 100cr and outflow is 100cr

31-12-2022 110
Value of this on 01/01/2022 110 110/110%

Otherwise, if we invest 100cr today, at 10% rate that will become 110 in 1st year,
121 in 2nd year etc.
Cash flow- Return –
Year Total Comments
Opening Balance 10%
1st Year 100 10 110 100*10%=10
2nd Year 110 11 121 110*10%=11
rd
3 Year 121 12.1 133.1 121*10%=12.1

Expense ratio: Generally, this is calculated as total expenses in the fund/NAV

of the fund.
Ex:
Management fee 100
Other expenses like audit fee 50
Total 150
If the NAV is 10000cr, expense ratio is 150/10000*100=1.5%

In P/E Funds, if the fee is on commitments, this ratio is calculated as

expenses/commitment.

75 | P a g e
Assuming commitments are 20000cr, 150/20000*100=0.755

1st year 100 10 110

2nd year 110 11 121
Total 121 12.1 133.1

Q: Once the balance sheet and other financial statements are prepared and
sent to investor, can an individual investor understand his NAV/closing
balance of the fund automatically?

NO. each investor would like to know their NAV/closing balance

separately so they can understand the amount they will get if they exit from that
fund or they can understand the profit made by them in that fund as of that day.

Ex: If Dhoni invested so far 40cr in that fund and his NAV is 45cr, he made 5cr
profit in that fund as of that day

In mutual funds, these fund houses report NAV per unit so investors can calculate
their NAV

Ex: If the net assets in the funds is 100cr (assets are 110cr, liabilities are 10cr, so
net assets are 100cr), if the fund has 10cr units in that fund, NAV per unit is
100/10=10. If you have 20 units in that fund, your NAV is 20*10=200. if you
have invested 180 then your profit so far is 20(200-180).

In private equity and hedge funds, they prepare separate capital statements for
each partner /investor, called partner capital statements (P-caps) . Since number
of investors are less in these funds, they can prepare separate statements for each
investor and send to them along with other financial statements if they calculate
the partner NAV as a % of total funds NAV, that can be incorrect since there are
exceptions in management fee and carry fee calculations.

Ex: If total commitments in the funds are 100cr, Dhoni committed 40cr, his
ownership is 40% if the fund level NAV is 100cr, his NAV may not be 40cr, he
may be paying 2%management fee and other investor (Trump) is paying 1.8%
fee so Dhoni NAV can be less like 39cr. so, these p/e and hedge funds do other
process called as allocation before preparing financial statements.

76 | P a g e
Q: What are allocations/allocation process in P/E or Hedge funds?

To prepare the capital statement of each partner, the fund admin needs the
finalised numbers of each partner in the fund so this allocation file is prepared. In
this process, all expenses and income of the fund is allocated to each partner in
their ownership ratio. However, there are some exceptions to be noted in these
cases, like;

1. GP, CIP, Employees of the fund house etc. will not pay any management fee,
carried interest. So, they should not be allocated that expense.

2. Discounted fee investors- Some investors in the fund may pay less fee like
1.5% when all other investors pay 2%. So, we have to calculate their numbers
separately and allocate their portion of fee rather than allocating it based on
their ownership.

3. Partner transfers- One investor may be transferred the stake to another investor
in between the accounting period like on 30th June, to allocate that year
expenses, we have to keep 50% allocation to partner A and balance to new
partner. If there is interest expense in the fund on loan taken from July 2022,
that should be allocated to only new partner and not 50% each to old and new
partner since this expense is incurred in the 2nd half of the year once these
allocations are approved, they prepare the capital statement of each partner (P-
Cap), the pro-forma of the capital statement is as below

Capital statement of Dhoni for the year ended 31-12-2022

Particulars Amount
Opening balance 100
Contributions 25 (this is only for 2022 year)
Distributions -10

Allocation of income/expenses:
Management fee -2
Other professional fee -2 (includes audit fee, custodian fee etc.)

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Equalisation and Rebalancing:

When a fund accepts new investors in the fund (2nd close/3rd close etc.)
those new investors also will get similar profits like old investors.

Ex: If A and B are partners in KKR Asia Infra Fund, they will have 50%
ownership each in that fund in the next year/after 6 months, if that fund has 2nd
close, new partners like C and D came, all ownership ratios will change to 25%
each (assuming all partners committed similar amounts).

2022- 2023- New

Investor Total
Commitments commitments Ownership
A 100 - 100 25%
B 100 - 100 25%
C - 100 100 25%
D - 100 100 25%
Total - - 400

If that fund incurred common expenses like audit fee/custodian fee etc. For 10cr
in 2022, that was allocated to A and B only in 50:50 ratio now, that will be
allocated to new partners so credit to old partners, all new partners will have
allocation of 2.5cr each that is rebalancing in case of equalisation, if the partners
already paid some contribution, new partners will pay that back to old partners or
adjusted in the next contribution.

Ex: If A and B already paid Rs 100cr to invest in flipkart, new partners also need
to pay Rs 25cr each so they will pay and old partners will take Also, old partners
expect some return like interest since they have paid more money (indirectly on
behalf of new partners also in the past) so, equalisation interest/ subsequent close
interest is paid by new partners C and D will pay 8% interest on that amount
25cr*8%=2cr will be paid by C and D to A and B all these adjustments are
between old and new partners going forward , any contribution or distribution
will happen based on new ownership ratios.

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 Differences between MF vs P/E vs HF

Details Mutual Funds Private Equity or VC Hedge funds

Investment Medium like 1-3 Less like 1 year or less
More like 5 plus years
horizon years or more (generally)
Mainly retail Accredited investors like Accredited investors like
Investor
investors HNI/IIN/SWFS etc. HNI/INN/SWFS etc.
Anywhere, mainly in to
Mainly into
Anywhere, mainly into listed securities including
listed company
Investments start-up company shares, derivatives like futures and
shares, bonds of
real estate, infra-assets etc. options, crypto currencies,
govt. etc.
commodities etc.
Low due to
Medium, invested for long High since short term
relatively safe
Risk term through illiquid investments use of
investments are
investments are derivatives is more
made
Return 6 - 14% 15 - 25% 15 -25 %
Open ended
(mostly) Mostly closed ended, Mostly open ended,
Structure registered as LP/LLC, master feeder LP/LLC, master feeder
trust, mostly structure is common structure is common
standalone funds
More since retail
Regulatory Less since accreditor Less since accreditor
investors money
reporting investors are investing investors are investing
is involved
No-of In 1000s or
1 to 100 mostly 1 to 100 mostly
investors more

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HEDGE FUNDS

These funds pool money from accredited investors like HNI, institutional
investor’s etc. So, they can take more risk and invest in any assets class they can
invest in to Shares/Bonds/Real Estate, Infra/Currencies/Commodities etc.…

• Generally, they invest more in liquid assets like shares of listed companies,
derivatives like futures and options that are traded in stock exchange or
commodities exchange etc.
• That will help them to arrange the money to investors by selling these
investments. If investors decided to leave the fund most of these funds are
registered as open-ended funds.
• So, investors can invest or exit at any time. Initially, they opted for
long/short strategy that is major difference from mutual funds that are
popular till then. In this strategy, fund manager will buy some shares /assets
and sell later at high price once the price is increased, that is called as long
position.
• In this case, they need not worry about market fall, they can aim for return
on bull market, bear market also, called as absolute return. In this way,
portfolio is hedged. So, the name is "HEDGE FUNDS".
• These hedge funds can be explained as aggressive version of mutual funds,
mutual funds have some restrictions like they can only invest into listed
securities, they cannot invest more than some % (like 10%) into one
company etc.
• These funds need not follow those rules so they can take more risk
including using more derivatives. Other features of funds like open ended
fund structure etc. are common in these hedge funds also.

However, they can keep some restrictions on investors on liquidity side like keep
restrictions like investors can only sell the units/share s in the fund and get money
by giving advance intimations like 1 month in advance to withdraw money, or
sell only 20% stake in one year etc. These restrictions on investor’s transactions
are called as "Gates".

Generally, they invest more money into liquid securities like shares of listed
companies etc. So, they can easily buy or sell based on market situations to make
profit or they can arrange money to investors if the investor want to exit. But
some funds invest in shares of start-up companies etc. Depending on the strategy
of the fund, fund can be open ended or closed ended fund.

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Generally, these funds are also registered as limited partnerships (LPs) where
investors are called as limited partners and the fund manager as general partner
like p/e funds, these funds also pay incentive fee like 20% to GP/Fund house if
the fund generates good returns to the investors to give more returns to investors,
they follow different strategies, some of them are unique to hedge funds, those
are
Long/Short strategy : Quantitative strategy
Short only strategy : Arbitrage (Merger Arbitrage/Convertible Arbitrage
etc.) Strategy
Macro strategy : Fund of funds

Short only Strategy:

In this case the fund manager finds over valued stocks or assets and sell
them today with an intention to buy later at cheaper price.

Ex: if Infosys stock is trading at 1500 per share , if the fund manager feels that
stock will go up to 1300 in a month , they can borrow shares today and sell at
1500 , buy at 1300 after a month and return the shares to other parties , they can
gain 200 per share this is risky strategy for long term since most of the
shares/assets price prices increases in long term so they have to close the trade in
short term and for that they have to accurate in predicting the prices in near term
for that stock /currency/commodity etc.

Quantitative Strategy:

In this strategy, hedge fund managers use more quantitative techniques to

decide on where to invest, when to invest/sell. So, mostly statistics and computers
are used to find the investment opportunities fund houses like Renaissance, D E
Shaw, AQR etc. use this strategy more some of the mutual funds are also using
this strategy, in India also some funds are launched with this strategy.

Long/Short strategy:

In this strategy, Hedge fund manager will but undervalued stocks and sell over
valued stocks so the portfolio has long positions and short positions.

Long position means purchasing the stock today at lower price and sell later at
higher price to take profit .

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Ex: Buy Reliance stocks in 2022 Oct at 2500 per share and sell later like in Nov
22/June 23/2024 etc. at 3000/4000etc.

Short position means sell today at high price and buy later for low price.
Ex: Sell Infosys stock today at 1500 and buy later at 1200 after a month so that
the net profit will be 300 in this strategy, they are using some money like 50cr to
take long positions and 40/50cr to take short positions.

So, if the market is up, long position will give profit and if the market is down,
short position will give profit since they make more profit if the stock price is
falling more to find out over valued and undervalued stocks, one of the measures
they use is price to earnings ratio.

Particulars TCS INFOSYS

Market price 3163 1513
EPS 108 54
P/E ratio 29.29 28.02

In this example, TCS is over valued by looking to P/E Ratio. So, they may sell
that stock and buy Infosys. However, they have to look into many other details to
conclude on the over /under valuations like management equity, recent-growth
in the business and expected growth in the future etc.

Macro Strategy:

In this strategy the fund manager follows the macro-economic indicators

like interest rates, inflation, GDP growth, tax rates in that country etc. and predict
those macro parameters, based on that predictions, they can estimate the market
conditions like equity market conditions, gold prices, bond prices, currency
markets etc.., based on that predictions/analysis, they can take the buy/sell
decisions.

Ex: Due to Covid, lockdowns in Covid, many companies are closed and
labour/employees lost their employments. So, demand for many goods and
services will were low due to less money with people. So, RBI/US federal bank
etc. decreased the interest rates. So, companies and consumers can borrow more
money and pay less amount as monthly instalments to bank. This helped to fuel
the economy/increase the demand for goods and services in 2020/2021. After
lockdowns, this caused inflation since more people having more money and
buying more goods or services like food items/houses/cars etc.
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This can trouble poor people since their income is same or similar but prices are
increasing. So, it is difficult for them to buy food and other necessities. So,
RBI/central banks increased interest rates in 2021, 2022.

So, EMI payable to bank is increased so less people are taking loans so
inflation is controlled to some extent all the above cases can be predicted based
on that predictions, hedge funds/other fund managers started selling stocks in
2021 and 2022 and taking money back to America (American investors) to repay
loans there to save in bonds etc. since interest rates are high , this means Indian
share market is falling and us dollar price is increasing (due to sale in India and
demand for dollars to convert rupees).

So, fund managers can sell shares and buy derivatives contracts on US
dollars to make profits. Similar ways, they can predict the crude oil prices, impact
of that on Indian rupee and inflation. Based on that impact on interest rates, on
share market etc. and decide on what to buy and what to sell. Generally, they sell
shares if economy is in difficult situation and buy defensive assets like gold since
those prices will not fall if there is slowness in economy so gold prices increases
when equity market falls.

Fund of Funds:

One hedge funds like D E Shaw hedge fund will invest in to their hedge
fund like renaissance hedge funds/bridge water associates/JP Morgan.

Hedge funds/Fund to make profit:

This strategy is popular in P/E and M/F’s also. Some fund managers are
more popular for some type of investments. So, their expertise can be used in this
case.

Arbitrage Strategies: Arbitrage means making profit based on price differences

between two markets.

Ex: If reliance stock is trading at Rs 2000 in cash market, at Rs 2100 in derivatives

market (futures), you can sell in futures and buy in cash market (if you research
says futures is overvalued). In a week/ month time by the time of
futures/derivatives contract expiry time, in both markets the price may 2050. So
Rs 50 profit in cash market (bought at Rs 2000 and sold at Rs 2050), Rs 50 profit
in derivatives market (sold at Rs 2100 and bought later at Rs 2050).
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Incentive Fee / Performance Fee:

In these hedge funds also, it is common to have incentive fee/ performance

fee where investors/LPs pay around 20% of profits to the GP/Fund manager /fund
house for generating returns to them in that fund.

Ex: If you have invested Rs 1cr in bridge water associates fund, by end of that
year, market value of the investment is Rs 2cr, you need to pay 20% of that Rs
1cr profit (1cr*20%=0.20cr) as incentive fee to GP. There are no waterfall
provisions/similar provisions in hedge funds unless that is also a closed ended
fund like P/E Fund.

Q: What is Crystallisation Date /Crystallisation Period?

In hedge funds, fund manager can take incentive fee on book

profits/unrealised gain also. They don’t need to sell all the investments and take
incentive fee only on the realised profits. So, they decide a date on which the
profits can be considered and incentive fee can be calculated and paid to GP, that
date is crystallisation date.

EX: If Renaissance Technologies launch a fund on 1st Jan 2022, they can keep
the crystallisation date as 30th June and 31st Dec of each year. in that case, if the
fund made 20cr profits from 1st Jan to 30th June, fund manager or GP will take
20*20%=4cr as incentive fee (assuming no hurdle rate like 8% per year). If hurdle
rate is applicable, profit over and above that hurdle rate is considered for
calculating incentive fee.

Q: What is HWM/High Watermark based on the below details

Fund name : Renaissance hedge fund

Launch date : 01-01-2022
Pooled money : 100cr
Per unit/ share : Rs 100/-, issues 1cr units - High Water Mark
Crystallisation date : 30th June Clawback
Value per unit 30th June : 150
Profit made : 50
Incentive fee rate : 20%
Incentive fee/Performance fee : 10

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Q: Assume, by next crystallisation date (31st Dec), if the value per unit is Rs
120, is there any incentive fee?

NO, since the incentive fee is already paid up to 150 level, investors need
not pay up to that level high water mark or (HWM). Means investors in a hedge
fund need to pay incentive fee only if the value per unit (/gross assets value) is
more.

Ex: In the above case, fund pooled money at Rs 100 per unit, that is HWM by
next crystallisation date (30th June), if the value per unit is Rs 90 there is no
incentive fee since the value is not more than the HWM (entry point is Rs 100,
today value is Rs 90, so there is loss. If the market value per unit is 101 and above,
fund manager is eligible for incentive fee. By 30th June if the value per unit is Rs
150, there is profit so they take incentive fee, this 150 becomes the new HWM.
So, by next crystallisation date like 31st Dec 2022 or later, if the market value is
above this new HWM of Rs 150, there will be incentive fee, else, no incentive
fee.

Value/
Incentive fee
Unit
Date HWM (Always after hurdle rate if any)
(GAV)
01-01-2022 100 100 No. Starting day of the fund, no profit /loss.
30-06-2022 150 150 Yes, (150-100) *20%= 10rs is incentive fee.
31-12-2022 120 150 No, since there is loss.
30-06-2023 140 150 No, Profit is 20 but not exceeded HWM.
31-12-2023 160 160 Yes.160-150=10*20%=2rs incentive fee.

Q: GAV and NAV in hedge funds?

GAV means gross assets value; it is calculated as NAV + Incentive fee

Or NAV = GAV - Incentive fee

If the value per units as of 30th June is Rs 150, fund manager will take incentive
fee on profit of Rs 50, 50*20% = Rs 10 and pay the balance to investor if the
investor is leaving the fund, that is Rs 140 (150-10)
So, GAV is Rs 150 and NAV is Rs 140.

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Q: What are series of shares or series accounting in hedge funds?

When a fund allows investors to come and invest any time, the value per
unit for all those investors can be different when purchased.

Ex:
• If Sania came in to fund in Jun 2022, she might have paid Rs 150 per unit,
• If Sania came into the fund in Sep 2022, she might have paid Rs 180 per unit
etc.

To settle all these investors accounts on crystallisation date, and calculate

incentive fee payable by them so all accounts are equal from incentive fee
perspective (equalisation process), these funds issue different series shares to
these investors like below;

Month GAV/unit series

Jun-22 150 202206
Sep-22 180 202208

Assuming the GAV on next crystallisation date is Rs 200, 202206 series investors
made Rs 50 profit so they will pay 50*20% = 10 as incentive fee, 202208 series
investors made Rs 20 profit (200-180) so they will pay 20*20% = 4 as incentive
fee.

Q: What is compulsory redemption of units in hedge funds?

There are different methods/practices followed in hedge funds industry to

settle any incentive fee payable/receivable between the investors and the GP/fund
house. One such practice is to settle any incentive fee payable/ receivable by
redeeming the units owned or credit some new units to that investor.

Ex: If Sania came in to the fund at Rs 180 per unit GAV, GAV as of next
crystallisation date is Rs 150, she made Rs 30 loss. If others made profit, they
will pay incentive fee to the funds (assume the HWM is Rs 120 by that time so
others made Rs 30 profit). So, if the fund can pay incentive to Sania on loss made
by her Rs 30, her high-water mark also become Rs 150, she will also pay incentive
fee like others on the difference between Rs 150 and GAV on the next
crystallisation date (assuming the GAV is Rs 200 by the next crystallisation date,
she will also pay incentive fee on Rs 50 profit, (200-150) (HWM).

86 | P a g e
 So, in this case, fund should pay Rs 6 (30*20%) to Sania she made loss of
30, for that fund can issue new units to her and credit those units to her account
assuming unit value is 60 (NAV), they will credit 10 units to her if incentive fee
is Rs 1600 (if she has 266.67 units, 266.67 units *6 on the other side if Dhoni
came at Rs 110 per unit todays value per unit is Rs 150, he need to pay incentive
fee on 40 profit assuming he has 1000 units, total payable is 1000*8 per unit (Rs
40 profit is 20%) = 8000 for that 8000, some units will be redeemed from his
account. If per unit NAV is 160, 8000/160=50 units are redeemed so he will have
only 950 units.

Side pocket:

This is a separate fund created from an existing hedge fund (now in mutual
funds also, it is allowed) by separating one /or more investments in that fund that
are underperforming this is created for assets /investments that are hard to sell/
illiquid assets in that fund.

Ex: If a hedge fund invested 100cr into bonds /debentures to the below two
companies, they can create side pocket for one asset that is in trouble / selling that
asset /investment is difficult for that fund.
Investment Type of Amount
Comments
Name Security Invested
Status is good, easy to buy/sell
Reliance Debentures 60
this asset in market
Hard to sell, no buyers to sell
DHFL Debentures 40
this asset
Total 100

So, fund can create side pocket for DHFL, they will calculate separate NAV for
that side pocket. if there are 5- investors in the fund as of that day, only those
investors will continue in that side pockets, no new investors can invest in that or
no old investor can exit from that fund.

Investments made by Hedge funds /Securities used:

These hedge funds can invest into listed securities like equity shares of listed
companies’ bonds issued by govt. /corporate, derivatives (both, listed like
options, futures and OTC derivatives like forward/swaps etc.), commodities etc.
They can also invest into advanced derivatives/exotic or structured products like
MBS/ABS/CDS etc. also.
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Some of the popular types of these securities are discussed below

• Securitisation of Assets
• Mortgage-Backed Securities (MBS)
• Asset Backed Securities (ABS)
• CDD (Collateralised Debt Obligations)

Securitisation of Assets:

Securitisation of assets means converting assets into securities, this process

will help the organisations to convert their assets into securities. So, they will get
the cash, investors will have different securities to invest their surplus money.

Ex: REITSs, INVITs, MBS, ABS etc.

MBS:

In this case mortgage loans owned /issued by banks are converted into securities.

Ex: if SBI bank issued 100cr worth of home loans they will receive that money
back in EMIs from customers for next 10/20 years. If they need money now, they
can convert them into 1cr mortgage-backed securities at 100 per securities and
sell to public if an investor like you have 1000, they can buy 10 MBS at 100 each.
You will get 8% interest per year, and 100 per MBA will be repaid after 10
years/any fixed duration if a hedge fund invested in this security, they can accrue
interest income and receive when it is due. This is fixed income security to hedge
fund/other investors who invested in these securities.

ABS:

Asset backed securities are similar to MBS, in this case underlying asset
can be any loan like car loan/personal loan/credit card receivable etc. and in MBS,
underlying assets in home loan /mortgage loans these ABS is less secured for the
investor compared to MBS so they offer better interest like 6% when MBS offer
4.5% both these MBS/ABS became popular in 2001 to 2007 period when interest
rates were low in US/other developed markets like US, there was a market crash
in 2000 due to .COM bubble (dot co bubble, shares of IT companies like
Yahoo.co crashed due to over valuations). So, interest rates were low at that time
like 1% range. So, investors invested in MBS/ABS to get better interest.

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CDO Market:

This is a common term used for this securities markets, where assets like
mortgage loans/cars loans converted into securities.

Ex: CDO market is growing in US and more MBS/ABS etc. are issued in this
year and raised money from investors.

CDS-Credit Default Swap:

An investor who purchased MBS/ABS can enter into CDS agreement to

protect from possible default of those MBS/ABS process;

1. Pay some premium like 2 per MBS security worth of 100 and get a right.
2. The seller of CDS like insurance company will take that premium and take
that premium and take that risk (Credit risk is swapped/exchanged)
3. If the MBS is defaulted (borrower did not pay in time), this investor who also
paid premium and bought CDS can get the money from CDS seller like
insurance company.
4. When CDS is sold, insurance company/other party thought this MBS/ABS is
safe, default will not happen so they sold this CDS by taking premium, if no
default on MBS, then premium is their income.
5. Investor buy this CDS as additional protection if the MBS is failed /defaulted
investor already paid premium to CDS seller, have right, if the security is
defaulted, investors can go to CDS seller and get the money invested in MBS.

CDS Seller : American Insurance Group (AIG)

CDS Buyer : Renaissance Hedge Fund
MBS Face Value : 100
CDS Premium :2

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Derivatives/Derivative Contracts:

Q: Why these funds use these contracts like forward futures options swaps
etc.?

Underlying Asset : Axis Bank Shares

Purchase Price : Rs 950/- in Dec-2022
Invested : 1 crore shares 950 crore rupees
View/Expectation : 850 in February due to budget related volatility
Decided to use : Forward Contract
Your Position : Seller
Buyer : Renaissance Hedge Funds Manager
Contract Date : 04-04-2023
Contract Expiry Date : 04-03-2023
Contract Price : Rs 950/- per share
Contact Quantity : 1 crore shares
Contact Value : 950 crores

In this case you are expecting the stock will fall to Rs 850/- so you have
entered in to the sell at Rs 950 per share in March other fund manager is expecting
stock price will increase to Rs 1050/- by March so he entered to agreement to buy
at Rs 950/- so he can sell in the market (After buying from you at Rs 950/-) for
Rs 1050/-.

Q: Assuming the Price on contract expiry date (4th March2023) is Rs 950/-

Who made Profit/Loss from the contracts?

Contract Price : Rs 950/-

Spot Price/Market Price : Rs 950/-

No gain/loss to both the parties since market price (spot price on expiry date of
contact) or contract price is same.

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Q: If the market price on expiry date/4th March2023 is Rs 600/- what is your
gain/loss from the contract?

Contract Price : Rs 950/-

Spot Price/Market Price : Rs 600/-

Instead of selling at Rs 600/- you are selling at Rs 950/- so profit is Rs

350/- (for seller of the contract) for buyer is loss of Rs 350/- per share (since he
is paying Rs 950/- though market price is Rs 600/-).

Q: Can these forward contracts (like above) can be used on any asset or only
stocks?

These forward contracts are contracts to fix the price for a future date so
any possible loss due to change in market price can be avoided.

Ex: KKR P/E fund sold an asset in foreign currency (it is launched in India and
sold an asset in America) they will receive 1 crore dollars in May 2024 as of today
1 US dollar is Rs 82.5 so they can get Rs 82.5 crore if realised today.by April
they are expecting dollar price will Fall to Rs 70 per dollar so they will get only
Rs 70 crore by selling the dollars in April. Now in Jan they entered in to a contract
with CITI bank to sell the dollars at Rs 82.5 in April. They need not worry about
market prices in April their sale price of dollars is fixed. as per their prediction if
price falls KKR fund will make profit due to conatcrt.is the price in the market is
Rs 75 they made profit of rs.7.5(sold at Rs 82.5 though market price is Rs 75). If
price increased to Rs 85 per dollar they made rs2.5 loss due to contract.

These forward contracts (Swaps CDS Swaptions etc. also) are OTC
contracts (Over the counter contracts) they can be used on any underlying asset
like commodities like gold/crude oil/wheat/paddy etc. currencies interest rates
etc. no limit on what type of asset it can be used.

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 Q: What are OTC Contracts and exchange traded derivatives?

Derivative is a contract that derive the value from the underlying asset.
There are many derivative contracts all of them can be grouped into
1) OTC contracts
2) Exchange traded derivatives/listed derivatives

• Over the counter derivatives are contacts that can be purchased or sold any
where.no need of intermediary like stock exchange/commodities exchange
etc.

• Exchange traded derivatives are ONLY available in exchange like stock

exchange (BSE/NSE/New York stock exchange etc.) or commodities
exchange like MCX/Multi Commodities Exchange etc.

Details OTC Exchange traded

Means Traded/used any Trade in Exchange only
Liquidity (Convert where
LOW/NIL cannot High we can find many buyers/sellers for same
asset in to cash) transfer/sell to others contract so it can be sold
Terms Customised Standardised
Risk More Counter Party Less/Nil Stock exchange act as intermediary to
risk is more settle the contract so less rusk

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Q: Why these contracts can be used (OTC/exchange traded)?

1. Hedging: To reduce the risk. Any business any investor/trader etc. will
have risk due to change in market price.to avoid that they can use these
contracts.

Ex: You are a farmer cultivating sugarcane started in Jan you can sell the crop in
June 2023.by that time you are expecting the price will drop.to avoid that loss due
to price drop you can enter in to contact today agree to sell 100 tons of sugar can
at Rs 25000/- per ton. Assuming your production cost is Rs 20000/- and sell price
is Rs 25000/- you are safe. If market price is Rs 5000/- in June 2023 you will still
get Rs 25000/-.

2. Speculation: Mainly in exchange traded derivatives like futures and

options many traders including fund managers like hedge fund managers
use derivatives for spculation.in this case they don’t have the underlying
asset like shares/commodities they predict the price in the future to make
profit they use these contracts

Ex: A hedge fund manager is expecting Axis share price will increase to Rs 1050/-
in a month time from Rs 950/- today. He can use futures or options and make
profit of Rs 100/- per share if his prediction is correct and stock price went to Rs
1050/-.

3. Arbitrage: If there is a difference between two markets like cash market

and futures market etc., they can use derivatives also to make profit.

Ex: If an axis stock price is Rs 950/- futures contract price is Rs 1000/- you can
sell in futures because it is over prices and buy in cash market. In the future cash
market price may increase to Rs 975/- and futures price can decrease to Rs 975/-
so profit of Rs 25/- from futures and cash market.

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Futures Contract

Underlying Asset : Axis Share

Current market price : Rs 963/-
View : Bearish
Target/Expected Price : Rs 850/-
Contract Date : 4th January2023
Contract Expiry Date : 23rd February2023
Sell Price/today price- Feb Contract : Rs 973.8/-
Lot Size : 1200
Contract Value : Rs 1168560/- (1200*973.8)
Margin : 20.78%
Margin Amount : Rs 242817.42/-

Q: On expiry date 23rd Feb if Market Price of Axis Bank share is Rs 820/-.
What you gain/loss

Contract Price : Rs 973.8/-

Spot price/Buy price : Rs 820/-
Profit : Rs 153.8/- (973.8-820)

Instead of selling at market price Rs 820/- this contract gave you Rs 973.8/-. So
there is a gain of Rs 153.80/- per share contract gain is 1200*153.8=184560. This
means the buyer of the contract opposite/counter party makers Rs 184560/- loss.

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Points to note for futures:

1. To avoid counterparty risk (like in forwards or any OTC contracts) these

exchanges like NSE collect margin amount from buyer/seller of contract.so
any loss can be deducted from that margin and paid to opposite party who
made loss (any derivative contract gain to one party is loss to opposite
party).

2. These are standardized contracts terms and conditions are decided by

exchanges like the expiry date lot size margin % etc.

3. This contract works similar to forward contract with above exceptions.

Any difference between the contract price and market price is gain/loss.

4. If you are expecting the underlying price will fall you can sell today at
ongoing price when market falls in future you can buy and close the
contact. Difference between buy and sell price is gain/loss (these contacts
can be closed on expiry date or before also since there are many
buyers/sellers in market).

5. If you think the price will go up buy today and sell later at high price

Ex: If you think axis price will go up buy today at Rs 973/- sell at Rs 1050/- may
be after a month gain is 1050-973 = 77/-

Q: You sold today at Rs 973/- price went down to Rs 950/- tomorrow can you
close the contract and making gain?

Yes, any time (till expiry date) these contracts can be closed since there are
many parties (buyers/sellers) for the same contract

Ex: If you are selling Axis futures there may be many sellers like you (may be
10000 people) and there can be around 10000 buyers for the same contract. So
you can buy or sell any time difference between buy and sell price is the gain/loss
In this case;
Sell Price - 4th Jan 2023 : Rs 973.8/-
Buy Price – 5 Jan 2023
th
: Rs 950/-
Profit per share : Rs 23.8/-
th
On 5 Jan2023 stock exchange will transfer that gain and your margin amount
deposited to your account your contract is closed.
95 | P a g e
Q: What is daily settlement MTM (Mark to Market) Margin in futures?

If you have a contract in futures they are settled on a daily basis

Ex-1: You sold a stock at Rs 100/- today with an expectation the price will fall
to Rs 80/- on that day if price increased to Rs 110/- you made Rs 10/- loss so
exchanges collect that Rs 10/- from you and pay to opposite party. Next day if
stock falls to Rs 90/- they will pay you Rs 20/- (110-90). This is to ensure the
margin amount paid by parties is sufficient to settle the loss.

Ex-2: If you deposit Rs 20/- as margin by the contract expiry date the price
increased from Rs 100/- to Rs 150/- loss is Rs 50/- but margin available is rs20
so you might default to settle the contract. if that loss of Rs 50 is collected on a
daily basis like Rs 10/- today and Rs 5/- tomorrow etc. whenever you made loss
stock exchange will always have appx.rs 20 as margin so default will not happen.

Extra margins collected by exchanges since there is shortfall is called MTM

margin

Ex: Assuming 20% margin if you need to pay Rs 20000/- margin on a contract
you have only Rs 16000/- after adjusting MTM loss exchange will ask you
deposit Rs 4000/- that is MTM margin.

96 | P a g e
Q: You are a gold trader you are expecting the gold price will increase from
today price of Rs 5000/- per gram to Rs 5500/- per gram in 3 months using
forward is better or futures to hedge this risk of increase in price so you can
still buy at Rs 5000/- per gram after 3 months?

Particulars Forward Futures

Underlying asset Gold Gold
Market Price Rs 5000/- Rs 5000/-
Expectation/View Bullish/Increase Bullish/Increase
Action Buyer Buyer/Long Position
Quantity 100 grams 100 grams
Contract Value Rs 500000/- Rs 500000/-
Margin No 20%
Margin Amount 0 Rs 100000/-
Q: Tomorrow price No (4900-5000) *100=10000 loss. You
moved to Rs 4900/- have to pay that amount (daily
any settlement? settlement)
On expiry date Rs 5400/- Rs 5400/-
price
Gain 5400-5000=400 5400-5000=400 per gram
per gram Note: Gain/loss will be difference
between contract price and expiry date
price. But daily settlement is done in
this case.

All these funds like MF/P/E or HF use all these derivative contracts. Mostly they
prefer OTC for convenience since the contact terms can be customised like expiry
date, Quantity etc.

Hedge funds use more listed derivatives like futures and options since they can
easily buy or sell mainly when they do that for short term for speculative reasons.

97 | P a g e
Options:

These contracts give a RIGHT to the holder/buyer of the contract to

buy/sell an underlying asset at a specific price there is no obligation.

Ex: Your expectation on Axis Bank Share is it will go UP from Rs 960/- today to
Rs 1160/- in a month. If you have entered in to forward or futures you will make
Rs 200/- gain if the price went up as you expected. If the price fall to Rs 700/-
our loss will be 260.so there is more loss/unlimited loss if your prediction goes
wrong. For the same reason/prediction if you are using an option contract like call
option it works as below

Underlying : Axis Bank Share

Current Market Price (CMP) : Rs 960/-
Target Price : Rs 1160/-
Decided to use : Option Contracts
Which Option : Call Option
What you get : RIGHT to BUY
Strike Price (Contract Price) : Rs 960/-

To get that RIGHT you need to pay premium like insurance contacts

How much premium : Rs 22.35/- per share

Lot Size : Rs 1200/-
Total Premium per contract : Rs 26820/- (1200*22.35)

Q: If the price on expiry date is Rs 970/- what’s your gain/loss status of the
contract?

Strike Price/Contract Price : Rs 960/-

Market Price/Spot Price : Rs 970/-

Strike Price is better to exercise/use the contract

Buy Price : Rs 960

Sell Price in Market : Rs 970
Gain : Rs 10
Premium already paid : Rs -22.35
Net loss/Payoff : Rs -12.35 (10-22.35)
98 | P a g e
Q: If the market price on expiry date is Rs 959/940/90/800/500/100 what is
the status of the contract and profit/loss?

Strike Price/Contract Price : Rs 960/-

Market Price/Spot Price : Rs 959/-

Which is better that is market price. So, LAPSE the contract or ignore the contract
and buy in the market itself.

Gain from contract : Rs 0

Premium already paid : Rs -22.35
Net loss/Payoff : Rs -22.35 (0-22.35)
(* even if the market price is Rs 100/- still the loss is Rs 22.35/-)

Q: When buyer/holder of the contract has the right what is the position of
the counter party (Seller/writer of the contract)? Difference between holder
and writer of option contracts?

Seller/writer of an option contract will have OBLIGATION to SETTLE the

contact when the opposite party (holder/buyer) decided to use the contract.

Ex: In Axis call option case you thought the price will increase so paid Rs 22.35
per share as premium and got the right to buy at Rs 960. if market price is Rs
1260 you decided to exercise/use the contract and buy at Rs 960 now the seller
(Assume his name is Sundar) MUST sell you at Rs 960 that means sunder is
buying at Rs 1260 per share in a market and selling to you at Rs 960 so the loss
to him is Rs 300 after adjusting the premium received by him Rs 22.35 payoff is
(277.65).

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 Buyer/Holder Seller/Writer
Premium Pay Receive
Right/Obligation Has right to SELL in put option Obligation to BUY in put option
Has right to BUY in call option Obligation to SELL in call option
Gain Unlimited Limited
If stocks fall more, gain in PUT Only premium is the gain if the
option stocks go up in PUT
If stocks go up more gain in CALL Only premium is gain if stock
option decrease in CALL option
Loss Limited to premium if stocks go up Unlimited if stocks go down in
in PUT PUT
Limited to premium if stock goes Unlimited is stocks up in call
down in call

PUT Option:

Underlying : Axis Bank Share

Current Market Price/CMP : Rs 960/-
Target Price : Rs 700/-
Decided to use : Option Contract
Which Option : PUT Option
What you get : RIGHT to SELL
Strike Price/Contract Price : Rs 960/-

To get that RIGHT you need to pay premium like insurance contracts

How much Premium : Rs 20.56/-

Lot Size : 1200
Total Premium per contract : Rs 24672/- (1200*20.56)

Q: If the price on expiry date is Rs 970/- what’s your gain/loss and status of
the contract?

Strike Price/Contract Price : Rs 960/-

Market Price/Spot Price : Rs 970/-

So better to sell in the market and LAPSE/Ignore the contract

Premium already paid : Rs -20.56/-
Net loss/Payoff : Rs -20.56/-

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 Q: If the market price on expiry date is Rs 961/1000/2000/10000. What is the
status of the contract and profit/loss?

Strike Price/Contract Price : Rs 960/-

Market Price/Spot Price : Rs 961/-

Which is better that is market price so LAPSE the contract or ignore the contract
and buy in the market it self

Gain from contract :0

Premium already paid : Rs -20.56/-
Net loss/Payoff : Rs -20.56/-

Q: If the market price is Rs 600/-?

Strike Price/Contract Price : Rs 960/-

Market Price/Spot Price : Rs 600/-

Better is Strike price so excise the option and sell at Rs 960/-

Gain : Rs 360/- (960-600)
Premium : Rs -20.56/-
Payoff/Net gain : Rs 339.44/-

Details Call PUT

Holder will
Right to Buy Right to Sell
get
Writer will
Obligation to Sell Obligation to Buy
have
If Spot price is less than strike
Exercise If Spot price is more than strike price
price
Ex: if you have right to sell at Rs
Ex: if you have right to buy at Rs
100/- if market price is Rs 99/-
1320/- market price is Rs 1321/- and
or below you will exercise the
above you will exercise
contract
Farmer who wants to sell paddy
at high price fund manager who
Super market to buy rice at low price
Helpful for want to sell stocks at high price
BPCL to buy USD at low piece
Infosys to sell dollars at high
price.

101 | P a g e
Q: What is put option seller/writer calculation to sell that contract?

• PUT buyer is expecting the price to fall. More the fall in the underlying
asset price more profit to the holder/buyer.
• PUT option seller/writer is expecting the stock/underlying to go up so
contact will lapse Premium received is their income.

Ex: If you are selling axis stock put option Rs 960 strike price you are assuming
the stock will price will stay at Rs 960/go up like Rs 961/980/1000 etc.in that case
put buyer will ignore this contract and sell in market for higher price.

Swaps:

In this case series of cash flows are exchanged between two parties for a
specific period like 1 year. We can say these are like multiple forward contracts
in one contract between two parties.

Ex: If Infosys Company is going to receive 1cr dollars each month their worry is,
if dollar price goes down. So, they can enter in to currency swap agreement with
BPCL company (BPCL need to buy dollars each month their worry is if price of
dollar increases). Each month on 5th day Infosys will pay 1cr dollars and BPCL
will pay Rs 80cr rupees the market price is Rs 90 per dollar BPCL made a profit
of Rs 10 per dollar since they paid Rs 80 only when the market price is Rs 90.
This is currency swap contract.

Other contracts that are popular in the market are

• Interest Rate Swaps
• Total Return Swaps
• Credit Default Swaps etc.

In TRS/total return swaps total return of one asset like equity shares (appreciation
+dividend) is exchanged with other party in return of total return on other asset
like bonds (interest + appreciation).

Ex: You are a fund manager invested Rs 100 crores in shares of Axis Bank
thought of seeing them since market may fall. Your friend invested in bond of
Axis getting 8% interest he thought of selling them since he feels equity shares
will give 20% return. You can enter in to TRS pay any income/loss from equity
to him and he will pay any income from bonds to you for next 12 months or so.

102 | P a g e
Swaptions: Swap + Option

If you have equity shares of Tata motors you will continue to hold these
shares if the company is expected to perform well and declare profits in the books.
if the company will declare results after 10 days you have a doubt that results may
be bad then you can enter is to TRS today with your friend so you can give equity
returns to your friend and take return on debentures from your friend .if you are
not sure on how the results will be after 10 days then you can use this Swaptions
contract.

You can pay some premium like Rs 5/- per share today get the right to enter in to
swap or not after 10 days. If the company results are good shares price will go up
so ignore the Swaptions contract and hold the shares. If results are bad use the
Swaptions contract enter in to swap agreement so you get return on debt and your
friend takes return on equity.

CFD (Contract for difference):

These are similar to forwards futures with small differences as mentioned below
1. Most of these CFDs are OTC contracts traded anywhere(outside stock
exchange)
2. Parties need to pay small margins like 5 to 10% on contract value
3. These are settled by paying the difference rather than physical settlement
Ex: You agreed to sell 10 tons of wheat at Rs 10000 per ton. If the market price
is 5000 you will still sell the wheat at Rs 10K and make 5K profit in forward
contarcts.in this forwards you will actually deliver the wheat and opposite party
pay total amount in CFD. Since you made Rs 5K profit opposite party pay you
Rs 5K per ton you can sell in the market for 5K and get total Rs 10K per ton but
there is no actual delivery between the parties.

103 | P a g e
Fixed Income Securities:

• Bonds
• Debentures
• All money market instruments – CD’s CP Treasure bills etc.
• MBS/ABS etc.

These fixed income securities (common term is debt securities) have two main
features;

1. Repay the principal amount on maturity of that instrument

Ex: If Reliance company need capital of Rs 100 crores they can issue 1 crore
bonds at Rs 100/- per bond in 2020 with tenure of 10 years. They will repay that
Rs 100 to you if you are an investor in 2030.

2. Pay interest/coupon in regular intervals like monthly/quarterly/semi-

annual basis/yearly basis

These funds may invest for interest and recurring income or for gains in the
market when the price of these debt securities increase or decrease for reasons
like credit risk is increased (if that company is expected to default on
interest/principal payment) interest rates are changed in market so old bond prices
are increased/decreased in market etc.

If a fund invested in to these securities (MF/HF/Private Equity) they have to

account all incomes from these securities in time like;

1. Accrue the interest at regular intervals like monthly though interest is due
on yearly basis since this is fixed income not like dividend.
2. Any change in the market value to be accounted as unrealised gain/loss.

104 | P a g e
Ex: If renaissance hedge fund invested in govt. of India bonds with below
conditions interest income to be accrued for January 2023 will be

Issuer Govt. of India

Face value per bond 1000
Interest rate 12%
Payment frequency 30th Jun, 31st Dec of each year
Tenure 5 years

In this case the fund will get Rs 120(1000*12%) as interest income per year.
January interest to be accounted in the books is 1000*12%*31/365 = 10.19

Entry will be:

Interest Receivable Dr XXXX
To Interest Income XXXX

Q: Can we consider all months the same and Rs 10 per month so Rs 120 per
year?

Industry follows difference DAY CONVENTIONS like ACTUAL

/ACTUAL (Act/Act) 30/360 etc. Based on the documents like loan agreements
or based on regular/consistent practice they have to choose the right approach in
the above case we have followed Act/act so calculation was 1000*12%*31/365
if it is 30/360 day convention calculation will be 1000*12%* 30/360 = 10. So, all
the months’ accrual is Rs 10 and yearly accrual is Rs 120.

Q: Fund invested in a debt security on 1.1.2023 Rs 10000 is face value interest

payable on 31st Dec of each year. If that fund sold investment in Nov 2023
who will get interest in Dec when interest is paid (for Jan to Nov period)?

Buyer/who hold that security on that interest payment date will get that interest.
Buy will get all 12 months interest from the issuer of debt security like
government of India/company like Airtel etc.

Q. What is the dirty price and clean price in these bonds/fixed income
securities buy/sell transactions?

If a bond/fixed income security is sold in market/purchased in market the

price agreed can be Including the accrued interest or excluding the accrued
interest if interest is included in the price it is called as Dirty price.
105 | P a g e
Ex: If the above security with face value of Rs 1000 and accrued interest of Rs
10 is sold for Rs 1100 as Dirty price the calculation is

Sale price 1100

Interest accrued 10 (since the company/issued paid interest in
Dec as of Jan accrued is for 1 month only)
Market price for the bond 1090 (1100-10)

So there is a gain of Rs 90/- on sale since Rs 1000/- & investment is sold for Rs
1090/-.

Journal entry is
Bank a/c Dr 1100
To Investment in bonds 1000
To Realized gain on investments 90
To Interest receivable 10

If the sale price is excluding the accrued interest it is CLEAN price. If the clean
price is Rs 1100 calculation is
Sale price 1100
Accrued Interest 10
Payable for sale 1110

So the profit on sale is Rs 100 entry will be

Bank a/c Dr 1110
To Investment in bonds 1000
To Realized gain on investments 100
To Interest receivable 10

Note: If it is clearly mentioned as a clean price we have to take accrued interest

in addition to the sale price as total consideration if it is not mentioned as clean
price or dirty price assumption is clean price so we can add the accrued interest
for total consideration

Q: Zero coupon bond? How to accrue interest on that?

Zero coupon bonds are issued at deep discount so they are also called deep
discount bonds the issuer will repay the face value difference between issue price
and the redemption value is interest income. No interest is paid in addition so they
are called Zero coupon bonds.
106 | P a g e
Ex: If the Govt. of India needs money for 3 months they can issue a bond at Rs
98 and repay at Rs 100 after 3 months difference is interest.

Entries when interest is accrued

Investment in bonds Dr 2
To Interest income 2

Types of Bonds:

• Callable Bonds – Company/issuer can repay that bond before there

maturity when they have alternative source of capital at low cost etc.
• Puttable Bonds – Investor will have right to ask for redemption of bond
before the maturity date of that bond.

Q: What are alternative investments and alternative investments funds

(AIF)?

Alternative investments means other than traditional investments.

Traditional investments are like equity shares bonds mutual funds etc. these
alternatives investments include real estate gold P/E funds hedge funds arts
paintings etc. These funds like P/E funs hedge funds VC funds are alternative
funds in asset management companies any division dealing these funds or
investments are called as alternative investment divisions /alternative investment
management division etc.

Q: How to know top asset management companies (AMCs) top P/E funds
top hedge funds etc.

That is decided based on AUM (Assets under Management) of those companies

Ex: If SBI AUM is 5 lac crores and HDFC AUM is 4 lac crore we can say SBI is
top fund house in India.

107 | P a g e
This is calculated as below:

To calculate AUM of any company they consider the assets on which that fund
house is earning fee/revenue

Mutual funds: - They charge fee on NAV of the fund. So, if BlackRock has 100
funds NAV of each fund is 1 lac crore AUM of BlackRock is 10 lac crores

P/E funds: - Most of the funds charge the fee on commitment based

If Black Stone charge fee on commitment fee for 10 funds and total commitments
of these funds of 10000cr they will add that sum to interest on 10 funds if they
charge fee on invested capital then 10 funds invested capital is added to AUM.

Hedge funds: Most of the funds follow NAV as base to charge the fee. So, NAV
of all hedge funds is AUM of that fund house.

Top fund houses in the world based on AUM are

S. AUM in USD AUM in India

Name
No (Trillions) (Rs in Lacks crores)
1 Black Rock 10 800
2 Charles Schwab 8 648
3 Vanguard Group 8 648
4 UBS 4 344

Top fund houses in India

S. No Name AUM in Lacks crores

1 SBI 6.47
2 HDFC 4.32
3 ICICI 4.3

108 | P a g e
AUC/Assets Under Custody:

Custodian plays an important role in the asset management industry, their

main role is to keep the assets of the fund in their custody (if the fund invest in
shares of reliance share certificates are with custodian) funds should appoint an
external party as custodian.

Ex: If Goldman Sachs launches a funds they should appoint JP/BNY Mellon as
custodian to know which company has more assets in their custody/who are top
in this business they announce the AUC/Assets Under Custody.

Ex: If GS launches a P/E fund with 100cr commitments, BNY appointed as

custodian fee is 0.2% on commitments then AUC is 100cr if they charge fee on
NAV then NAV of fund is custodian’s AUC.

Top Custodians in the world

Company AUC in $ AUC in Rs lacks crores

BNY Mellon 25 1875
Euro Clear 19 1425
JPM 16 1200
SST 15 1125

Assets Under Administration (AUA):

Fund houses appoint a separate fund administrator to take care of day to

day activities in the fund like preparation of NAV take care of bank payments and
receipts in the fund etc. If they charge fee on NAV of the fund as 0.7% etc. that
fund NAV is the AUA of this admin.

Top Fund admins in the world are:

Company AUA in $ AUA in Rs lacks crores

SS&C 2.5 187.5
State Street 2.2 165
Citco 1.5 112.5
Northern Trust 1.1 82.5

109 | P a g e
Regulatory Reporting:

To control an industry or to ensure the investors / stake holders are not

cheated /their money is not misused there are regulators.

Ex: To control banking system like who can do bank business how much amount
they can give loan/eligibility criteria etc. the regulator in India is RBI. Similar
way to regulate the stock exchanges companies issuing shares/debentures all
intermediaries companies stock brokers asset managers etc. there are regulations
in India and SEBI (Securities Exchange Board of India) or SEC (securities
exchange commission) just like SEBI in America it regulates securities.

These regulators will decide on who can launch these funds (like SBI HDFC etc.
has license in India) rules they have to follow to ensure the investors’ money is
not misused.

Ex: These fund house should appoint custodian for each fund who will keep the
assets of the fund like Gold/Shares etc. in their custody/control.

These fund manager/GP etc. cannot charge their personal expenses in the fund or
they cannot invest in more risky securities without mentoring it in investment
objective of the fund/legal documents like PPM etc.

These funds should submit many reports like financial statements on a

quarterly/monthly basis and specific forms to these regulators and they will
examine these and they can impose penalties or they can cancel the license of
these fund managers/fund house, if it is proved that the fund is not managed as
per the legal docs like PPM etc.

Some of the regulations/terms related to these alternative investments funds are;

• RDR (Retail Distribution Review),
• AIFMD (Alternative Investment Fund Manager Directive)
• MIFID-1, MIFID-2 etc.

110 | P a g e
Q: Difference between Open ended funds and Closed ended funds?

Details Open Ended Funds Closed Ended Funds

Investors are not allowed to
exit or invest later .at the
Funds allow investors to
time of investment they can
Meaning invest any time and exit any
invest and exit at the time
time from the fund.
of closing /liquidation of
the fund.
Varies/changes since new Fixed since no issue of new
investors can come and old units in the fund or
Capital amount
investors can exit any day redemption of old units in
(variable capital). the fund.
Fixed like 5/10 years.
Term/duration No Limit, it can continue any Investor’s money will be
of the fund number of years paid back on completion of
tenure.
More
suitable/opted Mutual, Hedge funds Private equity funds
by
Applicable to discourage Not applicable since
Entry load and
frequent entry/exit to reduce investors not allowed to
exit load
fund costs exit/enter in between.
To fund manager since no
Investors since they have pressure to provide money
Advantage to
liquidity to investors when they
want to exit.

111 | P a g e
 Interval Funds:

Not much popular, these funds work like closed ended for most part of the
year but kept as open approx. 10 days in year/6 months.

Ex: if HDFC launches an interval fund in 2020 with 10 years life time, each year
from 1st July to 10th July, the fund will keep it open where old investors can give
units back to fund and take money to exit from the fund, new investors can also
buy the units from the fund house (HDFC) in these 10 days. All remaining days,
fund is closed so no issue of new units or redemption of old units.

Note: In case of Mutual funds, to provide liquidity to retail investors, these closed
ended funds are listed in a stock exchange. So, an old investor can sell and new
investor can buy the units directly in stock exchange between them. Fund house
like HDFC not involve in this case.

Note: If mutual funds are closed ended, they list the units of the fund in stock
exchange so investors can buy and sell between them (fund manager will not pay
the money, investor can sell to others in exchange). If P/e or hedge fund is closed
ended, they will not list since investors not required that option/liquidity.

Number US Format Indian Context Example

1000 Thousands Thousands
HNI, Net assets more than 1
1,000,000 Millions 10 Lacks
million
Indian Population 1.4 billion,
1,000,000,000 Billion 100 Crores
vision fund raised 100 billion fund
1,000,000,000,000 Trillion 1 lack crores GDP, India GDP 3 trillion

112 | P a g e
Corporate Actions:

These are actions taken by a company that impacts all stake holders. Stake
holders can be shareholders who owns the shares in that company or
debenture/bond holders who gave money/lend to that company. These actions of
the company that impacts the shareholders can be dividends, bonus shares issue,
stock split, buy back of shares etc. reasons for a company to announce these
corporate actions are to distribute the profits to the owners (shareholders) or to
increase the wealth of the investors (shareholder wealth maximization) by
creating more liquidity for those shares in the market which can increase the
demand and increase the share price in market.

Ex: If the share price of a company like Eicher motors is trading at Rs 25000 per
share, that company can announce stock split where they will divide one share in
to 10 shares. So, the stock price will go down to Rs 2500 per share. Now, more
investors will buy that stock since price is less so the stock price will increase
from Rs 2500 to Rs 3000 in few months. Investor wealth is now increased to Rs
30000 (10 shares 3000 per share) rather than having 1 shares at 25000. (This C.A
is stock split where the fund reduces face value per share for Rs 10 to Rs 5 or Rs1
etc. So more shares with low denomination is created).

As an Investor, these fund houses like mutual funds, hedge funds need to
track these corporate actions on a regular basis and account them in time. So,
NAV calculations in that fund are correct.

Ex: If the company declared dividend today (22nd Jan) and payment date is 22nd
Feb 2022, fund cannot wait till 22nd Feb to account. The corporate actions since
they are not following the cash basis accounting system rather they follow accrual
basis accounting system.

The fund should account dividend income on ex-date (one day before record
date), which is 10th Feb (if record date is 11th Feb). So, NAV on 10th Feb is
correct.

These fund houses/fund admins generally have a separate team to capture and
process these corporate actions in time since it is important to capture in time and
they deal with large amount of shares/companies so there can be many corporate
actions on a regular basis to capture these ca in time and find out if the fund as an
investor need to participate in the C.A or not etc..,

113 | P a g e
They classify these corporate actions to below 3 categories and process them...
1. Mandatory C.A
2. Voluntary C.A
3. Mandatory with choice C.A

(Investor should participate. investor has choice that dividend as cash/shares.)

Mandatory C.As are those actions taken by a company where investor should
participate (once announced by the company after taking necessary approvals in
board meeting etc.), as a shareholder, if you have shares, this C.A will impact
you.

Ex: If company issue bonus shares today, if you have shares on ex-date, these
free shares/bonus shares will come in to your account, you don't need to
participate/confirm to the company separately.

Voluntary C.A has option to the investor, if they want to participate they can,
else, they can ignore this C.A. If they ignore (if not informed the company by
applying for that C.A), these investors will not get that benefit.

Ex: If company announces buy back of shares, they will only buy back 2% or 10
of shares they have in that company.(if company has 100cr shares, they may
announce buy back of 5cr shares) interested investors should inform the company
and apply for that process so company will take that investor shares and pay
money to them. Other investors can ignore this C.A so there is no change for
them.

Mandatory with choice C.A will give the investor a choice initially, if not
exercised that choice, company will decide one option/ choice and all remaining
investors will follow that ca choice.

Ex: If company declared dividend and gave option to investors to take cash or
take shares and gave the deadline as 20th Jan, investors has to choose one option,
if not exercises by that date, they will pay cash to all other investors who did not
exercised so that will become mandatory at that time.

114 | P a g e
Important dates in Corporate Actions:

To record the corporate actions in fund accounting, below dates are important;

1. Announcement Date: Date on which the C.A is announced by the company.

On this date company will announce the details like ratio of ca benefit (like %
dividend/1:1 bonus issues etc.) and record date etc.

Ex: Eicher motors announced stock split on 25th May and fixed record date as
25th Aug 2020.

2. Record Date: On this date, company will consider the list of shareholders in
their records (shareholder register/names as per Demat accounts) and issue the
benefit of C.A to them.

Ex: If Eicher motors says 25th Aug 2020 as record date, they will take list of
shareholders of that company on that day (end of the day like 5pm), and issue
new shares to these people. If your name is there in that list on 25th Aug, you will
get the new shares with face value of Rs 1 on payment date (generally around 10
days from record date).

3. Ex-Date: This is most important date for investors, if they buy shares on this
day, they WILL NOT GET the benefit of ca since the shares are trading
EXCLUDING the BENEFIT of C.A that day. This is one BUSINESS DAY
before the record date.

Ex: If Eicher motors stock split record date is 25th Aug, Tuesday, Ex-date is 24th
Aug Monday. if you buy on Monday 24th Aug or later, you will not get the stock
split benefit since your name cannot appear in the shareholders list on record date
in stock exchanges (Current system), it will take 2 working/business days to settle
all the trades happened in that stock exchange.(T+2 settlement).

Ex: If you purchase stock on Monday, stock exchange will credit the shares in
your DEMAT account by Wednesday

Trade day (T) - Monday

T+1 day -Tuesday
T+2 day -Wednesday
Since stocks are trading without the benefit of C.A on ex-date, share price will
automatically adjusted in the markets on this day.
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Ex: Eicher motors stock split record date is 25th Aug 2020(Tuesday), ex-date is
24th Aug (Monday).on that day 24th/Monday), stock price started trading at Rs
2100 appx which was earlier trading at Rs 21000 (appx) since 1 share is split in
to 10 shares Fund accounting teams can record this C.A on ex-date and give effect
in NAV calculation. If not updated on this date, NAV will be incorrect.

Ex: If the fund has 1 share, they will report Rs 21000 as portfolio value before
the ex-date. On ex-date share price decreases to Rs 2100, they MUST update the
number of shares as 10. So, the portfolio value will still be 21000 (10 shares 2100
per share), if quantity is not updated and left as 1, the pricing team/valuation team
(team responsible to update the market values for NAV calculations) will take the
today's market value which is Rs 2100 and consider old quantity which is 1 share
and report the market value of portfolio as 2100 and report the loss as unrealized
loss.

Journal Entry on ex-date for a CA like dividend is;

Dividend Receivable A/c Dr 1cr

To Dividend Income 1cr

This will be reversed when received, payment made

Bank A/c Dr 1cr

To Dividend Receivable A/c 1cr

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 • Dividend • Buyback of • Mergers
• Right issue shares • Acquisition
• Bonus issue • Stock split • Spin off

Dividend: If a company has profits and they want to pay these profits to investors,
they declare dividend this is most common C.A by most of the companies.
Companies not having expansion pains will distribute the profits. If company has
expansions they use profit to reinvest. So, no dividends.

Bonus Shares: These are free shares issued by company to investors (existing
investors) by converting reserves (accumulated profits/profits of previous
years).in fund accounting we update the quantity of shares in the books when this
is done. If it is 1:1 bonus issue, if the fund has 100 shares they will update the 100
more shares in quantity.

Stock Split: Stock face value reduced from Rs 10 per share to Rs 5/2/1 etc. so
more shares are created in that company.

Spin Off: One company is dividend in to many companies or two companies by

spinning off/demerging one division to a separate company.

Ex: If Reliance Company has 3 businesses like telecom, petrochemicals, retail,

they can spin off telecom/Jio as separate company to manage it better.

Buyback of Shares: In this case the company buy back some shares from
investors, share price will increase in this case since number of shares are
reduced.

Rights Issue: Issue shares to existing shareholders when company need more
capital generally they sell at discount to old investors, it is right to old investors.
If they are not interested, company will sell to others and raise money.

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Reconciliations:

These fund houses have to reconcile the data before finalizing the NAV
and sent to investors. Since the NAV process include many parties like custodian,
fund administrator, fund house/investment manager, prime broker etc.., there can
be differences between the data of these parties.

Ex: Goldman Sachs hedge fund has below parties in the NAV life cycle

• Goldman Sachs: General Partner/Investment Manager, who launched the

fund, managed the fund, responsible to send NAV to investors and regulators
etc.
• State Street: Fund administrator who prepares the financial statement and
NAV, operating bank accounts of the funds like make payments on behalf of
the fund, provide audit support etc.
• BNY Mellon/State Street: Custodian who keep the assets of the fund like
shares in their custody. They also update the corporate actions like bonus
shares in their accounts so number of share owned by the fund is correctly
reported.
• HSBC Securities/Goldman Sachs Securities: Prime broker, like a stock broker
they help these fund houses to open Demat account, trading account, place
order in the stock exchange on behalf of fund houses.

There is regular dependency, co-ordination between these parties to manage the

fund, to report NAV. There can be discrepancies in the data between two parties.
All line items/important line items in the balance sheet will be reconciled between
two parties to ensure they are correct.

Ex: If the investment manager like Goldman Sachs prepares management fee and
incentive calculations, they will compare the calculations made by state
street/fund admin and ask the fund admin to update/correct.

Similar way they reconcile all other important line items like bank loan,
Investments, cash etc..,

Most important line items or line items having more balance in a fund are
investments and cash.

***GS – Goldman Sachs***

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Ex: If the fund has total assets of 500cr, investments can be 450cr and cash can
be 30cr, other assets can be 20cr to ensure these two line items are correct, they
do the below reconciliation. most of the times this recon is out sourced to other
company where many team members will do this as a separate task (if GS out
sourced fund accounting to SST, they may give this recon to HCL State street
these teams main work is to complete recon of 100s of funds so fund admin can
use that finalized numbers in NAV calculations)

To reconcile investments and cash, the below reconciliations are done by

these recon team;

1. Position Reconciliation: To ensure the position of investments or value of

investments is correct between two sets of data.

Ex: In Goldman Sachs hedge fund, apple company shares reported by GS are
1000 and the balance of apple shares in fund admin books are 950. Similar way
there can be difference between prime broker and fund admin books. Reason can
be;

A. GS/Investment manager asked to buy 1000 shares of apple at Rs 500, prime

broker placed the order for 1000 shares, they are able. To buy only 950 shares at
that price is Rs 500 per share. Market price went up to 520 that day so they are
not able to buy balance shares in this case, GS numbers to be updated Rs 950.

B. Apple Company announced bonus shares of 1:1 which means if the fund has
100 shares, they will get extra 100 shares at free of cost. Today is the ex-date (one
day before record date, date on which the fund can record the benefit in books),
quantity of shares are updated by custodian on the same day but fund
administrator and investment manager forgot to update the quantity. so one
sources(custodian ) is reporting 200 shares and others are reporting only 100
shares, in this case custodian data is correct, others has to update.

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2. Cash Reconciliation: This is to ensure the cash balance of each fund is
correct.

Ex: As per prime broker who buy and sell shares on behalf of the fund, the closing
balance of Goldman Sachs hedge fund is Rs 10cr. As per fund administrator
books, it is reported as Rs 9 crore. Reasons for difference can be;

A. One trade (purchase of investment) is made in US dollars and paid 1000 us

dollars, it is updated as Rs 1000 paid by one party.

B. One trade is completely missed by one party so cash balance is not updated
This recon if made between two sets of data that data is from two different
companies, they call it as external reconciliation if that recon is done between two
teams in same company, and it is internal reconciliation.

Ex: If data of GS and SST is reconciled it is external recon, if data of Front office
of GS (where trades are accepted and placed into stock exchange) and back office
(where contract notes are prepared, profits are calculated on traders), it is internal
reconciliation.

Intercompany entries:
➢ GS Asia Fund Paid Expenses of GS Europe Fund

Receivable from affiliates A/C Dr 100

To Bank A/C 100

➢ When Received From GS Europe Fund

Bank A/C Dr 100

To Receivable from affiliates 100

➢ In GS Europe Fund

Professional fee A/C Dr 100

To payable to affiliate A/C 100

➢ When paid

Payable to affiliate A/c Dr 100

To Bank A/c 100
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If the master fund call the money from feeder fund, and feeder fund invest in
master;
1. For feeder it is an investment in master
2. For master it is capital received from investors

➢ When feeder fund received money from their investors

Bank A/c Dr 500
To Capital Contributions Receivable A/c 500
➢ When they invest money into master
Investment in master A/c Dr 500
To Bank A/c 500
➢ In the master books entries are same

➢ When called the money

Cap cont. Receivable A/c Dr XXX

To Capital A/c XXX

➢ When Money received

BANK A/c Dr XXX

To Cap cont. Receivable A/c XXX

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