Fund Accounting Notes

PRIVATE EQUITY FUND Private equity fund pools money from wealthy investors and they can invest that money into any business/ any asset class (like startup company shares, real estate assets, infrastructure projects…. etc.) give that money back to investors with profit/ losses. In case of mutual fund/ hedge fund, the money normally invested into equity share of listed company (like Apple, Reliance, … etc.). they will buy very less amount of stay from those companies like (0.1% to 1%). Eg: - total value of shares/ market capitalization of reliance company is Rs.16,27,000 crores. If mutual fund into shares that company, then they need approx. 16000 crores for 1% stake, it is not easy for that fund arrange that much money. Since the mutual fund raise small money, they can’t invest all (or) major portion of money in one (or) two stacks. Also, not easy to buy major stake in stock exchange from other investors. However, private equity funds target to buy major stake in company (listed company/ private company) to invest major amount on a company. They pool the money from wealthy investors, since they have major stake in the company. They will also have significant influence on the management of the company. Ex: - if KKR (Kohlberg Karvis Robert) fund company invest $1000 crores in a company CCD (Coffee Café Day), they will also participate in board directors meeting, appoint one of the KKR employee as a board director of that company so they can understand the risk in the CCD business and they can guide/ advice the company if needs. Since the type of investment, they are making is illiquid investments which means they cannot sell equity, then also expect their investor (investor in PE fund) to invest for long term like 10 years like without an option to withdraw that amount, so this PE funds generally closed end funds with approx. 10 years of life time. Ex: - If KKR launches a new fund, if Ratan Tata invest in that fund is 100 crores, Ratan Tata cannot withdraw that amount till the fund is able to sell the investment and give money back to Ratan Tata. Most of this fund collect money from developed countries like America and invest that money in the same developed countries (or) in emerging/ developing economics like India, China. So, they can give better return. 1 Ex: - if Block Stone launches a fund in America and raise 30,000 crores. They will not invest 1000 crores in China and 2000 crores India and give approx. 15% return on those American investors, for those investors this is very good return compared to 1% approx. rate of the interest in those countries. Characteristics of these PE funds and their investments are: a) Huge amount of investment in companies/ assets. b) Long-term investment like 5+ years in each company/asset. c) Take significant in the asset/ company so the fund can also have decision making right, this can help to drive the business and try to each earn more profit in 5 to 7 years period and exit from that investment. If the fund is launches in 2021, it may not be easy to the fund to invest all the money in 2021 itself. Since most of the times the money is invested into illiquid assets/ securities, rea estate assts, startup companies (there is no active market like stock exchange to find out the securities to buy). This means if the fund collects all the money, they have to kept it idle from some time till they find opportunity to invest that money. Considering these difficulties to manage the cashflows in the fund, finding investment opportunity in the market… etc. the activity in this PE funds are different when compared to mutual fund and hedge fund. Assuming a fund as closed end fund with 10 years life time tentative life cycle of the fund is given below 1st Year year Name of the period Launch Up to 4 years 5th to 8th year Investment period operations 8th to 10th year Exit period 10th year Windup/ liquidation Details Launch of the fund, finalize list of investors finalize structure of the fund Find the investment opportunity, negotiate and invest. Keep operate the investment, increase the value of investment. Keep selling investment/ existing from investment. (Finding right buyer at good valuations and sell on after the other) Each fund is separate legal entity, if investments are sold liquidate that legal entity. 2 Launch: If a fund house like KKR decided to launch private equity fund, they will target the potential investors with a document called as PPM (PRIVATE PLACEMENT MEMORANDOM). Which will have all the details that can an investor want to know like a) b) c) d) Duration of the fund Expenses in that fund Investment objective/ investment strategy of the fund Risk and expected return from the fund………………………. etc. If investors are ok with details and interested to invest, they will agree (or) if they are expecting any changes like reducing the duration of the fund, decrease the exposure to one industry investment (like investment in technology companies). the fund house will update those details and reach to investors, after all the process fund house can finalize the list of investors and the money that can be raised. Once the list of investors and their commitments (their promise to invest in the fund and their amount of investment), the fund can have a close like first close (close means list of investors and their commitments are finalized). If fund need more money and investor has invest fund can have 2nd close, 3rd close … etc. where each time the amount available for the fund (fund size) will increase. At the time of raising money / taking commitments they can come across international investors who are ready to invest in the fund, this creates some issues to the fund like some international investors not allowed to invest in that fund (based on that country rules) or those international investors may have to pay tax in the fund raised country (like America) and also country of that investor (like India). To avoid this issue, generally these PE funds will have (Hedge funds also) complicated structure like one fund in America (Main fund/ Master fund) and one sub fund in maturities/ Cayman Island (Feeder/ off shore fund). So that these tax and regulatory issues can be avoided or reduced. Once the close is over and fund has same commitments, they start researching for investment and it will take 3 to 4 years to complete the research and make investments one after the other 3 Generally, these funds are registered as limited partnership entities (LP) which are easy and convenient for this business of pooling money and invest and liquidate after certain period like 10 years. If Goldman Sachs has 100 PE funds, they will register 100 separate limited partnership firms (or) more after considering sub-funds (each fund / sub-fund is a separate legal entity) Limited Partnership: Most of the private equity, hedge funds register the fund as limited liability this means, each is a partnership between the partners and the fund managers this partnership will be dissolved once the business is over Ex: if KKR launches a PE fund in America, they will register that fund as “KKR Asia fund LP”. All the investors in that fund are partners in that partnership entity. Other format generally used by these funds is LLC (Limited Liability Company). if the fund house like KRR has 100 PE funds, 100 hedge funds, they will register all of them as separate entities like limited partnership or as limited liability companies/ any other legal entity Limited Partnership Agreement (LPA): This is an agreement between the limited partner (investor) and general partner (fund managers) in the fund that is registered as limited partnership This agreement will have all details about the fund like duration of the fund, how management fee or incentive fee is calculated in that fund, when the financial statements are prepared… etc. This is legal agreement between the partners and they have to follow the terms. (PPM is only advertising material) 4 Limited Partner (LPs): All the investor in this fund are limited partners, they will have limited liability in the extent of their commitment to that fund and not beyond that. Ex: - In KKR, Trump committed to invest 100 crores. If the fund in to some assets by borrowing more money like 1000 crores and incurs huge losses, Trump is responsible only to the extent of his commitment of 100 crores. This is similar to limited companies where shareholders are only responsible for the company losses up to their investment in that company and not beyond their investment in shares. Most of the PE/ Hedge funds will have these investors/ limited partners from 1 to 1000 (mostly less than 100). General Partner (GP): This partner is the main partner who manages the fund responsible for all gains/ losses in the fund. Generally, the fund house like KKR appoints a legal entity as GP. Ex: - In KKR Asia fund, limited partner is Trump, others, GP is KKR GP Ltd. That legal entity (KKR GP Ltd) is owned by KKR and fund manager/ managers (Robert and Ram for example) will be part of the legal entity In mutual funds, they appoint individuals like Ajay as fund managers since all investor fund manager will have limited liability (event fund manager investment) However, in PE/ Hedge funds, since they register as limited partnership, GP also should invest some money to become partner and suppose to have unlimited liability so to avoid this issue, they register the GP as a separate legal entity. If that legal entity (KKR GP Ltd) has net assets of 1 crore and liability of the fund allocated to GP is 100 crores, that GP can only pay 1 crore, legal protection will be there for that GP so on one can recover beyond that amount of 1 crore which are net assets. Investors Trump Dhoni KKR GP Ltd Limited partner 100 crores 100 crores General partner 1 crore Total 100 crores 100 crores 1 crore 201 crores 5 Investment Paytm Cost 201 crores Sold 20 crores Loss 181 cores In this case all 181 crores loss is absorbed by the fund/ investors in the fund in their ownership ratio approx. 90 crores loss to Dhoni and Trump. GP also responsible up to 1 crore that is commitment, not more than that. Assume fund took 400 crores loan from bank and invested 601 crores in Paytm, sale price is on 80 crores, then loss is 521 crores (601-80). Since loss is more that capital commitment, GP unlimited liability concept comes in to the effect. Loss Trump 100 crores Dhoni 100 crores GP ? 1 crore since net asset are 1 crore in this case as mentioned below, if the net assets are up to 1000 crores, then all loss can be recovered from GP. Assets Cash 2 crores Investment 1 crore 3 crores Liability Loan 2 crores Net assets 1 crore Close/ First Close/ Second Close: Close refers to finalizing the list of investors their commitment by PE fund. Ex: - KKR Asia fund LP raised $10 billion in the first close, most of the institutional investors came India, America participated in this close. If the fund needs more money, they can have second close where old investor can came at more money or new investor can came at for the 1st time. 6 Ex: - KKR had second close for Asia funds raised $4 billion where $2 billion dollars came from existing investors, $2 billion dollars came from new investors from Europe region. There can be funds where the first close is the final close, new investors are not accepted after the 1st close. Other funds can have 2 or 3 closes depends upon the requirements. However, most of the funds will have a condition that all these closes should be finalize within 18 months from the launch date, time period is called as commitment period. Onshore Fund/ Master Fund: This is the main fund where the general partners/fund managers are participating. Most the fund the investor are reported in the fund, generally most of the investment are also reputed/ invested in (through) this fund. Ex: - if sequoia capital raises fund in America, they will register the onshore/ master fund in America (mostly in Delaware state in USA) and most of the investors (local/America investor) will invest that fund. the money raised will be invested in America (or) other country like India. Sequoia Venture Capital (Asia) IV LP Is the Onshore/Master Fund. Investors Buffet Elon musk Sequoia (Cayman Island) venture fund LP Sequoia (GP) Ltd Commitments in cores 500 600 1000 100 Partnership type LP LP LP GP Offshore/ Feeder Fund: Name Investors Amitabh Priyanka Deepika Sequoia (Cayman Island) venture fund LP Commitments in crores GP/LP 600 LP 300 LP 100 LP 7 Off shore fund/ feeder fund is created (generally/common reason) to save tax to the international investor. If Indian investors re investing in America, they will launch a separate fund in a tax haven like Cayman Island and these international investors (from India/UK/Singapore… etc.) will invest in the fund. That offshore fund will invest into master fund/ onshore fund. In the book of master fund (Sequoia (Asia) venture capital IV LP) this offshore fund is the investor names of Amitabh…. etc. (international investors) not appeal. As per American government, Cayman Island tax treaties, these investment from Cayman will have no tax/ less tax so this can save tax to the international investors. Feeder funds means a fund that feeds (sends) money into the main fund/ master fund. Only purpose of this feeder fund is to pool money from some investors and send that money into main fund. Most of the times fund is the only feeder in the structure. however, there can be onshore feeds also some times. Ex: - sequoia Delaware entity is master Sequoia New York entity can be onshore feeder Sequoia Cayman Island it the offshore feeder Blocker Entity: This is another legal entity in the fund structure used by some funds Ex: - if the fund is investing in to India, they may have to pay tax in India also on sale of that investment (Flipkart) to avoid this they can have a separate firm/ company registered in Mauritius and it is blocker. Since this blocks/ reduces the tax liability of the fund, it is called as blocker Main difference between feeder and blocker is feeder/ offshore is to pool money from international investors and invest that money in that fund so tax of investors is saved. Blocker purpose (generally) is to save tax at fund level by avoiding tax on sales of an investment like Flipkart. 8 Sequoia Delaware fund is onshore Sequoia Cayman is offshore fund Sequoia Mauritius can be blockers which is intended to save tax on sale of Flipkart. Assume that fund is investing into Flipkart 1000 crores now the steps will be 1. Master fund (Delaware entity) calls money from investor 2. Onshore/ America fund investor pay money directly to the main fund/ Delaware fund 3. Offshore investor like Amitabh will pay to offshore (Cayman Island fund). That Cayman fund send money master fund in America 4. Master fund/ America fund has all the money. They will now invest into Mauritius company/ firm 5. Mauritius company/ firm will now invest into Flipkart company Private Equity Cashflows: Mutual fund & hedge fund pool the money at the time of launch and then invest that money in short term. However, PE funds generally takes time to finalize the investments since most of their investments are illiquid investment like startup companies, real estate, infrastructure companies… etc. they take commitment from each investor on how much that investor is ready to invest and start finding the investment opportunities. Once fine the right opportunity, they will collect the money from each investor by calling that money (send capital call notice) Generally, they give 15 days’ time to each investor to send that money to the fund. If that investor makes default to pay in the time, he is called as delinquent/ default investor. He should pay delinquent interest for that delay period, if the default continues general partners will decide the appropriate action like sell that investor stake to another investor. Similar way, if fund need money to pay for expenses, they will all money from each investor. Also, they will distribute the cash may be received as income (dividend/ interest) or selling investment. 9 Generally, fund collects money from 1st year to 4th year and start distributing from 7th year to 10th year. This will reflect as cash outflow to the investor in initial years and cash inflows in the later years. If we show this cashflow in graph, the curve will look like J. in the industry, they say the investors in pe fund should be ready to take J curve impact. J curve: Investor in private equity funds will have negative cash flows (and negative returns) in the initial years of the fund life time since fund is calling money from investors and investing but there are no sale/ appreciate of investments after 5 years, fund will sell the investment and distribute the money so money so investor will have positive cash flows. If we present these cash flows pattern in a graph, it will look like letter Ex: - Vintage year of the fund Found size Contribution Year Cash Flows 2020 -20 2021 -30 2022 -40 2023 -10 2027 50 2028 100 2029 150 2020 100 crores Cash flows 170 150 130 110 90 70 50 30 10 -10 -302016 -50 2020 2024 2028 2032 Commitment: This is the amount an investor is ready to invest in a fund, this is the maximum amount payable by that investor during the life time of the fund. Ex: - If an Amitabh committed Rs.100 crores to the fund, the fund has to ask/ call up that amount, generally they collect like below 1st year 2nd year 3rd year 4th year 20 crores 30 crores 40 cores 10 crores 10 This commitment generally includes management fee also which means there is no extra money payable by the investor beyond the committed amount towards expenses & investment, however, in some funds, this commitment is excluding management fee means total payable by end of the fund life time is 120 crores assuming fee payable in 10 years is 20 crores (fee outside commitment) Capital Call, Capital Call Notice, Contribution: When the fund need money for investment purpose or for expenses payment, they will call that money from each investor, it is capital call made by the fund. The notice sent to investor is capital call notice or drawdown notice. If investor pay the money to the fund against that capital call (cap call), it is contribution made by the investor. Fund is launched in 2021, they made investment in Flipkart in 2022 for 100 crores, call money from investor on their contribution. Distribution: Distribution means the fund is paying money to the investor this can be cash received by the fund by selling an investment (or) income received by the fund like interest/ dividend. Generally, these distribution-fund happens from 6th year. Depends on the nature of that distribution, these are grouped to a) Income distribution fund - received income like interest/ dividend/ rent and it is distributed to investor. b) Capital distribution fund – received cash by selling investment & distributed to the investor. c) In – kind distribution fund – received shares in a company in IPO process and they distribute those shares to investors in the fund. This investor can sell those shares in stock exchange. 11 Recallable Distribution: Distribution made by the fund belongs on investor and fund has no right on money, however if the fund manager thinks they may find more investment opportunity and they want to invest money later, so at the time of distribution they can inform the investors that a portion of money distributed will be called back and it is recallable distribution. Ex: - KKR fund launched in 2021, invested in reliance in 2021 and sold those shares in 2022 since they got good price. While distributing that money of 20000 crores, fund marked 5000 crores as recallable distributions. This means the investors should keep those 5000 crores ready to invest in the fund when the fund calls that money again, if they don’t recall to invest, investors can use it based on their requirements. Unfunded Commitment/ Remaining Commitment: This is the balance amount payable by investor to the fund. Ex: - If Amitabh committed Rs.100 crores in 2021 and paid Rs.50 crores till 2023, the unfunded commitment of that investor is 50 crores. if there is any recallable distribution, then the unfunded commitment will increase to that extent Ex: - in the above case there is recallable distribution of RS.20 crores (fund distributed some money in 2023 and marked 20 crores as recallable), then UFC (unfunded commitment) will be Rs.70 crores. Fund Name Investors Commitments In 2020 (A) Deepika Sunil Alia Bhat Akshay Investment In Dixon Technology Au Small Finance Bank NYKAA 50 100 150 200 500 India Business Excellence Fund IV LP ContributionsUnfunded Dixon in 2021 Commitments (B) In 2021 (C=A-B) 20 30 40 60 60 90 80 120 200 300 200 Crores 100 Crores 200 Crores Distribution Dixon in 2026 (D) 60 120 180 240 600 Recallable Distribution (E=D*50%) 30 60 90 120 300 Unfunded Commitments In 2026 (F=C+E) 54 108 162 216 540 Year 2021 2022 2023 Note: Every contribution decreases the UFC. Distribution will not impact the UFC unless it is recallable distribution. Recallable will increase the UFC. 12 Management Fees: Management fee paid by the investor to fund manager/ general partner for managing their money. This fee is generally charged on NAV of that investor/ fund. Ex: - if the management fee rate is 2%, NAV of the fund is 1000 crores, the fee in that will be 40 crores. If one the investor NAV is 100 crores, the fee payable by that investor will be 2 crores per year. In that private equity funds, the NAV will be very low in the initial years, also in the later years, since they may not invest the money in the first 2 or 3 years and they may have very few assets in later years in that year like 9th, 10th year So must commonly use method to charge management fee in the PE firm is charging fee on commitment. Ex: - if Amitabh committed 100 crores to the fund, he should pay 2 crores fee even if fund is not invested into investment (fund idle time in initial days & windup days) However, some investor not agree to pay the fee where the investment is not made so there are multiple methods which are decided based in negotiation between general partners and limited partners. This negotiation can be based on a) Efforts of the fund manager (the fund manager puts more efforts if money invested in startup companies compared to invested in public securities) b) Influence of investor of the fund c) The type of investment, tenure of the fund…. Etc. can also decide (if the tenure is more, risk of the investor will increase, so the refund may offer low fee rates for the begging or to words end of the life time of the fund. The other popular methods are 1) 2) 3) 4) 5) Commitment based Cost of the investment Fair market value of the investment based Switch/ conversion based NAV based Generally, this management fee is collected on a quarterly basis in PE funds. 13 Q. can the fund charges management fee in losses also? A. Yes, since the fund manager and their team time and efforts will go to manage the fund. 1. Commitments Based: Commitment Based Management Fee in Crores Commitment Investors Fee Rate Amount Kohli Kejriwal KCR Sharukh Total Year 100 200 300 500 1100 2% 2% 2% 2% Fee Amount 2 4 6 10 22 Fee Amount in crores 2022 22 2023 22 In this method, the fee from each investor will be same from the start of the liquidation/ closure of the fund even though the fund did not invest any money in that first year, they can collect money from the date launch this fund. 2. Cost of Investment: Ex: investment Q1 OYO rooms Q2 Paytm Q3 ----Q4 Bounce Total fee Amount (crores) 500 800 -1500 Investment Kohli Kejriwal KCR Sharukh Total Total amount 500 1300 1300 2800 No. of days 90(Jan-Mar) 91(Apr-Jun) 92(July-Sep) 92(Oct-Dec) Commitment 100 crores 200 crores 300 crores 500 crores Management Fee rate 2% 2% 2% 2% Fee amount Investment on 2.47(500*2%*90/365) 6.48(1300*2%*91/365) 6.55(1300*2%*91/365) 14.12(2800*2%*92/365) 29.62 crores. 1st January 2021 1st April 2021 ------1st October 2021 Fee 2.69 crores 5.39 crores 8.08 crores 13.49 crores 29.62 crores (2800 > 1100) → Because Borrowing in money, recallable distribution. 14 Notes: a) Quarter 1 (Q1) total fee is 2.47 crores, collected from investor in April 2021. b) Quarter 2 (Q2) total fee is 6.48 crores, collected from investor in July 2021. c) Quarter 3 (Q3) total fee is 6.55 crores, collected from investor in Oct 2021. d) Quarter 4 (Q4) total fee is 14.12 crores, collected from investor in Jan 2022. In cost of investment method/ invested capital method, The fund can charge the fees only on amount invested, which means if the fund is unable to make any investment in the first year, they will not get any fee in that fund Generally, the fee in this method will be compared to any other method if investor, negotiates to pay the management fee based on This method on it might create pleasure on the fund manager to invest the money quickly, they might invest without conducting proper research/ due diligence most of the times, the fund manager will negotiate for leverage option in this case, which means the fund can borrow the money and invest, so Total invested capital can be more, the fee also be more. 3. Fair Market Value of The Investment Based: In this case the market value of the investment is considered as fee base. If the fund makes good investment, The market value is increasing, the fee will be more, else the fee will be less. 4. NAV based fee: in this case net asset value of the fund is used as fee base. ex: as of 31st march 2021, the nav of that fund is 100 crores, so that fee for 1st quatres 2021 will be 0.49 crores, in the next quoter if the nav is 500 crores, the fee will be 2.49 crores. 5. Switch based fee/ conversion method: some funds follow a specific management fee method like commitment method for a certain period like 4 years, The method will be changed later (cost of investment method). Ex: - The fund. is launched in 2021, up to Dec 2021, the fee is 2'%. On commitments (2 crores per assuming the commitments of 100 crores) if invested capital is 500 crores, in the 5th year, The fund will get Rs.10 crores as fee. 15 while calculating of each investor, there can be adjustment are applicable only to investor in the investment. Those exemptions should be considered while raising the invoices/ allocating fee Expenses to each investor to calculate NAV The common adjustments are: 1) Tier based fee: This case an investor who committed/ invested more money will be the fee at lower rate Commitment 1 to 100 crores 101 to 500 crores 501 to 1000 crores Fee rate 2% 1.75% 1.5% 2) Fee Free Investor: some investor in a fund don't fee on their funds, they should Excluded to calculate management fee in that fund Ex: a) General parties of the fund b) Employees of the fund house (Goldman Sachs ⇒ Employee of Goldman Sachs fund) 3) Step down method: in some cases, investor can negotiate lower fee rate in the later year of that fund life time, if the efforts of the fund manager are Expected to go down, over a period. Ex: if the fund is following fund of fund strategy, The fund manager. efforts are more, in first 4 years to find out the names of that fund to make investment, later, those investment are managed by the fund manager of underlined fund (if KKR fund invested in JP Morgan fund, actual management of investment is done by JP Morgan fund manager, not KKR fund manager). so that fee rate can go down Year 1 to 4 years 5th year 6th year 7th year 8th year Fee Rate Terms 2% 75% on previous year 75% on previous year 75% on previous year 75% on previous year Effective Fee Rate 2% 1.5% 1.125% 0.84% 0.63% 16 4) Side Letter Arrangements: Sometimes, a fund will enter in to separate agreement/ side letter with some of the investor in that fund, those investors will get discount in fee. Ex: Kotak Mahindra private Equity ford has Dhoni, Amitabh each of them invested 500 crores, asper LPA (Limited Partnership Agreement), The fee rate is 2%. On commitment. However, the fund entries in to a side letter arrangement with Dhoni to give 0.5%. discount to him since he also investing anther fund launched by Kotak. Incentive Feel/Performance Fee/ Waterfall Provisions/ Carried Interest: - Private equity funds (Hedge funds also) take a portion of profits apart from charging the management fee to the investor. most of the funds will have these arrangements to shares these profits between General partner (fund Houses) and limited partner. In most of This fund the GP will take 20% of profit, Investors/ limited partner will take 80% of profits. However, based on the negotiation between General partner and limited partner. this profit-sharing ratio and terms & conditions of this profit sharing can be different in different funds. Investor can negotiate to give priority to them since they are investing in that fund, any losses should be borne by them. The GP can negotiate to have a higher profit share, since they have too more Efforts from the inception of the fund till liquidation of the fund, Their Efforts are generating very good profits to the investor. Based on negotiation between general partner and limited partner at the time of launch They will decide all terms and conditions include those terms in LPA (Limited Partnership Agreement). The section/ provision that are Explaining on how the profits will be distributed within general partner and limited partner are called as waterfall provisions. since the distribution of cash is done in a follow/ order between GP & LP. 17 Most common order/ Higher authority of cashflow distribution in this PE funds is: a) Distribute the cash to words principal amount/ invested amount of on the investors (from cash received by the fund on sale of investments/income receivable) b) Pay certain amount as return/ profit to the investors (since they can make some profit by investing in other sources/ asset also like govt bonds, stock market...etc.) C) If portion of profits/available cash in fund as general partner share before the remaking profits/ cash can be distributed between general partner & limited partner. Generally, this profit share by general partner (catch up) will be 20% of profits (preferred return of limited partner) that is already paid to investor in the above step. D) Distribute the remaining cash profits in the agreed ratio like 20% to general partners and 80%. to limited partner. Example: Water fall calculation Fund Name Commitments Year 2017 January 2017 January 2017 January ICICI Advantage series IV LP 2500 crores Name Amount ING VYSYA BANK 500 KIMS 1000 Star Health 1000 They sold investment in December 2021 for 10000 crores. Preferred return payable is 10% per year. Details Eligibility Paid Principal Preferred return Profit share-20% GP Profit share-80% LP 2500 250 NA NA 2500 250 1450 5800 Balance cash 10000 7500 7250 (7250*80%) 0 Carried interest/ profit share Rs.1450 crores transferred to the general partner. In this Waterfall provisions there are two types (commonly followed in the industry) They are: 1) European waterfall method 2) American waterfall method 18 1) American Waterfall Method: The profit sharing can be done based on the sale of one investment also (deal by deal profit sharing), Through there is a possibility that the remaining investments may give loss on a future date. Ex: - KKR fund collected 1000 crores, invested 200 crores in Paytm, 200 crores in Bijous...etc. in the 5th year, fund sold one investment (Paytm for 400 crores), since there in profit on that investment, the general partner can take profit share. 2) European Method (Whole of Fund Method): The GP can take profit share only after returning all the money to investors to words their principal and preferred return (expected return like 8%.per annum) Ex: - If the fund sold Paytm for 400 crores and made 100% profit on investment of 200 crores, the general partner will not take any profit share, rather all that money will be distributed to investors as principal. Till time all investors investment of 1000 crores are paid the general partner will not be eligible for-profit sharing. Hurdle Rate: This is the rate at which they will pay/ profit to the investor on their investment, Before the profit can be shared between GPs & LPs. Ex: - If the hurdle rate of fund is 10%. GP is eligible to share of the profits only after generating a profit 10% in that fund. This rate is applicable per annum/ year. investor can Expect certain return like 4% if the invest into risk free securities like government bonds, Bank fixed deposits...etc. so, they can expect more return than risk return 4% by investing in private equity fund. Since Risk more in PE investment compared to investment in govt securities. Since the risk is high, the investor can Expect a premium return then risk free return in that country 19 Ex: - If risk free return is 4% (on government bonds in a country like America), The investor can negotiate additional 4% and Expect 8% return per year. most common Hurdle rate in The PE funds across the global is 8%. If the fund is following Hard Hurdle Rate, The Fund manages/ General partner can take profit save on profits exceeding return calculated by using the hurdle rate Ex: - Investor gave 100 crores to the fund on 1st January, that fund returned 120 crones on 31st December, which means the profit is 20% per annum. if fund has 10% hurdle rate, The principal of 100 crores, The preferred return 10 crores belong to the investor and general partner can take 20% profit on the remaining profit of 10 crores. If the follow Soft Hurdle Rate, General partner can take profit share on total profit, if the return Exceeds the hurdle rate Ex: - in the above example can take 20%. On all the profits of 20 crores, since they made the profit, the profit is beyond the hurdle rate. Preferred Return: - This is amount calculated on investor principal amount as minimum return (expected return) to be paid to the investors before GP can take. The share in the profit, this calculated by using the hurdle rate. if an investor gave 100 or to the fund '1st January, the hurdle rate is 10'%, The preferred return payable as on 30th June Will be 5 crores, as on 31st Dec it will be 10 crores. Ex: - Date Contribution 1/1/2017 1/1/2018 1/1/2019 1/1/2020 100 crores 0 0 0 Preference return 10 crores 11 crores 12.1 crores 13.31 crores Closing balance 110 crores 121 crores 133.1 crores 146.41 crores on the same amount, Preferred return payable as on Dee 2020, Rs.146.41 crores. Out of the Rs.146.14 crores, principal is 100 crores so the preferred return payable as of Dec 2020 is 46.41 crores. 20 Catch Up: This provision in waterfall gives a right to the general partner to receive in the portion of cash before distributing in 20:80 ratio between GPs and LPs. Ex: - if the cash available in the fund is Rs.200 crores after distributing principal amount and preferred return, then the general partner will get Rs.40 crores (20% on Rs.100 crores) as share if there no catch up. If catch up will applicable 20% on preferred return, the general partner will get catch up of Rs.20 crores (let assume preferred return paid is 100 crores), the remaining cash of Rs.180 crores (200 – 20) distributed in the agreed ratio like 20:80. Sometime General partner can face an issue if remaining catch in the fund after distributing principal amount and preferred return is very less, sharing that amount also with limited partner may not be appropriate for the efforts of the general partner. For suppose, the amount of investment sold at 125 crores after 3 years. then general partner distributes Rs.100 crores as outstanding principal and Rs.24 crores as preferred return (8% per annum). The remaining Rs.1 crore will be distributed under agreed ratio 20:80 between GPs and LPs. So here general partner gets very lower incentive Rs.20 lakhs. To generate the 8% preferred return, the general partner should put the efforts like find out the right time to investment and find out right buyer to sell investment at right price… etc. after all these efforts, the investor can be happy with 8% return, if general partner is not receiving any incentive fee/ very low incentive fee, that can be discourage general partner. this Catch up will help some extent to give priority to the general partner. Most commonly agreed ratio Catch up percentage is 20% on preferred return amount. this will ensure the general partner is catching up with limited partners in profit share, at this stage, limited partners get preferred return and general partner get Catch up, so both can feel comfortable to share the profit in the next face In some of the funds, the catch up is kept at 25% on preferred return. 21 Examples: Fund Name Fund House Fund Size Name Kohli Sania Sindhu Dhoni Total Date 01-01-2021 01-01-2022 01-01-2023 01-01-2024 India Reality Excellence Fund Iv Motilal Oswal 1000 Crores Commitment 200 300 200 300 1000 Opening Total Hurdle Preferred Total Invested Balance Contribution Distribution O/S Rate Return Amount Sriram Apartments 500 500 10% 50 550 Nitesh Shopping Mall 550 200 750 10% 75 825 Prestige Office Space 825 300 1125 10% 112.5 1237.5 Rent Distributed 1237.5 -50 1187.5 10% 118.75 1306.25 Assumed the fund sold all the investment in 2024 dec for the below price, what is carried interest/incentive fee/performance fee to the general partner Investments Sales Price Sriram Apartments Nitesh Shopping Mall Prestige Office Space 500 250 375 1175 Cash Available Rs Outstanding Principal Preferred Return Catch Up Paid 950 356.25 71.25 Balance 950 225 Calculation 225 1175-950 0 Profit Share – GPs Profit Share - LPs if the sale price is different, the distribution/ water fall will be like Investments Sriram Apartments Nitesh Shopping Mall Prestige Office Space Sales Price 650 380 345 1375 Cash Available 22 Rs Outstanding Principal Preferred Return Catch Up Profit Share – GPs Profit Share - LPs Carried Interest Paid 950 356.25 71.25 Balance 950 356.25 68.75 Formula 425 1375-950 68.75 425-356.25 68.75 if the fund sold the investment for better price, the carried interest can be more to the GP as mentioned below Investments Sales Price Sriram Apartments 900 Nitesh Shopping Mall 600 Prestige Office Space 600 2100 Rs Outstanding Principal Paid Balance Formula 950 950 356.25 356.25 793.75 Catch Up 71.25 71.25 722.5 Profit Share – GPs 144.5 144.5 578 578 578 Preferred Return Profit Share - LPs Carried Interest 1150 2100-950 215.75 71.25+144.5 Catch Up Reconciliation Outstanding Principal GP LP 20% 80% 950 Sale Proceeds 2100 Profits 1150 share in profit percentage of profit catch up profit share total carried interest percentage of profit 230 20 71.25 144.5 215.75 18.76086957 920 23 Claw Back: Claw back means investors can pool back the excess carried Interest paid to general partner, if they realize that eligibility of carried interest is less, the have already paid more of it. Ex: - If the fund paid 100 crores as carried interest, based on the calculations it is 80 crores, The fund can collect 20 crores from GP, that will go to investor. This can happen based on the terms and conditions agreed in that fund, like in American waterfall method, The fund paid carried interest on sale of first one investment, since they made good profit on that investment. (If fund Made losses or other investments, investors may not receive their principal, preferred return on total investment into the fund). in this case GP should return a carried interest already Received. Ex: - Fund name: KKR India Fund Investments in Cost in crores Paytm 500 Biju’s 1000 Oyo rooms 1000 total 2500 Total investment Preferred return (assume 5 years) Sales prices in crores 1500 500 600 2600 Profit in crores 1000 (500) (400) 100 2500 crores 900 crores In the case, at fund level, the general partner can take carried interest only if the sale proceeds are more than 3400 crores (2500 principal +900 preferred return), However, the total sales proceeds are only 2600 Crores. On first sale of Paytm, fund made good profit so fund manager/ General partner took carried interest, later the fund made more losses. So, Limited partner are unable to receive their principal and preferred return, in this case, limited partners can pull back the carried interest paid on sale of Paytm from general partners. 24 Investment Strategies in Private Equity: At the time of launching the fund, the fund manages/ fund house will inform to the investor about the investment strategy of the fund. Like which asset class they are going to invest, in which market (location) they will invest...etc. based on this investor can decide. If they can take the risk, it is depending upon the investment strategy of the fund (if the fund invested in Real estate, the risk can be less. If invest in startup, the risk can be more). This private equity funds (Hedge funds also) can invest into any asset class Such as a) Traditional assets (shares/ Debentures) b) Alternative assets (Real estate, gold...) Most common investment strategies followed by PE funds are 1. Venture Capital 2. Real Estate 3. Infrastructure 4. Credit/ Debt 5. Distressed Debt 6. Fund Of Funds 7. Pipe (Private Investment in Public Equity) 8. Mezzanine 9. LBO (Leverage Buyout): Venture Capital: in this strategy, the fund will invest into startup companies since the business of these companies are new and the product/ services is innovative, it is difficult to predict the success/ failure of the business so risk is high in this strategy. Ex: if sequoia launches a fund and invest into startup's like Vogo bikes, Cred, Biju’s ...etc. It is venture capital strategy, if start up where the fund invested became successful, the fund will make very good profits (Since they get the shares at very low price), However, if the business is failure since founder of startup made mistake (or) business is unable to understand the requirements of the customer...etc. this business can be a failure and fund can incur 100% losses also by investing in these startups. 25 At the starting stage of business-like startup, they need less capital and over a period they business will grow and they need more capital. most of times the source of capital for these startups will be as below 1. Boot Strapping - Promotors own money arranged from savings and friends/ relatives. This can be sufficient to start the business and check the product/ service in the market. 2. Angle Investors → Wealthy investors like Ratan tata will invest into the startup funding can be in lakhs like 10/50 lakhs etc. they can also guide the startup increase the sales/ to understand the market. 3. Venture Capital Firm/ Venture Capital Fund: At this stage these startups can get move funding like 1 to 100 crores etc. company may be 3 years old by this time so venture capital firm (money of a firm/ family) or venture capital fund (pooled from investors as fund) will have some confidence to invest more money into the company. 4. Private Equity Fundings: By this time company is in growing phase trying to launch more products/ services (or) reach to more customers in different regions etc. so, they need more a capital like 500 plus crores. PE funds can also invest more money since the company has some reputation in the market and total collapse of business may not happen at this stage. 5. Public Issue/ IPO Initial Public Offering: - If company need more growth capital (or) earlier investors want to sell their stake, they can go for public issue and offer shares to public and list the shares in stock Exchange. Venture capital funds always invest in to startup and take more risk and aim for substantial returns. PE funds has more options on investing includes startups. If the funds provide finding to startups for the first time they call it as series a funding, second Line funding is made it is series B funding etc. Each time some funds came into the company as investors. They will value the company and shares and investment happens at that price Paytm funding/ series A, B, C. If the value of startup is more than 1 Billon dollars (7500 crores) it is called as unicorn. 26 PIPE (Private Investment in Public Equity): In this case a private Equity fund invests in to shares of a listed company like Bajaj finance, Axis back...etc. The reason can be the stock are available at Cheaper price so they can make good profit of the companies has plans to buy all the shares from public and delisted shares from stock Exchange so private Equity fund will help by funding...etc. Real Estate: This real estate funds (PE real estate fund) invest money into real estate assets like shopping malls, hotels, office parks...etc. These funds earn revenue from rent, parking charges...etc. and appreciation of properties over a period, will also contribute fund returns. To manage these assets, fund manager/ general manager take help from different parties like property consultants/ property managers, asset managers, valuers etc. fees paid to all this parties are included in the financial statements of fund. Asset managers help the fund to bring new tenants, navigate the terms and conditions of rental agreements etc. Property managers help to keep the property in good condition take care of maintains activity like guarding, lift maintenance ...etc. while preparing the accounts of these funds, they can be different adjustments, in the income (or) expenses/ Assets (or) liabilities depending on that type of assets, term and conditions relating to revenue from those funds...etc. Ex: - if a real estate fund offers rent free period to attract more tenants, The recognition of rental income can be different has Explained below. Fund name→ Blackstone Asia reality fund Investment name ⇒ Forum mall, Bangalore Tenant name ⇒ shoppes stop. Rent start time ⇒ 01/01/2021 Rent agreement tenure =⇒ 10 years/ 120 months. Contract end date ⇒ 31/12/2030 Rent per month => 10,0,000 Rent free period ⇒ 6 months from Jan to July. 2021 27 Rent collection period = 114 months. Total rent income from the contract ⇒ 114,00,000 (114×100000) Straight line rent ⇒ 95000 (11400000/120) This means the fund recognize Rs. 95000 per month as rent income from Jan 2021 itself though rent will be received from July 2021 (RS. 100000 per month). these 6 months from Jan to Jun, they can account the rent-free assets and reverse That asset from 7th from till End of the contract. Jan 2021 → Rent free asset account To Rent income account Dr 95000 95000 Post the same entry up to June, total amount rent free asset debited up to June will be Rs. 570000. From the month of July fund administrator can start reverse the rent free asset account (like a preliminary expenditure) throughout the life time of contract from amount of rent receives. Reversal per month ⇒ 5000 Number of months ⇒ 114 Total reversal ⇒ 570000 So, it will become zero by 10th year/ 120th month. From July 2021 → Bank account Dr 100000 To Rent income account To rent free account 95000 5000 To Sell this real estate properties, distribute that money to investor is not easy considering the amount of investment required is very huge. one of the roots available to sell the assets is launching a REIT (Real-estate investment trust) Steps: 1) Transfer all assets owned by these funds like office parks to a trust. 2) That trust can issue units to the public by converting the assets in to units. Ex: - if 10 office parks market value is 5000 crores, convert Them into 50 Cr units at Rs. 100 per unit and sell to public through IPO process. 3) List these units in stock Exchange like shares so These investors can buy and sell easily in the stock Exchange 4) Rent received from the property will be paid to unit holders as revenue at regular intervals like quarterly 28 Infrastructure Funds: These funds will invest into infrastructure assets like national highways, Air ports, Gas Pipelines, Telecom Towers etc. The revenue will be Toll gate charges, parking charges...etc. Selling these assets is difficult this fund, Similar to REIT, they can launch INVLT (Infrastructure investment trust). This Trust will own infrastructure assets, they will issue units to the investor, those units will be traded at stock Exchange. Distressed Debt/ Distressed Strategy; In this case the fund will acquire distressed company/debt from a bank/government authority/company at low price compared to market value, main source of revenue will be the appreciation in the asset value if they can complete the asset like real estate asset and sell to other. Fund of Fund: in this case one fund like KKR Asia fund will invest into other funds, like Blackstone Asia fund. main reason/ benefit is the money will go into the hands of specialized fund managers how knows the best opportunities in one specific area. Ex: - if Goldman’s Sarch launches a fund in America, they give amount to Blackstone who are specialized in real estate. They can also invest in sequoia fund who are specialized in venture capital (startup investments).it is also easy for the fund managers to invest the money in quick time they can provide more investment opportunities to the investors, Ex: - if HDFC launches international fund of fund, they can invest that money into JP Morgan US fund, so Indian investor can get the profits if US markets goes up. Major disadvantage of this model is more Expensive, since investor has to pay the Expenses at main fund level, The underlined fund level. 29 LBO: In this strategy, fund will take leverage, so they can earn more profit with less amount of investment. Ex: - If the fund holds 1000 crores, they can borrow additional 100 crores and invest. on the borrowed money, they will pay 4% interest, if they make 20% profit, there is a net profit of 16% on that borrowed money Asset value/ Company value Equity Debt Total After one year: Sale price Cost Interest payable Net profit Investor capital Return on % No leverage 10000 10000 0 10000 leverage 10000 2000 8000 10000 15000 (10000) 0 5000 10000 50% 15000 (10000) (480) 4520 2000 226% Due to borrowing, return is 226% in and case and it is 50% in first case. Mezzanine strategy → in this strategy the fund will invest in to hybrid securities like convertible Debentures where investors can get risk free return like investor for some time and return on equity later once the securities are converted into equity this strategy has medium risk and medium return (more return than debt and less than Equity. . 30 Financial Reporting: This PE firms/ all other funds has to prepare the financials and send to investor on periodical basis as agreed at the time of lunch. Generally, the frequency is 1. MF - Report NAV On Daily basis 2. PE funds → Monthly/ Quarterly financial statements. 3. Hedge funds → Generally on a monthly basis. This financial statements/ net asset value reporting will help the investor to understand the performance of the fund and to buy/ sell their stack in that fund from other/ to others. Generally, they prepared and send the unaudited financial statements on monthly/ Quarterly basis, they will send audited financials on annual basis. Most of this fund outsourced the preparation part to other companies (fund administrators), so they have co-ordinate between fund house and fund administrators to prepare Financial Statement and send to investor. Ex: - if Goldman Sachs launches the fund, they appoint state street as fund admin where state will prepare the financial statements, fund house (Goldman Sachs) will review, finalize this financial statement and then send to the investor (Goldman Sachs is responsible for investors to send in time and send accurate financials). These financial statements are prepared based on the relevant GAAP (generally accepted accounting principles) Ex: - if fund is launches in US, they follow Us GAAP. if it is launched in Luxembourg, Then Lux Gap...ete. Generally, they have to prepare separate set of financials for each fund and sub fund like feeder. Ex: - if KK R launches the fund and registered master/ onshore fund in America, they will prepare financial statements of that fund using Us GAAP, if they have feeder fund in Cayman Islands, they will prepare separate financials for that feeder also. 31 At times, the feeder investor will also receive the financials of master since the feeder do not have all details like while the money is ultimately invested, if those details are not there in financials, investors cannot understand the risk and return in that fund. Ex: - If Dhoni invested in KKR Cayman fund, that fund financial will report Dhoni’s investment as capital, investment in to onshore as investment. it will not have details of investment made by the master/onshore fund into Paytm/ flipchart etc. so, they will send feeder and master financial statements to Dhoni (offshore investor) NAV Life Cycle/ Sequence of Activities are like below: Journal entries post the bank receipts and payments entries which will have capital received/paid, investment made/sold, any expenses paid by the fund Etc. details. After this bank Entries, they post adjustments Entries like accrual Entries, prepaid Entries etc. (management fee payable, audit fee payable, unrealised gain/ loss on investments, dividends receivable etc.) once all entries posted, they can review the general ledgers (like investments ledger, management fee Expense ledges ete.). if all transactions are ok, they can close the General ledgers... If General ledger is closed, trial balance for that month/quarter is ready. This trail balance along with supporting calculations I documents will be sent to the fund house (like Goldman Sachs/ KKR) for review by fund administrators. This is called NAV pack/ monthly pack. Ex: give detailed calculation of management fee, carried interest in separate tabs in Excel tile and TB is separate tab so reviews can easily review and make corrections if need. Once TB is approved, they prepare allocations file which shows the allocation of income and Expenses to each partner/ investor in the fund. this helpful to prepare the individual capital statement of Each investor Ex: - if the fund has management fee is Rs. 10 lakhs, there are two investors, this file will show 6 lakhs fee allocation to Trump, 4 lakhs to Dhoni...ete. Once the allocation file also approved, they can prepare financial statements. (Approval of allocation file is required since there can be many Exceptions to allocate expenses like management fee where some investor pay 2% and others 1%. fee...etc. 32 each investor should be allocated correct amount else that investor NAV will be incorrect). Preparation of financial statements will be done by fund administration based on approved TB and allocation file. quarterly/ un audited financials need less amount of disclosure/ details and audited/ annual financial statements need more disclosures in notes to accounts. once the financial statements are prepared, they will be reviewed by fund house (like KKR) and then send to each investor, same financial statement are filed with regulators like SEBI, SEC (some time they have to file with Luxembourg regulatory if offshore is Luxembourg, with etc. if master fund in America etc.) for audit (annual financial statements) They have to coordinate between fund administration, fund house, auditors to complete the audit and send the audited financial statement. The set of financial statements prepared by the fund includes: 1. 2. 3. 4. 5. 6. SOA – Statement of Assets and Liability SOI – Schedule of Investments SOC – Statement of changes to Partners Capital SOO – Statement of Operations Cash flow statements Note to financials Journal Entries: Fund name: Godrej Reality Fund Fund size: 5000 crores. Jan 2021 fund raised 2500 crores in 1st close, where 5 investors came into the fund - No entry since money is not collected. Capital call also not issued so on receivable. March 2021, they have finalised a property to be fund (shopping mall in Mumbai) is 500 crores. 33 01-03-2021 Capital call made Capital contribution receivable account To capital account 15-03-2021 Dr 500 Money received from investor Bank account Dr To Capital contribution receivable account 16-03-2021 Dr 500 500 Dr 1 1 All expenses accrued in Quarter 01 is recorded Management fee expense account Dr Audit fee expenses account Dr Custodian fee expense account Dr Fund administration fee expense account Dr To Management fee expense payable account To Audit fee expenses payable account To Custodian fee expense payable account To Fund administration fee exp payable a/c 31-03-2021 500 Shopping mall rent to be received in April, now accrued Rent receivable account To rent account 31-03-2021 500 All money invested in to in shopping mall, Mumbai. Investment real estate account To bank account 31-03-2021 500 2 1 1 1 2 1 1 1 Market value of investment, no gain occurred Investments in real estate account To unrealised gain/ loss account Dr 50 50 34 Balance sheet of Godrej Reality Fund as on 31/03/2021 In crores Asset: Investments Cash and cash equivalents Rent receivables Liabilities Bank loan Management fee payable Other accrued expenses 550 0 1 551 0 2 3 5 Breck up capital Capital Reserves and Surplus Net worth (capital) / NAV 500 46 546 Total liabilities (capital + liabilities) 551 Statement of Operations for the period ended 31st march 2021 Rental income Unrealised gain/ loss Management fee expenses Audit fee expenses Custodian fee expenses Fund administration fee expense Net profit In crores 1 50 -2 -1 -1 -1 46 35 Journal entries for April to June 2021 period: 15-04-2021 Godrej wants to invest in a hotel (taj hotel) Rs.1000 crores, so, capital call notice issued towards investment and to meet expenditure @ 4 crores Capital contribution receivables account To capital account Dr 1004 1004 30-04-2021 Full Capital call money received Bank account Dr To Capital contribution receivables account 1004 1004 01-05-2021 Fund invested in taj hotel Investment real estate account To bank account Dr 1000 1000 10-05-2021 Sold investment in to shopping mall for 450 crores Cost 500 crores Unrealised gain 50 crores Market value of capital 550 crores Sale value 450 crores Loss from earlier market value 100 crores 1) Earlier accounted unrealised gain revered because asset is sold Unrealised gain/ loss account To investment account 2) Dr 50 50 Sale entry made Bank account Dr Realised gain/ loss account Dr To investment in real estate account 450 50 500 36 15-05-2021 Payment of Management fee already accrued Management fee payable account To bank account Dr 2 2 15-05-2021 Payment of expenses already accrued Audit fee expenses payable account Custodian fee expense payable account Fund administration fee exp payable a/c To bank account Dr Dr Dr 1 1 1 3 15-05-2021 Fund agreed to pay advance fee to auditor for Rs. 1 crore Prepaid audit fee account To bank account Dr 1 1 15-05-2021 Fund is accruing tax consultant fee Rs.100000, withholding tax/TDS applicable @10% Tax consultant fee expenses account Dr To TDS on professional charges account To Tax consultant fee expense payable a/c 100000 10000 90000 05-06-2021 TDS paid to government TDS on professional charges account To bank account Dr 10000 10000 15-06-2021 Tax consultant fee paid Tax consultant fee expense payable a/c To bank account Dr 90000 90000 30-06-2021 Rental income received from tenants Rs. 3 crores Bank account To rental income account Dr 3 3 37 On 30th June 2021, KKR Asia Fund paid Rs.10 crores fees on behalf of KKR Europe Fund. Write entry in the both the funds? In KKR Asia Fund, we have to post receivable entry, since is recoverable from KKR Europe: Europe fund / receivable from affiliates Dr 10 To rental income account 10 In Europe fund books this an expense, they to pay amount to Asia fund Management fee expense account Dr 10 To Asia fund / payable to affiliates 10 KKR Asia Fund is master fund, they have called money from feeder fund (KKR Cayman Fund), write the entries in books of KKR Cayman Fund? (Assume 500 crores) 1) Capital call made by KKR Cayman Fund Capital contribution receivable account To capital account 2) Dr 500 Money received from investor Bank account Dr To Capital contribution receivable account 3) 500 500 500 That money invested / transferred to master fund (KKR Asia Fund) KKR Asia Fund account To bank account Dr 500 500 38 Allocation: Once the trail balance approved, the fund administration will prepare this allocation file where all the income and expenses are allocated each partner, this allocation amount will be use to prepare capital statements of Each investor. Generally, all income & expenses are allocated based on the owner of that partner. Ex: - If the total commitments in the fund are 1000 Crore, one investor (Dhoni) committed 100 crores, which means is 10%. if the fund incurred 1 crore expense (audit fee), Rs.10 lakhs will be allocated to Dhoni, however there are some exemptions to be noted while the number allocated to investors, they are exceptions: 1) some of the investor in the fund do not pay management fee, carried interest so they should be Exempted from allocation of those Expenses. Ex: - General partner, Employees of the fund house do not pay these two Expenses. 2) Some of the investors pay less management fee due to their arrangement with fund like side letter arrangement to pay low fee. They may have invested more amount so less fee in that fund...etc. they should get less fee allocated to them. 3) if investor is transferred in a quarter (on Sep 30th, 30th June ...etc.) any allocation for that year should be proportionate between new investor and old investor. Ex: - If audit fee to be allocated is 1 crore to one investor, he transferred (100%) out at 30th June then he should be allocated 50 lakhs and balance to new investor. if it is nonrecurring item like legal fee and fund incurred it in December, then all should be allocated to new partner as old parties moved out of the fund by that time. Proforma capital statement: Capital statement of Dhoni for the period 1st Jan to 31st Dec 2021 Details Opening balance Allocation balance income & expense Dividend income Interest income Management fee Carried interest Professional fee Unrealised gain/ loss Rs. In crores 100 2 1 -2 -2 -2 10 39 Realised gain/ loss Net allocation Contribution Distribution Closing balance/ Net Asset Value 5 12 5 -15 102 (100+12+5-15) History data (HTD) Commitment Contribution Unfunded commitment distribution 500 100 400 200 Return/ multiple Invested money/ contribution capital Total estimated value (TEV) MOIC/ multiple on invested capital 100 302 (200+102) NAV + distribution 3.02 Common Discloser in Notes to Accounts: if the financial are unaudited financials (Quarterly/ monthly), the discloses will be less. if they are audited financials, they have disclosed more a) b) c) d) e) An Accounting policy, Accounting GAAP followed. Source of the valuation of investment (Fair valve Hierarchy) Financial highlights like IRR, Expense ratio Related party transactions Management Fee, Carried Interest provisions/ methods...etc. In the fair value hierarchy table, the funds will report the market value of investment based on the source for the market value. (LEVEL 1) Ex: if the fund invested into Equity shares of apple company, those shares are traded in New York stock exchange, so that fund can take market value from the stock Exchange data, without adjusting they can take the market value from stock Exchange. it funds has 1 crore shares today’s market value is $ 10 per share, they can report $ 10 crores as 40 market value of that investment. This number can be reported as LEVEL 1 in the fair valve hierarchy table. If the invested into a shopping mall, a similar shopping mall purchased in that city, they can use that information to calculate market value of other shopping mall, where this fund is invested, they can be considered as LEVEL 2 in fair value hierarchy table The fund invested in a shopping mall, similar shopping mall not purchased (or) sold in market in this Quarter / year. The fund can calculate NAV and report. That is reported as LEVEL 3 investment fair market hierarchy table. If most of investments are reported under level 01 in KKR Asia fund, most of investments are reported under level 3 in Black stone Asia fund, Risk is less in KKR Asia fund. In financial highlights (FIHIs), They report important returns, Expenses...etc. which will help the investor to compare to different funds. Ex: - If IRR of fund A is 10%, fund B is 8%, investor can Preferred fund... if Expense ratio of fund Asia 2%, fund B is 1% investor can prefer fund B. Expense ratio: Total Expenses ÷ NAV For PE, sometimes (Total Expenses ÷ commitment) Equalisation, Rebalancing: Rebalancing makes the income and expenses which are allocated to the old partners will be adjusted, a portion is transferred to new partners, so all the partners closing balances are same/ in proposition to their ownership. this is done when new partners/ investors are accepted into the fund during 2nd close/ 3rd close... etc. Ex: - Edelweiss India fund is launch in Jan 2021, there were 2 partners (A, B), total expenses of Rs.10 crores is allocated to them (Rs.5 crores each), two new partners are accepted in to the fund in Jan 2022 (C, D), those 2021 expenses are allocated to new partners also which mean 2.5 crores is reduced from old partners, allocated to new partners. 41 Equalization is done when the old partners already contributed some amount of money in that fund. conditions to have this equalization process in a fund are a) The fund had more than one close, new investor came in to the fund. b) Old investor already contributed some money in the fund. In this case the old partners will expect some extra return from new investor since they have already paid some amount. most common method used to pay extra return to the old investors is to pay some interest like 8% per year to the old investor. Investor Ownership Commit New Old -ment Commit 2021 -ment/ 2022 A 50% 5 Cr 0 B 50% 5 Cr 0 C 5 Cr D 5 Cr Total New Contribution Contribution Interest Commit ownership 2021 2022 At 10% -ment 5 Cr 5 Cr 5 Cr 5 Cr 25% 25% 25% 25% 1 Cr 1 Cr 0 0 -5000000 -5000000 5000000 5000000 -500000 -500000 500000 500000 Net Con/ Dist 2022 -55L -55L 55L 55L Total Con So far 50L 50L 50L 50L In the future, if fund need I crore, they will call 25 lakhs Each from all partners and any distribution also happen Equally. Key Points: Broken Deal Cost: - Cost incurred on a deal that is broken (fund spent 5 crores on research to invest in Flipkart, they decided not to invest, that amount is charged to the fund income statement) Escrow Account: - Restricted bank Account, fund cannot withdraw money unless some conditions are fulfilled. Placement Fee: - Fee paid by the fund to agent/other fund houses for arranging investors and making them invest in to a fund Management Fee Waiver: - Sometimes fund can voluntarily waive the fee to the investors in a fund. Ex: - If the fund life is extended by 2 years (still 12th year), fund can waive the fee and don't charge any fee. 42 Syndicate Cost: - the fund house like KKR will pay the common expenses of all the funds managed by them and it is recorded as syndicate cost. This will be charged to fund later once it is clear on how much to collect from Each fund. Ex: - KKR paid Rs.50 lakhs for travel cost to meet Flipkart management, it is recorded as syndicate cost. later, they have finalised to make investment in Flipkart on behalf of Fund 1-50% and Fund 2-50%, so they will Charges 25 lakhs each Fund 1 and 2. Retail Investor: Employees, Students, Small business...etc. who can invest less to take less risk. Institutional Investor: - Institutions who are registered with SEBI/ regulators to participate in Security market. Ex: - LIC, Mutual funds, Hedge funds, pension funds, any investment company. Sovereign Wealth Funds: - Wealth funds of governments, on behalf of governments who has surplus money, these funds invest in market and PE/ HEs etc. Ex: - government of Singapore has wealth funds like TPG, Temasek (Dubai, Norway etc. are also popular) Interval funds: - Not much, these funds work like closed Ended for most part of the year but kept as open approx. 10 days in years/ 6 months. Ex: - If HDFC launches an interval fund in 2020 with 10 years lifetime, 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 investor can also buy the units. Note: - in case of mutual funds, to provide e 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 do not involve in this case Asset Under Management (AUM): If a fund house like SBI says their AUM is 4 lakh crores, they are managing money on behalf of investors. This is used in the industry to know which is biggest fund house (or) what is the total money invested into funds in a country...etc. Ex: - AUM of black rock is more than 500 lakh crores (in rupees), India AUM (mutual fund industry) is 37 lakh crores. Top 4 fund houses by AUM in India are SBI, HDFC AMC, ICICI AMC, Adithya Birla AMC. 43 Worldwide top fund houses are Blackrock, vanguard, fidelity. State street, JPM …etc. To calculate the AUM, industry practice is to consider the assets on which They are earning fees (management fee/ incentive fee). Ex: If state street has 100 mutual funds, NAV of all those funds is 100 crores, then AUM is 100 crores if the fee is charged on NAV if they have 50 PE funds, total commitments of those funds is 50000 crores, Then AUM is also 5000 crores if fee charged on commitment. Asset Under Custody (AUC): Custodian keeps the assets of the fund (like share certificates) in their custody so investors’ money will not be misused by the fund houses. [custodian must be independent to fund, for transparency] Ex: - If Goldman Sech launches a fund, they will appoint BNY Mellon as custodian and pay custodian fees to them form the fund's money. To count the top custodians in the world, they use this AUC. The custodians in the world are BNY Mellon, JPM, state street...etc. Assets Under Administration (AUA): fund administrator is responsible to take care of administration activities of the fund like preparation of financials...etc. these admins are received admin fees from fund's money. NAV of each fund is considered as AUA of that fund admin if they charge admin fee on NAV to fund admins are – SS&C global, CITCO, State Street, Inter trust...etc. 44 Open ended vs closed ended funds: Details Meaning Open Ended Fund allow investor to invest any time and exit any time from the fund. Capital amount Varies/ changes since new investors can come or old investor can exit any day (variable capital entities) No limit, it can continue any number of years Term/ duration of the fund More suitable/ opted by Advantage to Mutual funds and hedge funds Details Investors Mutual Funds Retail investors Investment Listed securities like share, bonds… etc. Risk Less Type of funds Registration Fee Mostly open ended Trust Management fee Regulations More since retail investor invests Above thousand No. of investors Investor since they have liquidity Closed Ended Investor are not allowed to exit or invest later. At the time a launch they can invest and exit at the time of closing/ liquidation of the fund (of when fund has money they can pay) Fixed since no issue of new units in the fund (or) redemption of old units in the fund Fixed like 5/10 years. Investor’s money will be paid back on completion of tenure Private equity fund To fund manager since no pressure to provide money to investor when they want to exit. Private Equity/ VC HNI, Institutional, Investors, Sovereign wealth fund. Anywhere, generally in startups, Infrastructure assets. Medium (long term investment) Mostly closed ended LP, LLC Management fee, incentive fee (Carried interest) Less Hedge Fund HNI, Institutional, Investors, Sovereign wealth fund. Anywhere, generally listed securities, they use derivatives more to gain in short term High (generally short term) Mostly open ended LP, LLC Management fee, incentive fee (Carried interest) Less 1 to 100 (mostly) 1 to 100 (mostly) 45 Hedge funds Hedge funds pool the money from wealthy investors and invest that money in different assets like shares (mostly listed shares, sometimes in private companies), real estate, Bonds...etc. to make profit in short term, generally they use derivatives like futures and options on currencies, Equities, commodities (like gold). since the investors can take risk, these funds take more risk and try to get more returns. most of these funds launch open ended funds so to offer liquid securities like shares traded in a stock Exchange (or) derivative contracts traded in stock/ commodity Exchange etc. Based on the liquidity offered by the funds, investment choices, these are advanced version of mutual fund. However, Structure of these funds are similar to PE funds where they register the funds generally as limited partnerships and they also have Onshore, offshore funds since they will have international investors. Fee charged by these funds also similar to PE funds where they charge. management fee around 2% (Genially on NAV), They also take profit share (incentive fee) which is generally around 20% of profit. These funds generally keep some restrictions on which drawls by investor like 1) An investor can Exit/ withdraw from fund only in Month Ends 2) They can withdraw only after giving notice/ intimation to fund managers in advance like one 3) At times, the fund allows maximum of 25 %. withdrawal in one year... etc. These kinds of restrictions are called as GATES, since some of these funds invest money into illiquid securities also like shares of startups, these gates are required. These funds follow different strategies to maximize the return/ to reduce the risk. a popular strategy is long/ short strategy which means some portion of money will be used to buy some stocks and some portion used to sell/ short the stock so fund can aim for " absolute return" means they can make profit/ reduce losses if the market goes up/ down. if it is mutual funds, they only buy stocks and expect the market to go up, if market goes these mutual funds make losses. Investment strategy of hedge funds: 1) long/ short 2) short only 3) Macro 46 4) quantitative strategy. 5) fund of funds 6) merger arbitrage, convertible arbitrage. Long term strategy: In this case the fund will identify some undervalued stocks to by so, when the market goes up, they can make profits. They will also identify some overvalued stock to sell, they can make profit it stock falls. Ex: - it Infosys shares are increased by 30% in the lost one month, they are more Expensive compared to Wipro, then the fund can sell Infosys share, buy Wipro shares. In a normal market, the shares of the company, where the fund took short position (sell now, buy later) can go down, the other company stocks will go up (stocks in which the fund has long position (buy now, sell later) so the fund can make profit of both the trades. Even if market is following the fund can make profit from short position where they have sold the stocks at high prices (Rs. 100 per shares), they will buy at low price. Once the share price goes down (Rs. 70 per share) If The market goes up the long position, shares that are purchased will get the profits. To identify the overvalued stocks/ undervalued stocks, they commonly used the Price to Earnings ratio of this stocks.it P/E ratio is more, that stock expensive P/E ratio= market price ÷ Earning per share. Earnings per share= net profit ÷ number of shares. If profit of Infosys is 100 crores, there are 10 crores shares then EPS is 10 (100/10) If the market price per share is 500, Then P/E ratio is 50 (500/10), meaning for one rupee Earnings market is paying Rs. 50, That Expensive if other company like Wipro has P/E ratio of 23, it is undervalued than Infosys (25 P/E ratio is better than 50) Quantitative strategy: In this strategy fund manager will use statistical murals, computer programming to analyse huge amount of past data and predict the future moments in a stock/market. 47 Macro: In this strategy, the fund manages following Macro-Economic indicates like inflection rates, interest rates, Tax rates in country...etc. and predict the market based on those indicators. Ex: - If inflation is increasing, common people will suffer to buy basic things like vegetables. so, RBI is Expected to increase the interest rates it’s that happens, the consumption, taking loans ... etc. go down. since, loans are given at high interest rates or this will decrease the business of Real-estate companies, automobile companies...etc. so those stocks will go down. If the inflation started increasing Correction can be seen in the Equity market. Arbitrage: In this strategy, the fund will buy in one market where the asset is security is cheaper and sell in other market where the price is high. Ex: - is Infosys stock is trading at Rs. 1500 at BSE, it trading at Rs 1505 at NSE, the fund can sell in NSE and buy BSE. This kind of price differences are temporary, once more particles started using the arbitrage opportunity to make profits, these differences will be eliminated/ reduced, the fund can enter into opposite trade once the price differences are reduced. in this case the fund can buy at low price in NSE to close the trade and make the profit. Side Pocket/ Segregated portfolio: Fund name: HDFC short term debt fund Money polled: 100 crores Investment/portfolio Reliance Kingfisher cost 50 crores 50 crores market value 52 crores 40 crores Total market value = 92 crores. NAV of the fund is Rs. 9.2, down from Rs.10 NAV Q: if the Kingfisher company default on interest payment, will the NAV of the fund decreases? A: YES. Q: If so, investor try to Exit from the fund? A: YES 48 Q: As a fund manager, what can you do sell kingfisher or reliance to give money back to investor? A: since there are no buyer for King Fisher, need to sell reliance. This can further decrease the NAV in the fund and make more investors to Exit from that fund. also, this can be created panic in the market and many Securities value can go down and investors faith on market/ funds can godown to avoid these issues, funds can do the side pocket/ segregated portfolio. In side pocket, the fund can separate the troubled asset in the portfolio and create a separate fund. low investors will not exit from the main fund since that portfolio is good only. if investor want to exit from the side pocket, fund will return the money when they can sell those assets. Side Pocket accounts are exclusively used in the hedge fund industry by hedge fund managers. Their purpose is to separate illiquid, hard-to-value, and often highly risky assets from other, more liquid assets. The illiquid assets in these side pocket accounts include investments such as real estate, antiques, over-the-counter (OTC) stocks, stocks with extremely low trading volume, stocks delisted from exchanges, and private equity investments. Side pocket investments have typically been valued at cost (as opposed to being marked-tomarket) for the period they remain in the side pocket, and so generally excluded from the fund’s NAV calculation for determining performance, fees, redemptions, etc. When sidepocketed assets are not marked-to-market, the fund’s financial statements will not be GAAP compliant; this ability to circumvent evaluating a side-pocketed asset at “fair value” -- and thus the avoidance of certain accounting standards -- may be a primary reason for placing it in a side pocket. • Side pocket holdings will only benefit current fund participants, and new entrants will not receive any benefits, nor losses, from those holdings. • 49 Performance Fees/ Incentive Fee: If the hedge fund is making profits, The fund manager (General partner) takes 20% of the profit as incentive fee (Generally) To take this incentive fee, they fix a date on which the performance of the fund is measured, it the fund made profit in that period the General partner will take performance fee or incentive fees, that date is called as Crystallization date. Ex: - If a hedge fund is launched 1st Jan 2021, the crystallization date is fixed at 31st Dec. This means the fund will take any incentive fee on 31st Dec 2021, 31st Dec 2022...etc. If per unit value Rs.100 on 1st Jan 2021, it is Rs. 150 on 31st Dec 2021, the profit made is Rs.50 as of that date so incentive fee will be take on that amount, on that date. The NAV/ valve per unit will change on a regular basis, The fund might have taken the incentive fee at a specific NAV, it is difficult to track the performance fee paid in the future by different investor. So, the fund follows Highwater mark concept. This HWM refers to the price at which the fund has already taken incentive fee. next time the fund manager can take any incentive fee only if the unit value exceeds this HWM (lost high GAV on crystallization date). Found launch date Crystallization time 01/01/2021 31st December each year Date GAV Profit Jan-21 Dec-21 Dec-22 100 120 110 NA 20 -10 Incentive fee – 20% NA 4 0 Dec-23 130 10 2 Comment Begging time Since losses made this year Profit made is 20 but general partner can take incentive fee only on Rs.10 profit (GAV-HMW) NAV HMW 100 116 110 120 120 124 130 To know the valve per unit in the fund, they divide it to gross asset value per unit and net asset value per unit. GAV = NAV + incentive fee 50 NAV Calculation is given below: Fund name ⇒ Renaissance Medallion non-Fund per share ⇒ 100 launch date ⇒ 01/01/2021 number of shares ⇒ 1,00,000 total capital ⇒ Rs.100,00,000 Investment in ⇒ Apple shares cost of investment ⇒ 1 crore NAV Date ⇒ 31/03/2021 Market value of shares = 1.5 crores. Balance sheet: Asset Investment Receivables Total assets Liabilities Bank loan Accrued expenses Total liabilities Net assets No. of shares 1.5 crores 0.1 crore 1.6 crores 0 0.1 crore 0.1 crore 1.5 crores 100000 NAV Per unit/shares = Rs.150 (in hedge funds, it is GAV.) You have 1 unit/share in the fund, you want to exit from the fund, fund will pay Rs.150. For hedge fund incentive calculation that Rs.150 is GAV and the incentive fee calculation is given below: GAV = Rs.150 Profit made = Rs.50(150-100) Incentive fee%= 20% Incentive fee amount = Rs.10 NAV = Rs.140 Most of the hedge funds are Open Ended funds which means investor can Enter into the fund and Exit from the fund at any point of time. 51 Generally, they allow subscription and redemptions at End of Each month. This means some investors came in Jan, some in' Feb etc. When the value per unit is charging each month, these investors also pay different amounts. when the GAV is Rs.200 as of 31st Dee 2022, The fund many changes in performance/ incentive fee to investors since they made profit of Rs. 50 (200-150, assuming HMW is 150), all the investors profit is not Rs. 50 per share since they came and buy the units at different times and at different prices. to avoid This problem these funds, do Equalisation process at regular intervals like yearly. Ex: Month Dec-21 Jan-22 Feb-22 Mar-22 Investor A, B C, D, E F, G H GAV 150 140 180 210 GAV- dec 2022 200 200 200 200 Profit 50 60 20 -10 In this case, fund should charge incentive fee on Rs.50 profits for A, B investors and charge fee on Rs 20 profit for F, G investors ...etc. To keep track of all these investors coming in between, These funds issues different series shares. Ex: - investor came in 2022 Jan will be issued series A, investor came in Feb and March will be issued series B and C… etc. now fund knows, the investor who came in Feb 2022 at GAV of Rs.180, who came in March 2022 at GAV of Rs.210… etc. (as above table) If the fund is calculating the performance fee of the February series investor, it is like below GAV 200 GAV at entry 140 Profit made 60 Incentive fee % 20% Amount payable as incentive fee = 12 (60*20%) Assuming investor G has 100 units, he needs to pay Rs.1200 as incentive fee (12*100) So, fund will redeem units/ shares worth of Rs.1200 52 Units to redeem is NAV per unit Amount payable as incentive fee Units to redeem is Balance units that investor has is 188 (200 – 18) 1200 6.38 93.62 Now this investor is equal to old investor and incentive fee is calculated on Rs.100 only if the GAV is 300 as of Dec 2023 (300 – HWM of 200) Hedge funds- securities used to make investments: Hedge funds can invest into any securities/ assets to make to the profit/ to reduce the losses. They use traditional securities like Equity shares (common stock), preference shares (preferred stock), Debentures (corporate bonds), government bonds/ Treasury bills, certificate deposits......ete. Sometimes they also invest in funds like Exchange traded fund. To make profit with less amount of investment (or) to hedge the risk, this funds also use derivative contract. They use a) Exchange traded derivatives like Futures, Options b) Over The Counter (OTC) Derivatives contracts like forwards, SWAPs .... etc. This funds also use many structured derivative contracts (advanced derivative contracts) like Credit Default SWAP (CDS), Mortgage-Backed Securities (MBS), Swaptions, Contract for Differences (CFD) ... etc. 1. Bonds/ Debentures: Bonds/ debentures are fixed income securities means investors like hedge funds receive fixed income like interest on a regular basis (monthly/ quarterly), these are low risk instruments for the fund, since principal amount invested will be repaid by the company/ issuer of the securities (companies like reliance or government of India), at the end of the duration of that investment. Ex: - if government of India needs money, they can borrow from public by issuing bonds with 5 years tenure. Government will repay the borrowed amount at the end of these 5 years. If hedge fund invested Rs.1 crore, they will Rs.10 lakhs per year if the interest rate is 10%, they will get the principal amount of 1 crore at the end of the 5th year. 53 These funds should accrue the interest amount when the NAV is calculated like each month. The market price of these bonds also changes based on demand and supply. So, the fund should recognize unrealised gain when the market value of the bond is increased. At the time of buying (or) selling this debt securities, if the price includes the accrued interest. The price is called as DIRTY Price. Ex: - Government of India issued a bond at Rs. 100000, They pay interest of 10% at 31st Dee of each year. interest per will be Rs. 10000 if the fund purchasing on 1st July, there accrued interest for 6 months which will be received by the buyer in Dec. This means The buyer should pay those 6 months interest (Rs. 5000) to the seller at the time of purchase in July. if that bond is purchased at Rs. 1,10,000. Then Rs. 5000 to words interest, Rs. 1,05,000 is per price of the bond. In This case the DIRTY price is Rs.1,10,000. Debenture purchased on cum interest: Debenture account Interest receivable A/c To bank account Dr Dr 105000 5000 110000 If The price quoted is Rs. 1,05,000 as CLEAN Price, that is paid only for the bond, interest is not included. Debenture purchased on ex interest: Debenture account To bank account Dr 105000 105000 There are different types of bonds in the market, depends on the requirement of the issues, they can use any type of bond. a) Callable Bond- company can call and repay any time b) Portable Bond - investor can submit and take money from company any time c) Zero Coupon Bond/ Deep Discount Bond - Rs.100 bond is issued at Rs.85, repaid at Rs. 100 where that Rs.15 is interest, no separate payment as interest. d) Municipal Bond & Corporate Bond - if municipalities issue it is municipal bond, if corporate issues, it is corporate bond. e) Securities, Mortgage Blocked Securities (MBS), Asset Backed Securities (ABS), Collateral Loan Obligations (CLO), Collateral Debt Obligations (CDO) 54 Securitization process refers to converting different assets into securities Ex: - if a bank gave loan to borrowers (committer) it is an asset to bank, they can recover that money over a period 10 years/ 20 years. if any money immediately they can convert that loan (or) asset of Rs.1,00,000 into one lakh securities (MBS) of Rs. 100 each. any investor having Rs.100/ Rs.1000 can also purchase these securities where they get the interest on their invest. Bank will receive the interest, pay to this investor MBS (Mortgage Blocked Securities): These are securities (like shares) issued to the investor by converting loans of a bank in to securities. Ex: - HDFC bank gave home loan to Saina, Dhoni for Rs. 2 crores. generally, HDFC bank will recover that money on a monthly basis for next 20 years. if they want to get the money now, they can convert those loans in to 2 lakhs MBS, Rs. 100per MBS. Any investor having Rs. 100 can buy one MBS, he will receive interest like 8% on that MBS. Process: 1. Bank like HDFC issue home loans to borrowers/ home buyers, take that home as security (sells the house and recover money if the borrower makes default), process of giving that ownership to bank/ house as security to the bank is called as mortgage. (Right to sell the house is registered in the name of bank if the borrow make default.) 2. Bank like HDFC sell these loans to investment banking company like Goldman Sachs/JPM...etc. 3. The investment banks convert loan into MBS (making loan into small pieces) 4. It 2 crones’ loan is converted into 2 lakh MBS each RS.100, any investor can buy with lesser investment like Rs. 100/1000.... etc. 5. Borrower like Dhoni pays interest to bank (HDFC), That interest will be paid to investor like hedge fund. 6. If borrower like Dhoni defaults, the risk is to the investor, they have to recover from house and if house price falls below the loan amount, that amount is loss to the investor 7. Generally, if home loan borrower defaults, bank like HDFC has that risk of loss, in this risk is transferred to MBS buyer. 55 ABS (Asset Backed Securities): These are similar to MBS Where the loans given by bank is converted in to securities and sold to the investors. main difference is these loans are given for other reasons that to buy a home. if a borrower take loan for buying car, if that loan converted into securities, it is ABS. credit card receivables at bank level, personal loan given by banks.... etc. can be converted in to ABS. Credit Default Swaps (CDS). An investor who purchased MBS/ ABS can enter in to CDS agreement to protect from possible default of those MBS/ABS. Process: 1. Pay some premium like Rs.2 per MBS security worth of RS.100 and get a right. 2. the seller of CDS like insurance company will take that premium and take at 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, investor 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 ⇒ RS. 100 CDS premium ⇒ RS.2 56 Derivatives: Derivate contracts derive the valve from underlined asset. The underlined asset can be commodities (Gold), stocks (Infosys shares), index (NIFTY 50) ... etc. These derivative contracts are mainly used to reduce the risk (hedging), that arises from change in the market price of securities/ assets... EX: you are in the business of buying gold, selling the gold, you have purchased many tons of gold at RS. 5 crores per ton, you are varied about decrease in the market price in the next 2 months, you are Expecting price will go down to Rs 4.5 crores per ton to avoid this possible loss if market polices falls, you can use any derivative contract and the fix the price to sell at Rs. 5 crones per ton. so, you can still receive 5 crores after 2 months. Most commonly used derivative contracts are a) Forwards b) Futures c) Options. d) Swaps future, options contracts are trading in stock Exchange like BSE, NSE. So, more investor can buy and sell this contract on a regular basis, the contracts are called as Exchange traded derivatives/ listed derivatives. contracts like forward contracts, swaps are not traded in the stock Exchange, they can be used by any party at place, this are called as over the counter contracts. Forward contracts: Underlying Asset Seller Buyer Price Contract Quantity Contract Value Contract Date Contract Expiry Date ⇒ USD l00000 DOLLORS) ⇒ CITIBANK ⇒ Blackstone private Equity fund. ⇒ 1 dollar is 12s.70 ⇒ 100000 dollars ⇒ Rs.70.00.000 ⇒ 20th Oct 2021 ⇒ 20Th n10v 2021 Q: On the contract Expiry date if market police is Rs. 75, at what price black stone can buy the dollars? A: At Rs. 70 per dollar only so they have to pay Rs.70 lakhs only. 57 Q: who made profit and how much due to this contract? A: Black stone fond make profit of Rs. 5 lakhs they paid only 70 lakhs to buy one lakh dollars. if no contract, they could have paid Rs. 75 lakhs Q: How much gain/ loss to CITI? A: RS. 5 lakhs loss since they are selling dollars at RS,70 per doll or through the market police is 75 so loss is 5 lakhs any time one party gain is Other party loss in a contract. Q: CITI bank default to settle this contract and pays lakhs to Blackstone or make default to sell at RS. 70 per dollar? A: Generally, no. as This is a contract and other party can go to court etc. to setter this. However, if the opposite party (CITI) is in bank crypt situation (liabilities are more than their assets) Then the party can default. Future contract: Underlying asset Seller Buyer Price Contract quantity Contract value Contract entry date Contract expire date Margin % Margin amount Bharathi Airtel Tej kiran raja d 714 1886 13,46,604 20th Oct 2021 25th Nov 2021 24.74% 3,33,823.13 Q: On the expiry date of the contract if the stock price is 500, who will make gain/ loss? A: Since price went down seller make profit, for the seller the calculation is as below. Sale price 714 Buy price 500 Per share profit 214 Lot 1886 Total profit 403604 58 Futures contracts are similar to forward contract which can held to reduce the risk of in the future due to change in market price. this contract is traded in a stock Exchange like NSE, so to this purchase these contracts, The investor should have trading demat accounts. Ex: - if a mutual fund manager purchased one lakh shares of Bharathi Airtel at Rs.714 (similar price). Expected the share price to go down towards by 500 by the next 2 months, he can sell the future contract today at 714, after 2 months He can buy at Rs. 500. so, there is gain of Rs.214 on future contract. This will offset the loss made on stocks. Since these contracts are traded in a stock Exchange, the liquidity is more, which means more buyer and seller available. The same contract can be purchased or sold by many parties, The terms and conditions of the contract is same for all the parties. since the term and conditions are same for all the contracts. They are called as standardised Contracts. The terms which are standardised by stock Exchange are: S.no 1 2 3 4 5 Terms Lot size No of contracts available Contracts expire date Margin Settlement process Example - Airtel 1886 3 months (October, November & December) 24th November (last Thursday of each month) 24.79% (generally around 20%) Daily settlement Any Exchange traded Derivate contract like futures & options can be purchased or sold at any time before the Expire date. Ex: - You have purchased Bharathi Airtel future contract on 20th Oct, contract expiry date 25th November. you can wait till the Expire date (25th November) or Exit from the contract any time before 25th November. Ex: Underlying Asset Contract Date Price Lot Size Contract Price Margin% Margin Amount ⇒ Kotak Mahindra Bank ⇒ 20th Oct ⇒ 2023.9 ⇒ 400 ⇒ 809560 ⇒ 28.34% ⇒ 229,429.30 59 Q: Today, 21st Oct the stock price went up and you want to exit from the contract? sell price ⇒ 2135 profit/ share ⇒ 11l.1 lot size ⇒ 400 Total gain ⇒ 44440 Investment ⇒ 229,429.30 Q: If you continue to hold this contract till expiry date (28th oct) and the stock price reaches to 1800, what is the gain/loss? A: sale price ⇒ 1800 Buy price ⇒ 2023.9 loss ⇒ -223.9 lot ⇒ 400 loss will be ⇒ -89560 stock Exchange closes the contract on Expiry date and settle the contracts based on the market price of underlying stock that day Q: if you bought contract today at Rs. 2000 per shares and price went down by 200, total loss on contract is 10000 (lot size 50) do you have to pay any Extra margin tomorrow or till the margin became zero you don't need to pay? A: you have to deposit margin which is called Mark to Market Margin (MTM) to keep sufficient margin. if you are making profit then additional/ MTM margin not required. All These contracts are settled on a daily basis so they collect Extra money from loss making party and pay to profit making party Option Contracts: Option contract gives the buyer/ holder of the contract an option but not the obligation to buy/sell the underlying asset. Ex: - you have purchased gold at Rs. 5 crores per ton, expecting the price to fall to Rs.4.5 crores in a month time, you can buy an option contract (PUT Option), it will give you a right to sell at Rs. 5 crores per ton. on contract expiry date, if the market price is 5 crores, you can use/ Exercise the contract and sell at 5 crores so no loss due to market price reduction. however, if the market price are 6 crores (Above 5 crores), you can sell in the market and ignore/ lapse the contract. 60 In future contract/ forward contract, unlimited gain los is possible to both parties but in options contracts, holder/buyer of the contract will have limited loss and unlimited gain possibility Ex: same gold contract is used in future/ for word, you have agreed to sell at Rs. 5 crores per ton, if the market price on contract Expiry date is Rs.1 crore, you can sell at Rs.5 crores and get Rs.4 crores profit but you will make 4 crores loss if market price is Rs.9 crores on expiry date. so unlimited gain/ loss is possible on contract. when buyers/ holders of the contract have option but not obligation then he is Enjoying a benefit and the opposite party Seller/writer has a possibility of unlimited loss. This seller charges a premium to the buyer at the time of entering into contract like insurance contracts where you have to pay premium to buy life insurance contract/ vehicle insurance) This premium is one time income to sellers/ writers and one-time expense to buyer/ Holder Ex: If you are buying a put option to sell the gold at 5 crores per ton, you have to pay Rs.5 lakhs as premium, whether contract is used or not that amount will not come back to you. Ex: Underlying ⇒ Gold Quantity/ Lot ⇒ 1 Ton Price ⇒ 5 Crores Contract ⇒ Put Option Buyer of contract ⇒ Lalitha jewelers Seller of contract Kalyan jeweler’s premium ⇒ 5 lakhs paid by gold company. Contract date ⇒ 20th oct Contract expiry date ⇒ 20th November Q: On 20th November/ Expiry date the gold price is Rs.5 crores, who made profit/ loss from the contract? A: Since gold company is the holder/ buyer of the contract they have to use the contract if need. in This case They are able to sell at 8 crores in market so they don't need this contract which is giving 5 crores, so they will lapse/ ignore the contract. However, The premium of RS. 5 lakhs which is already paid belongs to seller of the contract (Kalyan jewelers) so they made a profit from the contract that is Rs.5 lakhs. 61 Thorough sellers have unlimited loss possibility, they enter into these contracts due to below reasons do: 1. They can close the contract if the loss is beyond their limit since There are more buyers and sellers in the market any time 2. They can increase the premium when the risk is high 3. They can use different strategies in the market like sell once contract at a different price and buy similar contract at different price so loss on once contract can be offset with loss on other … etc. There are two types of option contracts in the market, they are 1. call option → gives a right to buy but not obligation this can be used when an investor thought the price will increase but still, he wants to buy at low price in future. 2. Put option → gives a right to sell. Can be used when the price is Expected to go down so you can still sell at specific price. Call Option: Underlying Contract Contract Date Price Strike Price Contract Expiry Date Premium ⇒ Tata Motors ⇒ Call Option ⇒10th September ⇒ Rs.350 ⇒ 350 (right to buy at 350) ⇒ 25th Oct ⇒ Rs.10 Q: On 28th oct, stock price is 510, call option gave you right to buy at 350. whether you will use call option contract (or) market itself? A: You will use the contract and buy at 350. if need you can sell today at 510 and make profit of 160 per share after margin of 10, your profit 150. Q: On Expiry date stock price is Rs. 250, what is your gain/ loss? A: Since you have only option to buy at 350, market gives you the same stock at 250, you will buy in market and ignore contract so premium already paid Rs.10 is your loss. 62 Difference between the put. call option... Meaning Usage Buyer/ holder Ex: Call Option Gives right to buy If you think the price will go from 100 to 150, you can use to secure right to buy at 100 Has bullish view/ positive view on the underlying asset Buy tata motors call option strike price at 350, if stock price goes to 500, exercise the contract makes Rs.150 gain Put Option Gives right to sell If you think price will fall you can use. Buy a put option if you think gold price will fall from 5 crores to 4 crores Has bearish view/ negative view on the underlying asset Buy gold put option to sell a ton at 5 crores, if price goes to 4 crores, use the contract sell at 5 crores so profit of 1 crore. Difference between the OTC vs Exchange. Meaning Third party Examples Counter party risk OTC derivatives contract Contract are available/ can be used anywhere like in a bank, in an office etc. Not there between parties, they have to settle. Forwards, Swaps Counter party risk is there since one party to contract can default Exchange traded derivatives contract Can be available in stock/ commodities exchange only Stock exchange is third party who will settle the contracts Future, option Not there since stock exchange collect margin/ premium from parties to ensure no default can happen 63 Difference between Forward vs Futures: Meaning Whare Type Counter party risk Forward A contract between two parties to fix the price of an asset like gold/ rice today for a future date. Can be purchase/ sold anywhere (OTC contract) Customised contract (terms can be modified between the parties) Is there since a party to contract can default Futures Similar to forward used to fix the buy/ sale price of a stock/ commodity Exchange traded so you can buy/ sell only in exchange (NSE, NCDEX ... etc.) Standardised contract (exchange decides most of the terms like lot size, expiry date) Not there since stock exchange collect margin and settle. SWAPS: In swaps agreements two parties agreed to exchange series of cashflows to be exchanged between Them. Ex: - In a total return swap, one party can Exchange total return on Equity (Dividend, application/ Depreciation) with total return on debt (Interest plus appreciation/ Depreciation). In this case the person who invested in Equity can reduce losses, when the markets are falling. swap+ option= swaption Swaption: It is an option given to enter in to a swap agreement (or) not. Ex: - You have Reliance shares, planning to Enter in to a Total Return Swap (TRS) since you suspecting the price down form tomorrow. Once the company submits the financial statement (Expecting losses to be reported). However, the share price make increase of the results are good/ if company reports profits. You can now enter in to a swaption agreement, which will give you an option to enter in the SWAP or not (you have to pay premium, like an option contract). If the stock is following after the result announcement, you can use the contract by Entering to swap agreement where you get the return on Debt instrument in exchange return on Equity. if the result is good, you can ignore contract and continue to hold the Equity shared. 64 In this contract, both parties agreed to settle the contract by paying the gain (or) loss in cash, which means there is no physical delivery of good/ securities. Ex: - You have gold (one ton), you want to sell at Rs.55 crores after a month However you are Expecting the price to fall to Rs. 4 crores. you have Enter a EFD contract to sell at Rs.5 crores on the contract expiry date, the market price is 3 crores. The opposite party has to pay Rs. 5 Cr to buy 1 Ton of gold which mean that party is making a loss of 2 crores. that party will pay Rs.2 crores to settle the contract instead of buying gold from at Rs.5 crores and taking the delivery. (If required, you sell in the market for 3 crores. your effective price become RS. 5 Crores. CFDs → contract for differences. In the money (ITM)→ Contract gives profit to the holder of the contract At the money (ATM) → Contract gave no' profit/ loss to the contract. Out the money (OTM) → Contract gave loss to the holder of the contract. For all these moneyness calculations, Premium is not included. Ex: you bought reliance call option with stake price of Rs. 2000. on the contract Expiry date, market price (spot price) of reliance is Rs.2500, you will use the contract and buy at 2000 so profit of 500. this is In the Money (ITM). If the stock is Exactly 2000, no gain/ loss so At the Money (ATM) contract. If The stock is trading at 1800, This contract is not useful to you so that is Out the Money (OTM) contract. Ex: You have SBI stock purchased at Rs. 300, you thought price will fall so purchased a put option with strike price is 300 (premium paid to is 20). now you have right to sell at 300. on the Expiry date, if the stock price is 290, you will use the contract and sell at 300, so it is ITM Contract. (If spot price/ price on Expiry date is 299 and below, contract is useful to you so ITM contract) If stock price on Expiry is also 300, ATM contract (no gain/ loss due to that contract) If stock price is 301 and above on Expiry date, this contract is not useful to you can sell in the market itself so Out the Money (OTM) contract. This ATM/ OTM etc. is decided at contract level. This is not decided from holder and writer perspective if a contract give loss to holder, it is OTM contract, we cannot say it is ITM for seller etc. 65 Journal entries for Derivatives: Most commonly used derivatives are a) b) c) d) Forward Future Options Swaps Forwards: 1. Fund has gold, they are expecting the gold price to go down from current price of 5000 to 4000 per gram (No entry) 2. On 17th October 2021 based on they view, they entering the forward contract to sold 100 grams gold on current market price at month end (31st October 2021). Here also no entry has been taken but notional loss must be shown in notes accounts, the fund has so many forward contracts, so fund has might chances to forget about 1 or 2 contracts. So, the fund just shown a dummy entry with debiting asset and crediting liability without effecting financial statement. Like Forward contract asset A/c Dr To Forward contract liability A/c 500000 500000 3. On 31st October, settlement is happing that day, market price is 6000 per gram. Since that forward contract is there, fund has to tell at Rs.5000 through market price is Rs.6000. so, contract giving loss of Rs.1000. total loss will be (1000*100) = 100000 a) Settlement happens in cash: Loss on forward contract A/c To bank account Dr b) Settlements happens by delivery gold. Bank account Dr Loss on forward contract A/c Dr To Investment in gold A/c 100000 100000 500000 100000 600000 66 Note: Whenever we entering the OTC contract (forwards, SWAPs), there is no cash flows happens. Based on their controlling they posted a dummy entry. Futures: 1. On 17th October 2021, entered in to a future contract to sold gold at Rs.5000 per gram, contract value is Rs.500000 margin (on 100 grams) at 20% paid to national stock exchange which is Rs.100000. Margin on future contract A/c To Bank account Dr 100000 100000 2. On 18th July 2021, gold price went up to Rs.6000 per gram, so we making loss of Rs.1000 per gram, total loss is Rs.100000 MTM Margin on futures contract A/c Dr To Bank account 100000 100000 3. On 31st July (settlement date), Gold price is Rs.7000 per gram. Loss on future contract A/c Dr 200000 To Margin on future contract A/c 100000 To MTM Margin on futures contract A/c 100000 4. On 31st July (settlement date), Gold price is Rs.3000 per gram. Bank account Dr 400000 To Margin on future contract A/c 100000 To MTM Margin on futures contract A/c 100000 To gain on futures contract A/c 200000 You should not take gain/ loss on derivative contract directly or else it is • Balance sheet date • Date closing contract 67 Options: Holder pay the premium and get the right to buy/ sell. This premium is expenditure to fund. Fund wants to sell the gold at Rs.5000 per gram, they have paid premium of Rs.10000 per contract for sell 100 grams of gold. 1. They have paid premium. Option contract (Asset) A/c To Bank account Dr 10000 10000 2. Contract settled on 31st July 2021, market price is 6000, Since the market price is better than the contract price the fund will sell in the market, ignore/ lapse this contract means the premium is total loss Loss on option contract A/c Dr To Option contract (Asset) A/c 10000 10000 3. If the price is Rs.3000 in the market, then fund will exercise the contract, market profit. Sell 5000 Market price 3000 Profit 2000 Premium -1000 Net gain 1000 Bank account Dr To option contract asset A/c To gain on option contract A/c 100000 10000 90000 Option seller receive premium have obligation: Bank account Dr To option contract liability A/c 10000 10000 Expire since market price is 6000: Option contract liability A/c Dr To gain or option contract A/c 10000 10000 68 Corporate Action Corporate action is an action taken by a company (listed company), That impacts all stake holders (shareholders, Debenture holders). Ex: HDFC large cap fund invested in Infosys company shares, that company announced dividend, this mutual fund should account that dividend on time. If not accounted on time, The Nav of the fund will affect. The funds like mutual funds, Hedge funds calculate NAV on regular basis like Daily/ monthly...etc. based on that NAV, investor can invest in the fund (or) withdraw from that fund. If the fund missed to record to a corporate action in time, The NAV will be impact. To ensure all the corporate actions are recorded on timely basis, accurately, this fund houses grouped these corporate actions into below categories: Mandatory Corporate Actions: 1. Dividend 2. Bonus shares 3. Stock split 4. Reverse stock split/ Consolidation of shares 5. Mergers 6. Acquisition 7. Name changes of the company Voluntary Corporate Action: 1. Right shares 2. Buyback of shares Mandatory with choice Corporate Action: 1. Dividend at cash/ stock Mandatory corporate actions do not require any acceptance from the investor. if investor is silent also the company will process that corporate action and investor will receive it Ex: - if company declares dividend today and paid after 10 days, investor need not accept/ reject that, amount will automatically in the investor account. 69 Voluntary Corporate Action requires the investor approval/ application to process that corporate action if not, it is assumed investor is not interested, companies will not give that corporate action benefit to the investor Ex: of company wants to buy back I crone shares back from investor, they will announce, interested investors can submit their shares to company and get money, if not participated, these investors will continue to hold the shares with Them. Mandatory with choice Corporate Action will give some time to investor to accept/ reject the corporate action and if investor is silent than it will became mandatory. Ex: company decided a give dividend as shares/ cash, option is given to investor to confirm in 10 days. investor can choose one option in that time, if not, company will pay automatically in cash. Important dates for Corporate Actions: Record Date: - when company announce a corporate action, they will also announce they record date, this means any investor Whose name is there in the records of the company (Shareholder register) on that date is eligible to receive that corporate action benefit. Ex: - if TCS company says the record date for dividend is 10th November, that company will the names of share on that day and make the payments. Ex-Date: - This is one trading date before the record date, eligibility of an investor is decided on this day. In This stock Exchanges any transaction like buying/ selling of shares will take 2 business days to settle (If buy share on Monday, the share will be credited to you demat account by Wednesday). To get the benefit of corporate option/ to have an investor name in the records on the recorded date investor should buy that share at least 2 business days before the record date. if purchase on record date/ one date before record date. that investor was not eligible. one day before the record date is Ex- date, which means the share is trading without/ excluding the benefit of corporate action on that date. Ex: - If TCS company decided l0th November, Wednesday as record date, The Ex- date will be 9th November, Thursday. If you buy on Thursday, you will not get benefit of dividend. 70 On this Ex-date, it is decided whether an investor fund will get the benefit of corporate action (or) not. So, the funds like hedge funds/ mutual funds can be recorded/ post the Entries related to the corporate actions. Dividend receivable A/c To Dividend Alc. Dr If the corporate action is bonus shares (or) stock split, then the fund can increase the quantity of shares in the Ex- date. Ex: - Axis Mutual Fund invested into Wipro company shares, that company announced 1:1 bonus share, record date is 24th Nov, Wednesday. if the fund has 1 crore shares, they will get free shares from Wipro company (1 crone shares). This fund can update the quantity of shaves in their financial statements on Eu-date, which is 23rd November, Thursday If the company issue bonus share or announce stock split the number of shares in the company will increase without addition to cash balance in the company (or) asset of the company. So, market value per share will decrease, this decreased price can be seen the market on Ex-date. if the fund forgets to update the quantity on Ex-date. The market value of shares will also be incorrect... Ex: - If company share is trading at Rs. 100, on Ex-date. The share price will go to Rs.50. if company announce 1:1 BONUS shares. If fund takes market value of Rs.50 the old quantity of 1 crore shares, the market value will be Rs.50 crores only. The correct should be Rs.100 crores (Quantity of 2 crores x market value of Rs.50). Payment Date: On this date, the fund/ investor will receive the benefit of corporate actions. if the fund recorded receivable entry like dividend receivable, they can reverse the entry. Bank A/c Dr To Dividend receivable A/c main reasons for come to declare Corporate Action are: 1. To distribute the profits to own/ investor 2. Create liquidity for those shares and increase demand, which will increase the shares and wealth of investor. 71 Difference between Bonus vs stock split: Meaning Bonus Issue of free share like 1:1 Examples If an investor has 1 share, market value is Rs.1000. he will have 2 shares, market value Rs. 50 per share When If the company has profits (earlier year/ current year), then only free share can be issued (in the balance sheet, reverse will decrease and capital will increase) Company can repeat this any number of times if they have profits No. of times Stock split Decrease the face value per share from Rs.10 to Rs.5 If an investor has 1 share with Rs.10 face value (market value 100), now he will have 2 shares with face value of Rs.5 per share, market value decreases to Rs.50 in this case also. Company need not have profit to split the business. Company can repeat few times only in India. Face value of share allowed is Rs. 10, 5, 2, 1. This means if old face value is Rs.10, they can make directly 1 Rupees per share or 5,2. (max 3 times). Below 1 rupee they can’t split. 72 Reconciliations To report NAV in time, accurate numbers to the investors, these fund houses, fund administrators conduct different reconciliations... There are different parties in finalizing the NAV. So, differences can come in the value of investment/ number of securities/ Cash balance ... etc. between two different parties. Ex: - A mutual fund has apple company shares in the portfolio. Number of shares as per fund administrator is one latens, as per stock broker (prime broker) The Quality is 90,000. At fund administrator level (BNY/ state street), most of these reconciliations are done by comparing the number of shares, closing cash balance in Each fund. This reconciliation is done in between the fund admin books and prime broker records. The prime broker can be HSBC securities, JP Morgan securities.... etc. (stock broker/ prime broker buy and sell securities based on instructions from the fund house/ fund manager. the major balances are reported in investments, cash in balance sheet of any fund like hedge fund, mutual fund so they conduct reconciliations mainly to have correct balances in Those two lines in balance sheet. Position reconciliation – reconcile the quantity of shares between two parties’ data.Ex: if the fund has apple, Microsoft company shares, they will ensure the quantity in fund admin books/ custodian, prime broker records have same quantity. Difference can come due to corporate action not processed by one party. If apple company declared bonus issues of 1:1, That is not updated by fund admin then quantity is reported less. Or, if the fund manager asked to buy 100 shares of apple and record 50 shares in Fund 1 and 50 shares in Fund 2, they have recorded 50 shares in Fund 1 and 40 shares in Fund 2 since they are able to buy only 90 shares at the price of 1 100 per share (fund manages asked them to buy at Rs.100 per share, not more than that). same transaction is recorded as 45 shares to fund l and 45 shares to fund 2 by the custodian/ fund admin. Cash Reconciliation - in this process they will ensure closing cash balance of each fund is correct. 73 Ex: - As per prime broker, cash balance of JPM large cap fund is $ 50000, as pes fund admin it is $40000, difference is due to incorrect trade amount recorded by fund admin (they have recorded the trade using incorrect foreign currency conversion rate since they bought in GBP and recorded in USD) key terms: Trade blotter: To conduct the trade reconciliation, they use this file/ record which has all details of trades (purchase/ sale of securities). This trade blotter will have each trade like which security is purchased/ sold, quantity, price, currency, date of trade...etc. Fund house like JPM will update this after the reconciliations between bank records and transaction in stock Exchange for that fund etc. so this cash be used as final data for all trader Trade Life Cycle: - Once a security is purchased in a stock exchange/ sold, it is trade. That trade should be settled between the buyer and seller by stock Exchange to complete this settlement (where buyer get the shares/ debentures etc. and seller gets cash), The stock Exchanges co-ordinate between different like stock brokers, custodians, clearing house .... etc. Ex: - If a fund purchase reliance shares today (Monday), they will the shares by Wednesday (trade day +2 days) in to their demat account. in these 2 days, The stock exchange send the details to cleaning house who will co-ordinate with custodians, stock brokers, clearing banks, depositories and settle the trades (T+2 settlement). This can 1+1 settlement for derivatives Orders – To buy and sell any security in the market, buyers and sellers or their stock brokers will place buy order and sell orders once the buyer and seller matches the trade will happen. Bid price → Price of the buyer, Ex: you have placed an order to buy 100 shares of reliance at Rs.2500. ASK price → Price of the seller, Ex: -at fund house level also to ensure the final NAV is correct, they reconcile each investor allocation if the income and Expense is properly allocated. At each broker level also, they conduct internal reconciliation like data of front office (who place orders) and back office (who prepares contract note/documents to be sent to investor) 74 MUTUAL FUND Mutual funds pool the money form investors (mainly retail investors like employees, small business… etc.) and invest that money into various assets or securities. Ex: - ICICI NASDAQ fund launches in 2021. Collect Rs.100 crores from the investors and invested that money into stocks that are part NASDAQ (like Apple, Google, … etc. Since the type of funds are targeted for retail investors, they keep the minimum amount to in very low like 1000/5000. To collect money they issue units, generally per unit at Rs.10 Ex: - Investor invested is Rs.10000, he will get 1000 units at Rs.10 each. If fund is making profit from shares/ the asset where they have interested, value of the fund increases so the net asset/ NAV of the fund also increases so investors can market profit. Ex: - if NASDAQ goes up by 10% in the next 1 month, fund assts value goes up by approx. 10%. Net asset value pe unit will be approximately Rs.11, in the case, investor can get Rs.11000 if he wants to withdraw money from the fund For managing the money of investor, fund house (asset management company) like ICICI will collect management fees which is generally 1% to 2% on NAV of the fund Ex: - if the fund’s NAV is 100 crores, they will collect fee of 1 to 2 crores as fee per year At the time of launching the fund, they will announce the type fund, investment objective of the fund (like fund will invest in to equity shares of NASDAQ index or invest in government bonds … etc.) investors who are ready to take risk, can invest in to equity funds and who can take less risk can invest in to debt funds … etc. depends on investor profile, they can decide the right fund and invest. The fund house (asset management company) like ICICI will calculate the profit and losses, declare NAV on investors can withdraw any time and fund will pay based on that day NAV per unit. Some way any investor can invest any time (if open ended funds), they will be charged based on that day NAV. (simply it is an open-ended fund, means the investors can invest into/exit from the fund at time based on that day NAV) Ex: - fund launched on 1st oct 2021, NAV per unit is Rs.10. on 31st oct, NAV per unit is Rs.12. since the investments value increased. If investor wants to invest on this day, he should pay Rs.12 per unit so for 100 unis he needs to pay Rs.1200. 75 Benchmark: This will indicate, the risk in the mutual fund, possible return from mutual fund scheme. Ex: - Axis large cap fund will have Nifty50 as benchmark. This means this fund will give approx. 10% returns if nifty50 goes up by 10% in the next one year. If nifty50 is 15000 today, it reaches to it 16500 by the next year (10% increase in nifty50) At the time if launched the fund, the fund house/ fund manager doesn’t know the expected return from that fund. So, they cannot come at (or) indicate the fund return of that fund to the investor. Rather, they can indicate the possible return, risk by the announcing this benchmark. Ex: - If benchmark like Nifty50, BSE Sensex will have historical returns approximately 12% to 15%, if a fund is announcing these indices as a benchmark. this fund may give approximately 12% to 15% return in the long term. Unit: This is the smallest unit/ denomination available in a mutual fund to invest. This units are issued to investor while pooling the money by the fund. Ex: - ICICI NASDAQ fund pooled/ collected Rs.200 crores by issuing 20 crores units at Rs.10 per unit. By the default per unit price will be Rs.10 at the time of launch the fund.This unit price will increase over a period if the fund is making profits for the investment. Ex: - these 200 crores in invested in to Infosys company shares on 4th October, those shares increased by 10% in October, then the unit price also increase to approx. 11% (10% increases) Investor in mutual fund can buy (or) sell any number of units based on their investment capacity/ requirement. Ex: - if you have Rs.50000, you can purchase 5000 units (or) you can purchase 100 units if you have Rs.1000. If these mutual funds are registered in India as a trust, they can issue units, if they registered as companies, they can issue shares. 76 Unit Capital: Total amount raised by issuing units called as capital. Ex: - if the fund raises 200 crores by issuing 20 crores units, it is unit capital. New Fund Offer (NFO): When the fund is launched, they keep around 15 days’ time for the investor to apply for that fund units, it is NFO. Ex: - ICICI NASDAQ fund has NFO period now from 27th September to 11th October. During this period, Investor can purchase at Rs.10 per unit. Later it will be based on market value per unit (NAV) Open Ended Funds: At the time of launch of any fund (mutual fund/private equity fund/ hedge fund…etc.), the fund should mention if the fund is open ended fund/ closed ended fund… etc. Open ended fund means the investors can invest/exit into/from the fund at time. Ex: - the ICICI NASDAQ fund launched in Oct 2021, you have invested in that fund in that month and want to exit in November 2021, you can withdraw money, the fund house (ICICI) will settle the account to you. Some way, if Invesco fund is launched in 2013, you want to invest now in 2021, you can invest. Most of the mutual funds are open ended funds (approx. 90% and above), since retail investor (employees, students… etc.) wish to invest and withdraw money at any time (they prefer more liquidity means their cash in to investment in to cash based on their needs). Closed Ended Fund: These funds will collect the money at the time of launch and closed for any further transactions till the end of the time of the fund. Ex: - if the fund is launched in 2021 with 10 years life time, investor can receive their money back in 2031, others cannot invest between or Exit in between. However, Closed Ended mutual funds generally list the units in stock Exchange so if an Existing investor in that fund need money, they can sell the units in stock Exchange to another investor (if investor is there to buy). Fund house like ICICI will arrange the money for investors if they want to Exit, but those investors can sell in stock Exchange to another investor. 77 Interval Funds: These are like closed ended funds for most of the time in a year, however like 10/20 days in a year, they keep them as open-ended funds Ex: - if investor launches the fund in Jan, they may keep 1st July to 10th July of Each year as open-ended fund so investor can buy or sell units from (to the fund in other days they can only buy or sell in stock Exchange Net Asset Value: In mutual fund (any other fund like hedge fund), this NAV is calculated at regular intervals like daily/weekly/monthly/quarterly… etc. All the assets and liabilities in the fund are calculated based on the market value units to know NAV. NAV = Assets in the fund – Liabilities in the fund Each investor/ unit holder would like to know this NAV in that fund. So, they can understand if they investment increase or decrease. Ex: - if an investor invested Rs.1,00,000 from on 1st January 2021, the NAV as of 4th October is Rs. 1,50,000. The profit made is Rs.50,000. Different investor in that fund can have different number of units/ shares. So mutual fund calculates NPV per unit. Based on this NAV investor can decide number of units/ shares they want to purchase (or) sell; profit made by them… etc. NAV per unit = Nav that fund / no of outstanding units Ex: - Assets of the fund = 500 crores Liabilities of the fund = 10 crores Net assets = 490 crores (500 – 10) Number of outstanding units = 10 crores NAV per unit = 490/10 = Rs.49 per unit If you have 100 units in that fund (purchased at Rs.20 unit), decided to sell 50 units, you will receive Rs.2450 (50X49) from the fund. 78 Entry Load: Entry load charges/ collected from investors at the time of their subscription/ investment into the fund. this is income in the fund (income of fund house), The reason to collect these additional charges (over and above NAV per unit) to recovers, some administration cost such as Brokerage charges paid to Stock Exchange/ Stock Broker. Ex: - In mutual fund, investor can invest/ withdraw any time from the fund. due to their investment or exist, the fund will incur additional Expenses like brokerage charges to buy the stock to invest money received from investor. Assuming an investor give Rs.100000, The fund purchased Infosys company shares for Rs 98000, RS 2000 may go for brokerage charges/ other charges. if this investor transactions like subscription (investing into the fund), redemptions (Exit from the fund) are more expenses in the fund will increase so they collect these Expenses back from investors in the form of Entry lord, Exit lord...etc. Ex: - if entry load is applicable at 1%.NAV per unit Rs.100... the fund will collect Rs.101 per unit from the investor who is investing into the fund. Investor name = Sachine money invested = Rs.1,00,000 NAV per unit = 100 Number of units to be issued (100000/100) = 1000 units (if no Entry load charged) If Entry load is applicable, they will collect RS.101 per unit where 100 is for capital/ investment and RS.1 is for Entry load. Investment = Rs.1,00,000 Per unit price = 101 Number of units = 990.10 units (100000/101) Entry of Mutual fund book will be: Dr Bank A/c 100000 Cr Capital A/c 99,009.90 Cr entry load income A/c 990.10 In the fund books, entry load income will be presented as income, and Rs.99,009.90 will be presented as capital increase Note: - In India, SEBI banned Entry load charges currently. so, they are not collecting these charges for funds launched in India. 79 Exist Load Charges: - If fund collect some money from investor while exiting/ leaving the fund, they are exit load charges to that investor. Ex: - Sachine has NAV of Rs. 15000 as on 4th October, when he is leaving the fund, they have paid 146000 and collected Rs. 4000 as changes, they are Exit load charges. Reason to collect these are similar to Entry load (To recover admin Expenses like brokerage charges incurred by the fund due to these investor exit/ entry) If any investor invested in 2010 and continued for 10 years... etc. there is no Extra charges to fund due to that investor. However, another investor is investing for a month and exit in next month and reinvest after some time.... etc. The charges in the fund will increases so to recover those extra costs for these investors who are coming and exiting the fund, they charge this Entry load/ Exit load is applicable. Exit load is also optional and fund house can decide if they want to charge or not. Generally, they charge an investor if they Exit within one year from the date of their investment, and do not charge if the Exit is after one year. These load charges to investor and income to fund happens in open Ended funds only since fund incurred those Extra cost to accept new investors/ to arrange money to old investors.in closed Ended funds, investors can buy/ sell units in Stock Exchange directly so fund has no additional Expenses so no Entry load/ Exit in those closed Ended funds. Ex: - investor = Sindhu Number of units in the fund = 100 NAV per unit = 100 Amount to pay =10000 (if no Exit load) If Exit load 1%. applicable, then the fund will pay Rs. 99 per unit to the investor, so Rs. 9900 will be paid to investor and the fund will have income of Rs. 100 as Exit load. Entry of Mutual fund book will be: Dr capital A/c 10000 Cr Bank A/c 9900 Cr Exit load income A/c 100 80 Options - MF Schemes: within a mutual fund scheme, Investor will have different options/ plans to choose and invest. if you have decided invested into Axis small cap fund, you can choose one of the plans, depending on your requirements, common plans and options available in the market are: 1) Growth Plan: In this plan, the fund will reinvest any income received in that fund Ex: - if the fund invested in to shares, they will receive dividend and that amount will be reinvested and purchase shares in fund. this will increase the NAV of the fund. If investor do not need regular/ frequent income, they can choose this plan. NAV of the plan will be Higher than the Dividend/income plan since the income is reinvested in this case. 2) Dividend Plan/ Income Plan: In this case, the fund will distribute the income received like dividend to the investors. Since money is going out from the mutual fund scheme to investors, NAV of the fund will be less in this plan Ex: - If the NAV per unit growth plan 104, NAV of income/ dividend plan can be Rs.100 Investor who need regular income can opt for this plan. 3) Direct plan: in this case investor will directly invest into the scheme/ fund without taking help from mutual fund distributor.so, the fund need not pay commission to the distributor so expenses in this plan are less and NAV will be more. 4) Regular Plan: in this plan investor take help from mutual fund distributor to decide on where to invest, the fund need to pay commission to them so those charges are collected from investors and NAV will be less in This plan compared to Direct plan. If an investor chooses Direct, growth option that combination will have more NAV, if an investor chooses, regular and income option that will have least NAV. They can choose any option/ combination out of these 4 options 81 Type of Funds: Based on the type of investments made by the funds, there are many types of mutual funds all of them can be grouped into below categories 1) Equity schemes a) Large cap/ Bluechip funds. b) Mid cap c) Small cap d) Multi cap/ Flexi cap e) Value funds f) ELSS/ Equity linked saving scheme g) Focused h) Thematic funds i) Sectoral funds. 2) Debt a) Low / Short duration/ Liquid funds b) Long duration funds c) Medium duration funds d) Credit risk funds e) GILT fund f) Banking and PSU fund g) Money market fund. 3) Hybrid a) Aggressive hybrid b) Conservative hybrid c) Balanced funds 4) Others a) Index funds b) Solution Oriented funds. 82 Equity Schemes: this mutual fund invests into equity shares of listed companies (companies whose shares are listed/ available in the stock Exchange). Since they are invested into equity share, they will have ownership in that company. If the company makes profits, the share price will go up and the fund will make profits. If the company is making losses, the share price will go down, the fund will make loss. Ex: if Axis small cap fund invest in Narayana Hrudayalaya stock, The stock price will increase from Rs. 500 to Rs. 600. if the profit of That company is increasing, this will increase the NAV of that fund. This Equity share price will also increase/decrease due to other reasons; this fund performance can also impact due to those other reason such as a) change in interest rates b) change in government policies c) change in international market d) liquidity in the market e) political reasons...etc. so, risk is high in this Equity related scheme. The return also can be high in this fund since most of the business will grow over a period, that will increase share prices and create wealth for the investors. Large Cap/ Small Cap/ Mid Cap/ Flexi Cap Funds: Market Capitalization/Market Cap is the value of the company in the market, calculated based on the market price as of that day. market cap = current market price x number of shares. Ex: Reliance market price = 26092. number of shares = 644.51 crores. market cap -1681655 crores Top companies and their market cap a) Reliance = 1681591 Cr b) TCS = 1418105.32 Cr c) HDFC Bank = 883389.70 Cr d) Infosys = 720956.74 Cr e) HUL = 636445.53 Cr 83 Large cap funds invest in to top 100 companies by market cap so they can have consistent return in long term, less volatility/ risk compared to small cap funds/ small companies. These large companies will have risk management practices to survive any down trend in economy so collapse of those companies may not happen easily so investors principal is protected. Mid cap funds invest into those companies in 101 to 250 range by market capitalization. these are next level companies having potential to become large cap companies in future and return can be more than large capital if the Economy is growing. However, these are more risky than large cap particularly in tougher economic conditions/ when economy and Business are growing slow (when inflation and interest rates are high, growth in GDP is low...etc. Ex: a) federal bank b) Malappuram finance. c) apollo tires. Small cap funds invest into the companies below 250th position by market cap, these are small companies so they can grow at a faster rate if the management of the company is good and the product is good so returns to the investor/small cap funds can be high. since these companies may not go out of business if they make mistakes in the business/competitors came in that business/ economy is in recession/ tough times etc. Ex: Just dial, PVR cinemas, Blue Dart, Indian cement Flexi Cap/ Multi Cap Funds can invest in to any company (large, small cap... etc.) generally they invest major portion in large cap companies. 84 Thematic Funds: This fund will follow a theme like infrastructure like digital, ESG (environmental social governance... etc.) Ex: - ESG can be invest into a company doing electric vehicle business any company following environment friendly business, since most of these countries are targeting to reduce the pollution, they are Encouraging this Environmentally friendly business, share prices of those companies are expected to increase, this thematic funds with ESG Theme can continue to invest in this companies. In India, there are infrastructure funds targeting cement companies, Real estate company etc. to gain from government of India plan to develop more infrastructure like Roads, airports in next few years. Sectoral Funds: This fund will invest in to stocks of companies from a specific sector like Banking, health care, information technology ...etc. Compared to thematic funds, this sectorial fund has less choice to make investment since they can only invest into one sector. This fund is riskier since all the stocks in fund can give negative returns When there is negative news for that industry so the benefit of diversification is not there in this fund Ex: - when interest rates are increase all real estate companies can report less sales, that fund can give negative return. though the fund invested into more than 20 Stocks Focused Fund: In this case the fund will concentrate on few stocks rather than investing into more stocks at a time. Normal large cap fund/ small cap fund invests into 40 to 60 stocks to diversify the investment, these focused funds invest around 20 to 30 stocks only. The idea is to focus on some specific stock by the fund manages/ research team. So, they can better understand those companies find out when to buy or sell, those stock to get better profits compared to other funds. Eg: - Axis Focused 25 Fund. 85 Contra Fund: This fund will buy more stocks when the market is in bearish mode/ negative mode, this fund will sell, when the market is bullish mode/ positive mode. Idea is to sell the stocks when most of the market participants are buying the stocks are overvalued, so the fund will not stuck when the market will fall. This fund will purchase more stocks when the market is following, so they can find undervalued stocks, good quality stocks at low prices. At times, this strategy is risky, since this fund is going against most of the Market participants. Value Funds: These funds will try to find out, the undervalued stocks to buy, so they can appreciate more in the future when compared to other stocks (Bull/ Bearish market). ELSS/ Equity Linked Saved Scheme: This kind of Equity MF schemes will also offer income tax benefit to the investor on the amount invested into this MF Schemes. This tax benefit is given on the amount invested in the fund (not on profit made in that fund). Ex: - If you are a salaried Employee, earning Rs.10,00,000 per year, you have to pay tax Rs. 3,00,000 (assuming 30% Tax rate). if you invest Rs. 1,50,000, out that salary income into this mutual fund, your taxable income will be Rs.1,50,000. The tax liability will be Rs.2,55,000 (8,50,000*30 %). There is a tax saving off 45,000 approximately. When the awareness on MF is less in retail investors category, government announces this kind of additional benefits to Encourage them invest in MF 86 DEBT: This MF funds invest the money into fixed income securities like Debentures, Bonds, these mutual funds can offer a consistent return to debt investors like 6 to 10%. If a company like HDFC bank/ TCS need money, they can borrow from the public, MF… Etc. by issuing Debentures (bonds) Ex: - If a company need 100 crores rupees, they can issue 1 crore bonds/ Debentures at Rs. 100 per debenture. They will pay 8% interest per year, Repay the principal amount after 5 years, if the tenure of the bond is 5 years. The company who issued the Debentures/Bonds must pay the interest amount, the principal amount at agreed interest rate on agreed Date, in this bonds investor in these bonds has lower rates making loss, those kinds of investors looking for lower risk, lower return can invest into Debt MF. Depends on the company who are issuing the debentures, interest rates will differ. Ex: - The company like Reliance industries will have good credit rating like AAA. which means they have good financial condition to repay the debt in time, so they will offer lower interest rate like 7.5%. if company like Vodafone will have low credit rating like B- which means they more debt and losses, so the repayment capacity is less, they should offer more interest like 11%. An issues like government of India will pay lower interest rate like 6%. on the bonds since they can repay the interest and principal quit very or nil credit risk/ default risk. This is also offered different debt MF to the investor like low interest/ low-income funds; High interest/ high income funds… etc. If an investor wants to Earn more interest/ return They can take the risk and invest into credit risk funds... etc. If they want lower return/ Risk They can invest into funds like GILT funds (government bonds/government securities) If the tenure of the bond is more, they offer more interest rate since the default risk/ credit risk is more in those bonds (easy to predict if the company can repay money in next 2 years but difficult to predict if the same company can repay in next 10 years since a good company can become loss making in long term) same way, if the tenure of the bond is more like 10 years, interest rate risk is also high so investor Expect better interest on long term bonds compared to short term bonds. 87 (Interest rates normally change and predicting those interest rates for short term is easy, but predicting for long term is difficult) Ex: - if reliance company offer bonds/debentures in 2010 at 10% per year bond. they will pay 10% interest only from 2010 to 2020. If the market rates in 2016 are 15%, still this company pays at 10%. So, investor expect more interest on long term debentures/ bonds to reduce thin interest rate risk if investor is risk takes, he/ she can invest in long term debt funds who invest in long term bond. if investor can take low risk only, then they can invest in low duration funds like liquid funds, short duration funds, money market funds… etc. since these funds invest in to low duration securities having expiry date of less than 1 year so default risk is very low/nil. Short Term/ Ultra Short Term/ Liquid Market: This kind of funds invest in short term Debt securities like certificate of Deposit, treasure bills...etc. which means these Securities has maturity time of 3 months/ 6 months...etc. and they are liquid in the market (easy They can sell in market). The risk is very low, since the investor/ fund will assess the repayment capacity of the issues (company/ government/ banks), if that issuer is in good financial condition, investor will invest and within those 3/6 months. The issues will not default (generally). Most of the companies/ corporates (institutions also invest/park their money for short term in this fund, if they have access cash available for few days. Money Market Funds: Money Market means the place/ market where banks, financial instruments, companies... etc... raise short term money for their requirements by issuing different Debt securities like. treasury bills, Certificate of bonds, commercial papers, pre purchase agreement...etc. This money market funds invest into this kind of short-term securities so the risk is very low, they can get lesser interest like 5 to 6%. 88 Medium, Long-Term Bonds: Average maturity medium duration funds invest debt securities having time period of 3 to 4 years, The risk is moderate. long term/ long duration funds invest in debt securities having maturity time of more than 7 years. so, the Risk is Higher. GILT Funds: They invest in government securities like bonds issued by government of India, the risk is very low. Corporate Bond Ford: These funds invest in bonds/ Debentures issued by companies, the risk will be more compared to Gilt funds Credit Risk Bonds: These bonds invested in securities with low credit rating, which means the default risk is more, this company will pay more interest since the credit risk is more. Ex: - if fund invested into companies like kingfisher, big bazaar (future group), Vodafone, idea ...etc. The risk is more interest rate Will be more. Fixed Maturity Period (FMP): These funds will have a definite life like 5 years, they also invest into similar Debt securities (having similar maturity period like the fund duration/ 5years). Ex: - if HDEC launches 5 years FMP plan they will invest into Debt securities which will invest in 5 years, so they can repay the money through investor and close the fund. 89 Hybrid Funds: These funds invested into multiple asset classes, like some portion into Equity, some portion into Debt, some portion into gold...etc. In this case the risk diversified since the loss from Equity markets (if markets are going down) is offset with gain from debt market/ gold market. conservative hybrid funds invest more amount like 60% in Debt securities so low risk, low return. Aggressive hybrid funds invest into Equity securities more (More than 60%).so, comparatively more returns. Balanced hybrid funds invested into Equity, Debt in similar proposition like 50% Each. All the common Expenditure in office covered under management fee like Rent, salary, administration ...etc. Ex: Fund: Aditya Birla Healthcare Fund Launch date ⇒ 8th October Money collected = 30 crores Units = 3 crores at Rs.10 each 20-10-2021 Capital received from investors and units received bank account capital account Dr 30 crores 30 crores 21-10-2021 Cipla shares bought for 5 crores investment in shares account TO bank account Dr 5 crores 5 crores Apollo hospital shares, Dr Reddy, Narayana hrudayalaya brought for 10 22-10-2021 crores Investment in shares account TO bank account Dr 25 crores 25 crores 90 25-10-2021 All shares went up by 5% in these 5 days Investment in shares account Dr To unrealized gain/ loss on shares 1.5 crores 1.5 crores 25-10-2021 Management fee payable at 1% per annum NAV 30 crores fee rate 1% fee amount per annum 30 lakhs 41095.89 fee amount per 5 days management fee exp account Dr To management fee payable account 3000000*5/365 41095.89 41095.89 25-10-2021 All professional expenses are accrued Audit Fee Expenses Account Dr Custodian Fee Expenses A/c Dr Trustee Fees Account Dr To Audit Fee Expenses Payable A/c To Custodian Fee Expenses Payable A/c To Trustee Fees Payable Account 25000 10000 15000 25000 10000 15000 Balance sheet of Aditya Birla Health Care Fund of 25th October 2021: Assets Investment in Shares Cash/Bank Balance Receivables Total Assets Rs. In crores 31.5 0 0 31.5 Liabilities Bank Loan Management Fee Payable Other Professional Fee Payable Total Liability Capital/Net Assets Value/ Net worth 0 0.004110 0.005 0.009109589 31.49089041 91 number of units NAV per unit 3 crores 10.49667 statement of operations/ profit and loss account Dividend Interest Unrealized Gain Realized Gain Forex Loss/ Gain Management Fee Other Professional Fee Net Profit Rs. In crores 0 0 1.5 0 0 -0.004110 -0.005 1.4909 partner/ unit holder capital reconciliation: Units Capital Net Profit Net worth/ Total Assets/ Net Assets 30 1.4909 31.4909 Journal Entries: 26-10-2021 One investor wants to leave the fund by redeeming 100 units (Assuming no exit load) investor name: Dhoni number of units: 100 units NAV per unit: 10.4969635 Amount Payable: 1049.69635 Capital account To Bank account Dr 1049.69 26-10-2021 100 investors came into the fund, fund sold 1,00,000 units (Assume no entry load) number of units: 1,00,000 units NAV per unit: 10.4969635 Amount Payable: 10,49,696.35 Bank account Dr 1049696 Capital account 1049.69 1049696 92 26-10-2021 Purchase shares of Cipla for Rs.5,00,000 Investment in shares account To Bank account Dr 500000 500000 26-10-2021 total decrease in the share value is Rs. 7,00,000 Unrelised gain/ loss account Dr to investment in shares account 700000 700000 26-10-2021 All Expenses and income entries to be posted by daily Management fee expenses A/c Dr 25000 Audit fee expenses a/c Dr 15000 To Management fee expenses payable a/c To Audit fee expenses payable a/c 25000 15000 if there is any Entry load and Exit load charges applicable in a fund, that is income to the fund (expenses to only incoming/ outgoing investor, not to all investors). If The investor is leaving the fund, fund need to pay 10000, deducted rs.100 and paid Rs. 9900 Capital account To Bank account To Exit load account Dr 10000 9900 100 This income will reduce the overall (net) expenses of the fund, expenses already paid like brokerage is recorded and now if we record this income, net profit of the fund/ NAV of investors will increase. 27-10-2021 Fund sold an investment (Cipla shares) for Rs. 5,40,000 Cost: Rs.500000 Market value reported in books: Rs.520000 Today they are sold for Rs.540000 since the unrealised gain/ loss on these shares are already reported we can reverse that entry. Unrealised gain/ loss on shares a/c To Investment in shares a/c Bank account To Unrealised gain/ loss shares a/c To investment in shares a/c Dr 20000 20000 Dr 540000 40000 500000 93 29-10-2021 Assume TDS is applicable on lawyer fees, lawyer send the invoice for Rs.100000, @10% TDS Legal fee expenses a/c To Legal fee expenses payable a/c To TDS payable on professional fee a/c 05-11-2021 Legal paid to lawyer Legal fee expenses payable a/c To Bank a/c Dr 90000 10000 Dr 90000 90000 05-11-2021 Professional fee paid to government of India TDS payable on professional fee a/c Dr To Bank account General Questions on NAV: 100000 10000 10000 - Q- Axis long cap fund launched in 2013, today NAV is 100. HDFC large cap fund launched today, NAV IS Rs.10. which one is better? A- Since both the funds are investing in similar stock, the return in future will be same if the present NAV is Rs. 100 (or) 10, the return in future same. Today NAV Investment amount Number of units get AXIS HDFC 100 10 100000 100000 1000 10000 If the underlying stock like reliance increase the share price by 10%. The gain will be 10% so NAV will be (approx.) NAV after one year will be Money we will get after one year is AXIS 10 110 110000 HDFC 1 11 110000 So, just because per unit price is more in AXIS it is not expensive (or) HDFC is not cheaper. If the future NAV per unit is increased by similar % then the gain is also same in both the cases. 94 Note: - Most of the times, old funds are established and they have more AUM in the fund so total Expenses in the fund will be shared by more unit holders so Expenses ratio will be less. so, slight advantage will be there for old funds. Ex: if audit fee is Rs. 10000 for both the funds, axis/old fund has 100000 units in total, each unit holder gets RS. I as Expense in HDFC/ new fund there are 50000 units, The shares of audit fee will be Rs.2 per unit. Q- Fund already accrued Rs. 10000 as management fee, while paying that amount, fund accountant recorded Expenses entry again (fee due to bank), what is the impact on 1AV, how to correct it? The first entry already posted regarding the management expenses rs.10000. it will reduce the NAV by Rs.10000 Management fee expenses a/c Dr To Management fee expenses payable a/c 10000 10000 at the time payment, the fund accountant again posted expenses entry in the place of payment of outstanding. So, liability not reverse and doble impact on expenditure it will decrease the NAV of fund, so we have to reverse the incorrect posting Wrongly posted entry Management fee expenses a/c To Bank a/c Dr the correct is Management fee expenses payable a/c To Bank a/c Dr Ratified entry Management fee expenses payable a/c To Management fee expenses a/c Dr 10000 10000 10000 10000 10000 10000 95 Q- Fund invested in Cipla stock, company declared dividend of Rs. 50000 (this fund portion), fund accountant forgets to post that dividend receivable Entry, what is impact on NAV? Since Dividend is income to the fund, if accounted it will increase the NAV, since it is not recorded NAV is reported less to increase, the below Entry need to be posted Dividend receivable account To dividend account Dr 50000 50000 Active vs Passive Funds: A general Mutual fund follows active management style to select these stocks to invest/ sell. Ex: - If an investor invests Rs. 10,00,000 in AXIS large cap fund. The fund manager invests that money in Infosys, Reliance, there search say, these stocks will increase by 20% in the next one year. The passive fund like index funds, Exchange traded fund (ETF), invest that money based on the weightage of the underlined index, not based on the research made them (passive management of the fund) Ex: - If HDFC launches nifty50 index fund/nifty50 GIF, they will invest more amount in reliance if that is major stock by weightage in that index. This indices like nifty50 are managed by stock Exchange like NSE and they will decide what stocks to be included or Excluded from the Index based on criteria like top 50 companies in India based on free float market cap will be included in the index. free float market cap means the market cap shares owned by public like Mutual fund, investors to calculate free float market cap, They Exclude shares owned by promoters …etc. since they don't sell (or) buy the stocks in stock Exchange. Ex: If market cap of reliance is Rs. 16 lakhs crones, Ambani has 51% shares then free float market cap is 7.84 lakhs crores. (16 Lakhs crores* 49%) When the NSE/ BSE etc. changes the stocks in the index, this passive fund like index fund/ ETF also changes the portfolio. so, decision making / research of the manages is less/ nil. They can only find the right time to buy more stocks/ sell more stocks but the names of the companies and quantity / proportion is already decided. 96 Ex: - If the market is Expected to crash 10% tomorrow, fund manager can sell more today and keep the cash so they can buy more tomorrow after the crash in market. These funds are more popular due to below reasons: 1) Low cost, generally fund charges approx. 2% fee on NAV. These index funds/ ETFs charge very less like 0.2%. since efforts are less from the fund manages/ research team. 2) Then funds are also giving good returns, very few actively managed funds are able to give better than these passive funds. 3) Risk management (possibility of these funds giving more losses if market crash) is good in these funds since top companies are part of these indices so portfolio is full of quality stocks (generally since they are issued based on benchmark indices like SEP 500, Nifty 50 etc.). common Examples of these passive/ passively managed funds are. 1) Index funds 2) ETFs (Exchange traded fund) Index funds invested in index like nifty 50, 500 etc. These are generally open-ended funds which means investor can invest (or) exit any time and also the fund house like HDFC will arrange the money to investors when they want to exit from that fund. ETFs are like a stock where they are traded in a stock exchange and the price changes in real time, these funds do follow an index like nifty 50. Ex: - If Nifty50 ETF is launched by HDFC, they pool money and invest that money in nifty 50 stocks, they will list the units of ETF in stock Exchange Price of these ETF changes in market on real time basis without depending in NAV, since investor know the underlying asset, they can understand when the NAV/ value per unit increases. Ex: - If Nifty 50 goes up from 17000 to 18700, 10% in today market, the price of NIFTY ETF goes up from 100 to 110 automatically. Investor need not wait for tomorrow for the fund house to declare NAV. If more people want to buy these ETF units, fund houses arrange that through market/ intermediaries where they will sell more unit in the stock Exchange. In India these ETFs are yet to become more popular so liquidity is less in the stock Exchanges. These GTFs can be launched on other assets like BONDS (Bharat bond ETF by Govt of India), Gold (Gold ETEs) ...etc. 97 Advantages: 1) Professional management 2) Risk management is better 3) Low-cost advice from professionals 4) Diversification 5) Liquidity 6) Less amount to start investing 7) Regulatory support. 8) Tax savings in some schemes. Disadvantages: 1) No guaranteed return 2) Cost can be high in active fund/ fund of funds 3) Some scams like front running/mis use of investor money in some cases Parties involved in mutual funds (or other funds): 1) Sponsor → launches the fund 2) Trustee → protect investor interest by monitoring activities of the fund 3) AMC/ asset management company → who manages the fund and main and important party. 4) registrar and transfer agent ⇒ who keep the record of unit holders/owners in fund like Karvy, cams companies. 5) custodian → who keeps the asset of the fund like share certificate in custody. normally third party. (Internal control). 98 99 Crypto currency: Derived two parts 1.cryptography 2. currency Cryptography: cryptography is associated with the process of converting ordinary plain text into unintelligible text (which can’t be understand) and vice versa. It is method of storing and transmitting data in a particular form so that only those for whom it is intended can read and process it. Cryptocurrency: (digital cash) Generally, Mr. A (India) wants send the money to Mr. B (USA) in between the transaction bank will be acts as a third party for transferring currency by taking some charge. But in the cryptocurrency currency can transfer digitally from Mr. A to Mr. B without any barriers. Here no third party involved. Advantages: 1. 2. 3. 4. No intermediary required No geographical transfer Less charges Very fast Disadvantages: 1. Transactions are irreversible 2. Used for illegal activity Cryptocurrency legal by Indian’s supreme court on April 2018 allowed to bank to handle cryptocurrency to encourage business relations and transactions digitally. But cryptocurrency is an illegal tender of money, which means it doesn’t have 100 Block chain: Derives two words 1. Block 2. Chain Block: block nothing but a data base, it stores lot of information. Block chain: it maintaining data of cryptocurrency transfer person to person. Every data base tied with a chain system like A sends B, B sends C, C sends D…etc. That entire follow of crypto currency has been maintaining at block chain. Bitcoin: one of the cryptocurrencies. Launched in 2009. The supply of bitcoin is Limited (21 million) How does a bitcoin transaction work? Why invest in bitcoin? Jan 2021: $36000/bitcoin. Its rapidly increases in a short time. We can buy a fraction of a bit coin. Where to store cryptocurrencies? 1. Store it with the exchange 2. Store it yourself (hardware wallet) Fictitious assets amortized over the period of time (5 years) Notional gain (unrealized gain) transfer to reserves & surplus 101 Invertren, e frant block stone , erd real ,jeniva Once we done book keeping Cash reconciliations Bank reconciliations Prepaid expenses statement Accrued expenses statement Real estate investment: Rent/ differed rent Revenue recognition Financial statements Get the JD, Tell me about yourself. If you can allow me, I can explain. I have found interest in fund account, I have grown some skills in fund accounting by knowing about private equity, hedge accounting and mutual funds IRR AUM Group of finance & IB (telegram group) 8374749796 Jitendra Sai Absolute return is the return that the mutual fund has provided over a specified period. ... For example – If a mutual fund' current value is Rs 10,000 and investment value is Rs 8,000, then the absolute return is (10,000-8,000)/8,000, which turns out to be 25%. 102 Relative return is the return an asset achieves over a period of time compared to a benchmark. The relative return is the difference between the asset’s return and the return of the benchmark. Relative return can also be known as alpha in the context of active portfolio management. Absolute return is simply whatever an asset or portfolio returned over a certain period. Relative return, on the other hand, is the difference between the absolute return and the performance of the market (or other similar investments), which is gauged by a benchmark, or index, such as the S&P 500. Relative return is also called alpha. • • • Absolute return is what an asset or fund returned over a certain period of time. Relative return is the return an asset or fund achieved over a period of time compared to a benchmark. Absolute return fund managers are focused on shorter-term results, whereas relative return fund managers are geared toward the bigger picture. An absolute return fund is positioned to earn positive returns by employing techniques that are different from a traditional mutual fund. Absolute return fund managers use short selling, futures, options, derivatives, arbitrage, leverage, and unconventional assets. The returns are looked at on their own terms, separate from other performance measures, with only profits or losses considered. Relative return is important because it is a way to measure the performance of actively managed funds, which should earn a return greater than the market. Specifically, the relative return is a way to gauge a fund manager's performance. For example, an investor can always buy an index fund that has a low management expense ratio (MER) and will guarantee the market return Yield Yield is the income returned on an investment, such as the interest received from holding a security. The yield is usually expressed as an annual percentage rate based on the investment's cost, current market value, or face value. Yield may be considered known or anticipated depending on the security in question, as certain securities may experience fluctuations in value. Yield is forward-looking. Furthermore, it measures the income, such as interest and dividends, that an investment earns and ignores capital gains. This income is taken in the context of a specific period and is then annualized with the assumption that the interest or dividends will continue to be received at the same rate. A bond yield can have multiple yield options depending on the exact nature of the investment. The coupon is the bond interest rate fixed at issuance, and the coupon rate is the yield paid by fixed103 income security. The coupon rate is the annual coupon payments paid by the issuer relative to the bond's face or par value. The current yield is the bond interest rate as a percentage of the current price of the bond. The yield to maturity is an estimate of what an investor will receive if the bond is held to its maturity date. Return Return is the financial gain or loss on an investment and is typically expressed as the change in the dollar value of an investment over time. Return is also referred to as total return and expresses what an investor earned from an investment during a certain period. Total return includes interest, dividends, and capital gain, such as an increase in the share price. In other words, a return is retrospective or backward-looking. For example, if an investor bought a stock for $50 and sold it for $60, the return would be $10. If the company paid a dividend of $1 during the time the stock was held, the total return would be $11, including the capital gain and dividend. A positive return is a profit on an investment, and a negative return is a loss on an investment. Risk and Yield Risk is an important component of the yield paid on an investment. The higher the risk, the higher the associated yield potential. Some investments are less risky than others. For example, U.S. Treasuries carry less risk than stocks. Since stocks are considered to carry a higher risk than bonds, stocks typically have a higher yield potential to compensate investors for the added risk. What Is Yield to Maturity (YTM)? Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. Yield to maturity is considered a long-term bond yield but is expressed as an annual rate. In other words, it is the internal rate of return (IRR) of an investment in a bond if the investor holds the bond until maturity, with all payments made as scheduled and reinvested at the same rate. Yield to maturity is also referred to as "book yield" or "redemption yield." KEY TAKEAWAYS • • • Yield to maturity (YTM) is the total rate of return that will have been earned by a bond when it makes all interest payments and repays the original principal. YTM is essentially a bond's internal rate of return (IRR) if held to maturity. Calculating the yield to maturity can be a complicated process, and it assumes all coupon or interest, payments can be reinvested at the same rate of return as the bond. ETFs vs. Index Mutual Funds: An Overview Exchange traded funds (ETFs) have become increasingly popular since its inception in 1993. But despite investors' love affair with ETFs, a closer look shows that index mutual funds are still the top choice for the majority of retail index investors. Here we will look at the 104 reasons why ETFs have become so popular and analyze whether they make sense—from a cost, size, and time-horizon standpoint—as an alternative to index mutual funds. As with many financial decisions, determining which investment vehicle to commit to comes down to the numbers. Given the comparison of costs, the average passive retail investor will decide to go with index funds. For these investors, keeping it simple can be the best policy. Passive institutional investors and active traders, on the other hand, will likely be swayed by qualitative factors in making their decision. Be sure you know where you stand before you commit. KEY TAKEAWAYS • • • Because ETFs are flexible investment vehicles, they appeal to a broad segment of the investing public. Passive retail investors often choose index mutual funds for their simplicity and low cost to own. Typically, the choice between ETFs and index funds will come down to management fees, shareholder transaction costs, taxation, and other qualitative differences. ETFs Because ETFs are flexible investment vehicles, they appeal to a broad segment of the investing public. Passive investors and active traders alike find ETFs attractive. Passive institutional investors love ETFs for their flexibility. Many see them as a great alternative to futures. For example, ETFs can be purchased in smaller sizes. They also don't require special documentation, special accounts, rollover costs, or margin. Furthermore, some ETFs cover benchmarks where there are no futures contracts. Active traders, including hedge fund traders, love ETFs for their convenience because they can be traded as easily as stocks. This means they have margin and trading flexibility that is unmatched by index mutual funds. Ironically, ETFs are exempt from the short sale uptick rule that plagues regular stocks (the short sale uptick rule prevents short sellers from shorting a stock unless the last trade resulted in a price increase). Index Mutual Funds Passive retail investors, for their part, will love index mutual funds for their simplicity. Investors do not need a brokerage account or deposit with index funds. They can usually be purchased through the investor's bank. This keeps things simple for investors, a consideration that the investment advisory community continues to overlook. Key Differences ETFs and index mutual funds each have their own particular advantages and disadvantages when it comes to costs associated with index tracking (the ability to track the performance of their respective index) and trading. The costs involved in tracking an index fall into three main categories. A direct comparison of how these costs is handled by ETFs and by index 105 mutual funds should help you make an informed decision when choosing between the two investment vehicles. First, the constant rebalancing that occurs with index funds because of daily net redemptions results in explicit costs in the form of commissions and implicit costs in the form of bid-ask spreads on the subsequent underlying fund trades. ETFs have a unique process called creation/redemption in-kind (meaning shares of ETFs can be created and redeemed with a like basket of securities) that avoids these transaction costs.1 Second, a look at cash drag—which can be defined for index mutual funds as the cost of holding cash to deal with potential daily net redemptions—favors ETFs once again. ETFs do not incur this degree of cash drag because of their aforementioned creation/redemption inkind process. Third, dividend policy is one area where index funds have a clear advantage over ETFs. Index funds will invest their dividends immediately, whereas the trust nature of ETFs requires them to accumulate this cash during the quarter until it is distributed to shareholders at the end-of-quarter. If we were to return to a dividend environment like that seen in the 1960s and 1970s, this cost would certainly become a bigger issue. Non-tracking costs can also be divided into three categories: management fees, shareholder transaction costs, and taxation. First, management fees are generally lower for ETFs because the fund is not responsible for the fund accounting (the brokerage company will incur these costs for ETF holders). This is not the case with index mutual funds. 2 Second, shareholder transaction costs are usually zero for index mutual funds, but this is not the case for ETFs. In fact, shareholder transaction costs are the biggest factor in determining whether or not ETFs are right for an investor. With ETFs, shareholder transaction costs can be broken down into commissions and bid-ask spreads. The liquidity of the ETF, which in some cases can be material, will determine the bid-ask spread.2 Finally, the taxation of these two investment vehicles favors ETFs. 2 In nearly all cases, the creation/redemption in-kind feature of ETFs eliminates the need to sell securities; with index mutual funds, it is that need to sell securities that trigger tax events. ETFs can rid themselves of capital gains inherent in the fund by transferring out the securities with the highest unrealized gains as part of the redemption in-kind process. Special Considerations Typically, the choice between ETFs and index mutual funds will come down to the most important issues: management fees, shareholder transaction costs, taxation, and other qualitative differences. 106 Index Fund vs. ETF: An Overview Learning investing basics includes understanding the difference between an index fund (often invested in through a mutual fund) and an exchange-traded fund, or ETF. First, ETFs are considered more flexible and more convenient than most mutual funds. ETFs can be traded more easily than index funds and traditional mutual funds, similar to how common stocks are traded on a stock exchange. In addition, investors can also buy ETFs in smaller sizes and with fewer hurdles than mutual funds. By purchasing ETFs, investors can avoid the special accounts and documentation required for mutual, for example. • • • • Mutual funds are pooled investment vehicles managed by a money management professional. Exchange trade funds, or ETFs, represent baskets of securities traded on an exchange like stocks. ETFs can be bought or sold at any time, whereas mutual funds are only priced at the end of the day. In general, ETFs are lower cost and more tax efficient than similar mutual funds. Index funds are funds that represent a theoretical segment of the market. This can be large companies, small companies, or companies separated by industry, among many options. It is a passive form of investing that sets rules by which stocks are included, then tracks the stocks without trying to beat them. Index funds are not investable. Exchange-Traded Funds ETFs are baskets of assets traded like securities. They can be bought and sold on an open exchange, just like regular stocks, as opposed to mutual funds, which are only priced at the end of the day. Other differences between mutual funds and ETFs relate to the costs associated with each one. Typically, there are no shareholder transaction costs for mutual funds. Costs such as taxation and management fees, however, are lower for ETFs. Most passive retail investors choose index mutual funds over ETFs based on cost comparisons between the two. Passive institutional investors, on the other hand, tend to prefer ETFs. • • • Comprehensive income represents the changes to owners' equity that originate from non-owner sources and traditional income. Comprehensive income includes adjustments made to the prices of securities held for sale by the firm and/or derivatives used to hedge such positions, foreign currency exchange rate changes, and adjustments to pension liabilities. Comprehensive income and how it is accounted for will usually appear in the footnotes to a company's financial statements. Comprehensive Income Examples Consider an example in which a co-worker wins the lottery. The lottery winnings are considered part of their taxable or comprehensive income but not regular earned income. This is because the lottery winnings are unrelated to their work or occupation, but still must be accounted for. 107 Another example would be a stock investment that company A makes in company B. This transaction is recorded on company A's balance sheet at the purchase price and is carried forward at this price until the stock is sold. However, if the stock price were to appreciate then the balance sheet entry would be erroneous. Comprehensive income would rectify this by adjusting it to the prevailing market value of that stock and stating the difference (gain in this instance) in the equity section of the balance sheet. A = P (1 + I)nt What are Dividends? A dividend is generally considered to be a cash payment issued to the holders of company stock. However, there are several types of dividends, some of which do not involve the payment of cas h to shareholders. These dividend types are noted below. Cash Dividend The cash dividend is by far the most common of the dividend types used. On the date of declaration, the board of directors resolves to pay a certain dividend amount in cash to those investors holding the company's stock on a specific date. The date of record is the date on which dividends are assigned to the holders of the company's stock. On the date of payment, the company issues dividend payments. Stock Dividend A stock dividend is the issuance by a company of its common stock to its common shareholders without any consideration. If the company issues less than 25 percent of the total number of previously outstanding shares, then treat the transaction as a stock dividend. If the transaction is for a greater proportion of the previously outstanding shares, then treat the transaction as a stock split. To record a stock dividend, transfer from retained earnings to the capital stock and additional paid-in capital accounts an amount equal to the fair value of the additional shares issued. The fair value of the additional shares issued is based on their fair market value when the dividend is declared. 108 Property Dividend A company may issue a non-monetary dividend to investors, rather than making a cash or stock payment. Record this distribution at the fair market value of the assets distributed. Since the fair market value is likely to vary somewhat from the book value of the assets, the company will likely record the variance as a gain or loss. This accounting rule can sometimes lead a business to deliberately issue property dividends in order to alter their taxable and/or reported income. Scrip Dividend A company may not have sufficient funds to issue dividends in the near future, so instead it issues a scrip dividend, which is essentially a promissory note (which may or may not include interest) to pay shareholders at a later date. This dividend creates a note payable. Liquidating Dividend When the board of directors wishes to return the capital originally contributed by shareholders as a dividend, it is called a liquidating dividend, and may be a precursor to shutting down the business. The accounting for a liquidating dividend is similar to the entries for a cash dividend, except that the funds are considered to come from the additional paid-in capital account. Cash Dividend Example On February 1, ABC International's board of directors declares a cash dividend of $0.50 per share on the company's 2,000,000 outstanding shares, to be paid on June 1 to all shareholders of record on April 1. On February 1, the company records this entry: Debit Retained earnings Credit 1,000,000 Dividends payable 1,000,000 On June 1, ABC pays the dividends, and records the transaction with this entry: 109 Debit Dividends payable Credit 1,000,000 Cash 1,000,000 Stock Dividend Example ABC International declares a stock dividend to its shareholders of 10,000 shares. The fair value of the stock is $5.00, and its par value is $1. ABC records the following entry: Debit Retained earnings Credit 50,000 Common stock, $1 par value 10,000 Additional paid-in capital 40,000 Property Dividend Example ABC International's board of directors elects to declare a special issuance of 500 identical, signed prints by Pablo Picasso, which the company has stored in a vault for a number of years. The company originally acquired the prints for $500,000, and they have a fair market value as of the date of dividend declaration of $4,000,000. ABC records the following entry as of the date of declaration to record the change in value of the assets, as well as the liability to pay the dividends: Debit Long-term investments - artwork Gain on appreciation of artwork Credit 3,500,000 3,500,000 110 Debit Retained earnings Credit 4,000,000 Dividends payable 4,000,000 On the dividend payment date, ABC records the following entry to record the payment transaction: Debit Dividends payable Credit 4,000,000 Long-term investments - artwork 4,000,000 Scrip Dividend Example ABC International declares a $250,000 scrip dividend to its shareholders that has a 10 percent interest rate. At the dividend declaration date, it records the following entry: Debit Retained earnings Notes payable Credit 250,000 250,000 The date of payment is one year later, so that ABC has accrued $25,000 in interest expense on the notes payable. On the payment date (assuming no prior accrual of the interest expense), ABC records the payment transaction with this entry: 111 Debit Notes payable Interest expense Credit 250,000 25,000 Cash 275,000 Liquidating Dividend Example ABC International's board of directors declares a liquidating dividend of $1,600,000. It records the dividend declaration with this entry: Debit Additional paid-in capital Credit 1,600,000 Dividends payable 1,600,000 On the dividend payment date, ABC records the following entry to record the payment transaction: Debit Dividends payable Cash Credit 1,600,000 1,600,000 112 113