Fund Accounting Notes

17.10.2002 What is Fund Accounting? Fund Accounting: - Asset Management companies (AMCs) like SBI, HDFC AMC, BLACK ROCK, ICICI PRUDENTIAL, etc., manages investors’ money and give returns/ profits or losses on that money back to the investors. Eg: - SBI will launch a mutual fund any investor can invest money in that fund like Rs 1000/5000 etc., SBI will invest all that money collected/ polled from the investors in any assets like shares, bonds, gold etc., and investment will give a positive/ negative return. Since these AMCs/ fund houses are in this business of pooling money from investors and invest that money into various assets for many years, they can understand the risk of investing in one asset and return they can get from that investment better than others. Eg: - SBI mutual fund manages to invest in the stock market from 1990, he will understand the stock market better than the new persons who is following the market form 2019/2020 when markets are falling down during covid time normal investors are started selling their stocks at very cheaper prices also with fear, meanwhile, fund managers are buying stocks at that time also since they are available at very low prices by expecting the prices will back to normal in 2021/2022.The normal investor might have 20% loss, fund managers has got 30% profit in one year. Investors like employees, small owners or wealthy people and institutions having more money like insurance companies, provident fund houses etc. will invest their funds launched by the AMCs since investing on their own is risky and they may get lower returns to collect/pool money from these investors the fund houses like black rock, SBI will launch these funds like mutual funds, registry funds separately invest into assets like shares, in the name of funds and distribute profits in that fund to the investors based upon their investments. There are different types of investors like low-income groups who can invest a lower amounts and who can take less risk and there are rich investors who can invest more money and take more risk. So, fund houses or AMCs also launch different types of funds those funds are grouped into the following categories- 1. Mutual Funds, 2. Private equity/ Venture capital funds, 3. Hedge funds. 18.10.2022 What is Mutual Fund? Mutual fund raise/ pool money from retail investors they invest that money mainly into listed companies/ shares like (Reliance, Infosys icici bank etc.,) bonds, gold etc. so the risk is less and the return is also low. What is Private equity/ venture capital funds? These types of funds are pooled from the wealthy investors like high-net-worth individuals (HNI) institutional investors like insurance companies, provident fund houses, etc., govt., funds like sovereign wealth funds like fund owned by Dubai or Fund owned by Singapore government etc., they can invest that money anywhere, generally we see that venture capital funds are invested in Startups like ola, uber, Zomato, real estate etc., since they take more risk and invest in these high risk assets so that they can expect more return. What is Hedge funds? These funds also pool money form the wealthy investors they can invest anywhere/ in any asset generally, it is invested in listed blue chip companies, crypto currencies etc., to take more profits with in short term and more profit with less investment, they also use derivate contracts like Futures and options and many more. When more investors are investing into these funds, these fund houses are launching different types of funds, these leads to the growth of industry. Eg: - India, total assets under the management of (AMCs) are less than 10 lac crs in 2010 and in 2022 it is crossed to 40 lacs cr. These leading to the growth of industry, various participants in the market. That is further leading to more regulations to the regulators like SEBI (SECURITIES EXCHANGE BOARD OF INDIA). IMPORTANT PARTIES IN THE INDUSTRY 01. AMC/ Investment managers/ Fund houses compact that launches the fund, decide on where to invest, when to invest/ sell etc., they collect the management fee from the investors. Eg: - Black rock, JP Morgan, SBI AMC etc. 02. Fund administrator/ Fund admins they take care of the day-to-day activities in the preparation of BOA (BOOKS OF ACCOUNTS) of the fund and it support for the fund tax filings related to the funds, bank transactions like pay and receive money etc. 03. Auditors- These people are meant to be audit the financial statements of the fund which is launched by the fund house. Eg: - KPMG, PWC, DELOITEE, EY, etc. 04. Custodians- Assets of funds like shares, bonds, gold, etc., should be with a third party and that party acts as a custodian. Eg: - If the fund is launched by SBI they will appoint Citi bank/ BNY melon as a custodian. 05. RTA- Register and transfer agent, they keep rewards of ownership details in the fund like who invested in a particular fund. Eg: - If SBI/ Black rock launches a fund, RTI like (AMs/ karvy etc., will take care of updating the investor details like date of an investment and buying and selling of units/ shares in a fund, how many units the investor hold etc. 06. Prime Broker/ Stock Broker- These people act as an intermediary person between the fund houses and investors and helps in buying and selling of stocks/ units. Eg: - Companies like Zerodha, Grow, Up stocks, SBI AMC, ICICI Direct etc. Mutual fund Analysis Now take look into the JM large cap fund: This fund is launched in 02nd Jan 2013 by JM financials (Fund house / AMC) as a open ended fund. This means an investor can invest any time into this fund at the time of launching or till date and in the same way an investor can exit into this fund as investor needs at any time. Eg: - If we invest in 2013, the fund might have issued each unit of Rs 10/- each, so if we invest Rs.1000/- you will get 100 units (1000/10 =100). If you want to buy the same unit in that fund now it costs of Rs 110.383 per unit. If the fund is investing in the good stocks those same prices are increasing and the value of the fund also increases mean while the value of your investment also grew up simultaneously. Eg: - If the fund collects Rs 1crore and invested in the reliance shares at Rs. 2000/each per unit/ share in 2020 fund value or investment value will increase to Rs. 2 crores if the share price is Rs 4000/- per unit/ share in 2025. Funds profit are calculated as total income in the fund (profit on sale of investment, increase in the value of share market, dividend etc.,) less expenses in the fund like Management fee, audit fee, custodian fee etc. Therefore, Total income in the fund – Expenses in the fund = Profit/ Loss on sale of investment. This fund was managed by the fund managers named Satish and Asti and these people will where to invest these money to get good returns. The fund was invested in the stocks like L&T, Infosys, ITC, ICICI Bank etc. If they feel Infosys share will go down in next month due to recession in US and HUL stock will grow up they can sell the Infosys stock and invest the same in HUL stocks. 19.10.2022 Net Asset Value: - Net Asset Value (NAV) is the market value of all securities held by the mutual fund scheme. You would find the performance of a mutual fund scheme denoted by NAV or the Net Asset Value. You can calculate the NAV per unit of the mutual fund by dividing the market value of the securities of the mutual fund scheme by the total number of units of the mutual fund scheme on any specific date. Calculation of NAV/ NET ASSET VALUE: Let’s assume that Invesco has launched a Midcap fund as on 19.10.2020 with 1000 and 10 units. Assets Investments Cash Dividend Received Total Amount Rs 1000 50 5 1055 Liabilities Management Fee Audit Fee Other Fee Payable Total Amount Rs 10 2 2 14 Formula for NAV: - Total Assets - Total Liabilities = NAV 1055 – 14 = 1041 Now, NAV per unit = 1041/10 =104.1 rs. This NAV is very important since all investors transactions like subscriptions and redemptions will components at this. If the fund making profit due to dividends received or investments value is increased etc., the NAV will increase. In some cases, the NAV will reduce in the market value of shares or due to the high expenses. Mutual funds calculate this NAV on daily basis since this allow the investors can exit at any time. PRIVATE EQUITY FUNDS: Private equity funds pool money from the wealthy investors and invest that money into the assets like real estates, infra structure projects, startups, distressed funds etc., these funds are target to rise of money like 1000 corers or 10,000 corers etc., so that they can buy assets more value or buy a major stake in the company like 5% or 10% of the shares that will give ownership in that company so, they can also involve in the decision making in the company. If these fund managers involve in the decision making, they can understand the business more, assess the rising in the business, since that company to take right decisions which can help to increase the shares at higher price after some time like 5years. This active involvement in the business and increase the share price in short term like 5 years compared to the longer period of time. It will help funds to get better returns com pared to mutual funds. A mutual fund can generate around 10% to 15 % per annum but these private equity funds can generate more than 20%+ return per annum. 20.10.2022 Since these Private equity funds invest huge amount in the companies, they invest for long term like 5yrs in that company that will help them to understand the business, make that company grow. This means that funds need investors who can invest in long term in the fund and don’t ask for redemption/ exit for a short period. Eg: - If Goldman Sachs has launched a fund, these keeps the fund time as 7yrs to 10yrs, pool money from the insurance companies or other institutions etc., these investors should okay to take money back after 7yrs to 10yrs. So, these private equity funds are launched on Closed ended funds, generally with 10yrs of life span or in some cases these may have the life span of 5yrs to 15yrs also. In these 10yrs they will invest the money and make the investment grow and sell and return the money to the investors. Life cycle of a fund that is launched as a 10yrs that will be (TENTTATIVE LIFE CYCLE: 1st year – Set a plan to meet the investor to launch the fund and register the fund. 1 to 4yrs – Research, find investments, invest the money at the negotiations. 1 to 9yrs - Operations, guides the company, wait for the valuations to grow, and the time for exit/ sell. 8 to 10yrs – Exit time, keep selling investments over a fund. 10th year – Liquidation of the fund. Launch of Private equity Fund: - To launch a private equity fund, these fund houses like KKR will prepare a document called an “PPM” (PRIVATE PLACEMENT MEMORANDUM). This document will be presented to the prospective investors who are willing to invest in the fund for a long run. This document will contain the details like the following: - 1. Tenure / Span of the fund. Eg – 5yrs or 10yrs. 2. Investment strategies of the fund / where the fund is going to invest. 3. Expenses in the fund. 4. Expected return in the fund They may reach out 100+ Investors and present the details of the fund and in some cases 20 / 30 investors may like to invest in the fund. Depends on the interest on the investor they will finalize the fund size. Some investors are agreed to invest, their profile is finalized (like they Individuals, institutions, etc., and they form India, America, or any other country in the globe). Based on this the fund manager will plan the structure of the fund like: A. To register the fund as like a company, partnership, trust etc. B. Where to register the fund in India / America / elsewhere so, they can get maximum tax benefits. C. Whether to stand-alone fund/ single fund or to have 2 entities like one is main fund/ master fund in America and sub funds in India or other country etc. In most cases these funds are registered as limited partnership entities to avoid regulatory issues like GOI may not allow Chinese companies/ investors to invest in India fund launched by an Indian company. Tax related issues like an American investor investing in Indian funds may have to pay Tax in America since, the investor living in America and he needs to pay tax in India since, the fund is launched by Indian company. Most of the funds are registered as more than one entity/ fund like 1. Register Main/ master fund in India. 2. Register sub funds/ feeder funds in Singapore / Dubai etc. to reduce the tax or any regulatory issues. Once, the registration is done list of investors, fund size is divided on the basis of list of investors, then announce to close of the fund like First Close. Eg: - Edelweiss has a first close of Private equity fund and the fund raised Rs. 1500cr. 21.10.2022 Key terms – Launch L.P. – Limited Partnership Generally, these private equity or hedge funds are registered as limited partnerships, this means all investors in the fund and fund manager in the fund, their liability is limited to their investment/ commitment. Eg: - If a fund or any business is registered as partnership (other than limited partnership), partners will have unlimited liability. That means any excess losses over and above the capital can be recovered from partners, (if capital in the business is Rs. 10cr bank loan availed for 10cr, bank can recover the loan from partners from their personal assets, if the losses are more than in that business and there are no assets to sell in business). If that business is registered as limited partnership like a company, partners/ investors in that business will have limited liability to the extent of their capital. Other format used to register these funds is LLC (LIMITED LAIBILITY COMPANY) however most of these follow limited partnership structure. If KKR launched a private equity fund to invest in Indian companies, they can register the fund as “KKR INDIA VENTURE CAPITAL FUND LP”. This fund / Limited partnership will be managed for 10yrs and liquidate once the tenure is completed. If they launch another fund, it can be registered as “KKR AISA FUND LP” etc. Limited Partners (LPs): The investors in the fund like HNIs, institutional investors, etc., these people commit/ invest some amount in the fund their liability is limited to that extent. These LPs will not participate in the decision-making operations in the fund they only invest when the fund manager / fund house ask to invest and pay expenses in the fund and take profit/ loss in the investment. Eg: - If Dhoni and Ambati have invested in the fund launched by Kotak/ JP Morgan they are limited partners. General Partners (GP): - General partner is the main partner in the fund who takes all the decisions like where to invest, when to invest, etc., this partner is from fund house like KKR/ JPM. Eg: - If the fund is launched by KKR, and 4 external investors are invested into the fund an amount of Rs 4000crs, there will be an internal investor from the fund house like KKR also, in the fund that person, will manage the fund (GP = fund manager). This is common practice in the industry to have investment from General partner/ person form the fund house since that will increase the responsibility in the fund to find good investments and manage the fund with responsibility. As per limited partnership rules, this general partner who takes decisions should have unlimited liability through other partners will have limited liability. Eg: - If general partner committed/ invest to Rs. 10crs, and his liability is Rs. 100crs/ 1000crs also the fund has unsettled liabilities after that fund’s assets. If the funds has committed of Rs.100crs and taken loan of Rs. 400crs, losses in the fund can be more than of Rs.100crs. In this case after selling assets in the fund and settling liabilities, there can be pending liabilities, general partner should have to pay that pending liabilities with their personal assets to avoid this problem, these fund houses has register as a separate company as general partner like “KKR LTD”, KKR general partner 1 ltd etc., and appoint that company as general partner. If capital / net assets in that general partner its of Rs.1cr any court / bank etc., can recover maximum of up to that Rs.1cr only, so fund house is not in trouble even if fund incurs huge losses beyond the capital in that fund. Limited Partnership Agreement: - (LPA)- When a fund is registered as limited partnership, all investors in that fund/ LP are partners, they entered into this LPA which will have all the details like: 1. Tenure of the fund. 2. Management fee/ incentive fee (Waterfall provisions) needs and how that to be paid. 3. When the financials of the fund are sent to the investors. 4. An expenses gap like max amount that can be paid by investors in that fund. 5. Rights and responsibilities of the investors/ partners can they transfer their stake to others etc. This document is important for accountants also to accrue different expenses and to know dates for financial reporting etc. Structure of the fund, Master fund, Feeder fund: Generally, these funds are registered as closed end funds as limited partnership since these funds collect money from international investors also to avoid double tax to those investors, they register sub funds in that fund. Common structure is to have one master fund, generally it is registered in America, one or more feeder funds/ sub funds registered in Cayman Islands/ Luxembourg etc. Master fund: - This is the main fund in the private equity fund/ hedge fund. This fund will have general partner/ decision maker, most of the investors and also investments are reported in this fund. Eg: -If black rock launches a private equity fund and rises Rs.5000crs to invest in India, they will register the main fund/ master fund in America mostly at Delaware state more than 60% of money is received in that firm from American investors or investors from other countries across the globe and general partner will be the part of this fund, if the fund invests in 5 companies like Oyo rooms, byjus etc., all these investments or majority of the investments are in this fund. 23.10.2022 They register this funds in America, accept all investors from America into that fund GP will also be the partner in the fund. Fund is register in the name of “Black stone real estate (India) fund LP”. This is also called as ONSHORE fund since the fund is in America where GP is also located and the business of the fund is run from that Location. Feeder fund: - This fund (Sub fund with in the fund structure) is registered as separate entity like Partnership/ company. Mainly to pool money form the internal national investors. Eg: - If the fund is launched in America by Black stone often that American investors may have to pay tax in their country like Indian investors in India or Russian investor in Russia etc., and also America can earn profits from that fund. So, that one more company/ partnership can be registered in the countries like Cayman Islands, Luxemburg etc., with the name of “Black stone reality fund (Cayman Islands) LLC” and take all these investors into that fund. Now these funds will have not any tax in company in anywhere and also no tax in America due to some tax treaties/ agreements between America and Cayman Islands so international investors have to pay tax in their home countries. Example for all funds and investors is give below: MASTER FUND Investor Name commitment Country Trump Ivanka Trump Warren Buffet Black stone LP Ltd 100 200 300 50 Black stone real estate (Cayman) LLP Total 350 1000 USA USA USA USA Cayman Island Partner Type LP LP LP LP LP FEEDER FUND Investor Name commitment Dhoni Putin Xijun Ping Total 200 100 50 350 Country India Russia China If Dhoni pays the amount 1. Dhoni pays to feeder fund in Cayman Island. 2. That Cayman fund (feeder fund) invest/ funds that amount into in America. 3. That master fund in America will invest into the companies like apple, byjus etc. Blocked entity/ Blocked funds: - It means block of tax lability at the fund at investment level. This separate entity registered in the fund. Structure will be used to invest in a company. Eg: - If the above Black stone real estate wants to invest in real estate property like Nexus mall in India, they have to pay tax in India on the profit made on that investment. To avoid that they register a blocked fund/ entity in Mauritius by the name “Blackstone real estate (Nexus mall) LTD” and invest that money into the company and that company will invest in nexus shopping malls. For Indian govt., records that money came from Mauritius and not from America for low tax/ No tax. Now this fund is sold in India after 10yrs the cash flow movement is 1. Cash sale of nexus mall will send to Mauritius company. 2. That Mauritius company will send amount to the America for master fund/ main fund. 3. Money from master fund/ America fund send to feeder funds in Canyon. 4. Feeder fund will distribute the amount to investors like Dhoni, Putin etc. Note: - Generally this blocker has no separate financials since they have as a limited activity to take money from master fund in a company. In the schedule of investments in financial statements this fund is disclosed as Byjus investment is held through blocker entity” Black stone byjus LTD., etc. Vintage fund: - This is known as first year of the fund or launch year of the fund. Eg: - If ICICI launch as private equity fund with “India advantage fund” in the year 2017 we can say that it is the vintage year of the fund is 2017. If KKR says that they have 25 funds in the year 2020 all these 25 funds known as vintage funds because they are launched in the year 2020. First close/ second close/ subsequent close/ Final close: - Here close means a private equity fund is finalized list of investors with their commitments of each investor in that fund. Eg: - Kotak has a first close in September 2022, raised an amount of Rs.1500crs with 10 investors are committed to invest in that fund. If the same fund wants more money, then it will go for second close or subsequent close the maximum time of that fund to close is 3/6/12 months of span to shut that fund in that span new investors or existing investors can invest in to the fund. Eg: - Kotak fund had 2nd close or subsequent close in dec 2022 raised an amount of Rs.2000crs. So, now the total fund size has come to 3000crs i.e., (first raise – 1500 + second raise 2000 = 3500crs). Generally, these private equity funds keep this close span as 18 months / 24 months from the launch of day of funds. Some funds need more money at that time they come for 2nd close to complete very soon, so that fund manager can concentrate on investing that money in the companies up to the end-of-life time of funds like 10yrs. Investors cash flows/ Cash flows mngt. In private equity funds: These private equity funds are generally launched as closed ended funds with the certain life time like 10yrs., invest huge amount of money into each investment and most of the times into illiquid assets like start-ups, shares, or real estate funds etc., so pool the money at the time of launch and keep that money idle for months/ years till the investment opportunities is finalized ins not a good idea, they are keeping the money idle if they collect on day 1 of the fund’s lifetime. These managers take commitments from the investors, which means they will give money to the fund when the fund need money. Most of the times funds take up to 4yrs to invest all the money so they also collect money form the investors like below: 1st year – Collect up to 10% of the money from the total investments and invest them into one or two companies. 2nd year – Take 30% of company and invest into two or three companies. 3rd year - 40% of money collected form the investors and invest in three or four companies. 4th year – Remaining 20% money collected form the investors and invest companies. So, investors cash flows also negative in these first 4yrs, same way it is positive for fund and fund will sell and distribute the money in the last 4yrs (disinvestment period) the distributions can be below: - 7th year – 10% of investments are sold, 8th year – 30% of investments are sold, 9th year – 50% of the investments are sold and 10th year – remaining 10% of investments are sold. Also, if fund receive any cash like dividend, interest, rent etc they will distribute to investors. Q) If the fund asks/ calls money from investors and the investor is fail to give / invest in the time? A) An investor who become default to make payment is called delinquent interest or defaulted investor for the number of days delay. That investor has to pay penalty or penal interest called as “delinquent interest” like 10% per year. That income is the income to the fund if that investor is continued to default. GP/ fund house can be find other investors in that place and transfer the stake to that new investor for temporary period if the fund need money they can take amount. Key terms related to Cash flows: Commitments: - This is the amount an investor is agreed to pay to the fund as the time of launch. Eg: - If Kotak launched a fund today and Sarukhan committed Rs. 500crs he needs to pay that amount whenever the fund calls/ asks him to pay. Fund will asks/ calls that money when they want to invest some where or the fund need to pay for expenses like Mngt. Fee/ audit fee etc. Generally, this commitment includes al reasons like towards investments, mngt. Fee other expenses which mean the max amount that investor need to pay is that amount only. However in some funds, management fees are outside commitments, this means Sharukh need to pay Rs.500crs for investments and towards other expenses and some money for management fees. Assuming the fund is charging management fees on commitment as 2% per year, he needs to pay Rs.10crs per year as management fee (500X10% = 10crs) so 101X10% = 100crs for 10yrs as fees, his investment in the fund is 600crs in that case. Capital call notice/ contribution: - When the fund need money to invest or to pay expenses, they issue capital call notice (drawn down notice) to each investor, money sent by investor to the fund against the capital call is called “contribution”. Generally, they give around 15 days’ time to each investor after receiving from them, the fund will invest into the company. Ex: - Dhoni committed to Rs. 100crs to Kotak fund, total fund commitments (fund size) is Rs. 1000crs he has 10% of ownership in the fund. If the fund is calling to Rs.200crs to invest in a company (Karnataka bank), they will call 10% of 200crs that is Rs. 20crs from Dhoni. Distribution: - When the fund has money, they pay that money to investors it is distribution. The different types of distributions are as follows: Income distribution: - When fund receives income like interest, they will distribute that money to investors. Capital distribution: - When an investment is sold, that will be distributed to investors in kind distributions. Ex: - Carlyle fund invested in SBI cards shares, when that company went for IPO (Initial Public offer) this fund can transfer 100 shares to each investor in the fund and these investors can directly sell their shares in stock exchanges when they need money fund will not sell and then pay that money to investors. This can happen when the fund has to liquidate the fund so they cannot wait for good time and price to sell the shares or if the shares are available in the stock exchanges so investor in the fund can sell them when they need. Recallable distribution: - This is a portion of distribution amount an investor has to contribute again to the fund, if the fund says it is recallable distribution at the time of distributing it. Ex: - Deepika committed to Rs.100crs to the fund, paid already Rs.50crs in 2020, in 2021 fund distributed Rs.25crs to her (on sale of investment) and mention Rs. 10crs in that is recallable distribution this means out of that 25crs, she can spend Rs.5crs anywhere but she has to plan to invest Rs.10crs again in the fund asked her to invest. This is not normal in all the funds however, if the GP (General partner) feels the market conditions are good to invest more money so they can make more profits etc., they can use this option however fund should have this condition in LPA (Limited partnership agreement) and inform the investors in advance while distributing to them so, they can plan and have this money available to invest in fund when GP asked them to invest. Unfunded commitment/ remaining commitments: - Unfunded commitment (UFC) = Commitments – contributions. If Katrina committed to Rs.100crs to ICICI fund, already paid/ contributed to Rs.50crs the UFC is 50crs normal distributions made by the fund to investor will not impact this UFC, that distributed amount is investors money GP/ fund cannot recall. If it is recallable distribution that will increase the UFC since investors has to invest that money again in the fund. Ex: - If the fund paid Rs.20crs to Katrina and mentioned 10crs is recallable. UFC = Commitments – contributions+ recallable distribution. 100- 50 +10 =60crs. Original unfunded commitment is 50crs and the recallable distribution is added to is 10crs so total UFC is 60crs GP will ensure the UFC is not exceeding the original commitment of investor so it is easy for the investors to arrange money in time and plan their cashflows. Ex: - If Katrina committed to Rs. 100crs her UFC is at any point time will not exceed to 100crs. 27.10.2022 Incentive fee/ Performance fee/ Carried interest/ Water fall provisions: Apart from Mngt., fee these fund houses like KKR who manages private equity funds take incentive fee/ profit share also in these funds, whereas Mngt., fee is compulsory expense to the investor even if the fund is making losses, they have to pay the fee to fund house. This incentive fee/ performance fee/ carried interest is paid only if the fund is making profits, this is paid as on percentile basis like 20% of profits in that fund is paid to GP/ fund house. Since investors is taking risk, they have to bear those losses if any in that fund, they also expect some return and they will be ready to share profits if the return is beyond that expectation. So, these investors can negotiate with GP/ fund house at the time of launch on terms and conditions to share these profits, these terms will be included in LPA (Limited partnership Agreement), these provisions in LPA called as “Waterfall Provisions” these profits, since explain the cashflow distribution since carry in a private equity fund like who will get cash first (investors or fund house) and when will get next whom the fund has get cash (by selling investments). There are 2 types of waterfall provisions in this industry that are commonly used, they are as follows: 1. European waterfall fund method and 2. American waterfall fund method. American waterfall method it is less popular method GP/ fund house can take incentive-based profit on each investment (deal by deal). Eg: - If the fund collected Rs. 100crs and invested 10crs in a company they can take incentive fee after the sale of that investment for Rs. 20crs. Since there is a profit on sale of investment, if they sale that investment in 6th year they can take incentive fee at that year only. But there are other investments yet to be sold, perhaps there may be chances to get losses in other investments later. European waterfall method: - It is the most commonly used method in the industry fund house take carried interest only if the investors got their principal amount and some minimum return on that investment, not based on profits in the deal. Common cashflow distribution hierarchy/ waterfall method: 1. Pay 100% investment/ principal amount to the investors. 2. Pay 8% return per year as preferred return to the investors on their investments (if GP invested in the fund, GP money also returned). 3. On the remaining cash available in the fund pay catchup to fund house, calculated as 20% on the preferred return amount. 4. Remaining profit/ cash in the fund can be scummed between the GP and partners. Key terms: Hurdle rate: - This is the rate at which these investors in the fund expect the return/ profit beyond that they are key to share profits with GP/ fund house. Most commonly agreed return/ rate is in these funds at 8% per annum. Eg: - If investor invested Rs.100crs on 1st Jan if the fund is closed and amount paid back to investors on 31st dec of that year, then assume that 8crs is expected return as preferred return/ minimum return, but the actual profit is 10crs now the minimum return 8crs will got to investors directly and the remaining 2crs will be shared between GP/ fund house and partners with the agreed rate of percentage between them. This hurdle rate is decided at 8% based on the risk-free return in that invested country and risk premium for the risk taken by the investors in that fund. Eg: - If an American investor invested in govt., bonds issued by the American govt., they can expect 4% as risk free return approximate and risk premium is 4% approximately. Hence by clubbing these 2 concepts hurdle rate is fixed in these types of funds. In India it is around 10%. Soft hurdle versus Hard hurdle: - This can be explained with the help of following example: Date of Investment - 01.01.2022 Date of Liquidation - 31.12.2022 Capital invested - Rs.100crs. Hurdle rate - 8% If the fund got 109crs by selling the investments and after selling all fund level expenses/ liabilities, the cash flow distribution as follows: - Particulars Hard hurdle rate Principal repayment Preferred rate of return Total paid to investors Remaining cash available GP share LP share 100 8 Soft hurdle rate 100 0 108 100 1 0.2 0.8 9 1.8 7.2 So, in soft hurdle rate GP can take more incentive fee only the fund crosses the hard hurdle rate or equivalent return. If the return is 8crs below in both cases that will go to investors only. If the return is beyond 8% / hurdle rate all profits are shared in soft hurdle rate concept. In hard hurdle rate concept 8% return belongs to investors only and balance amount is shared between the partners and fund house. Preferred return: - This is the amount calculated based on the hurdle rate and investors money/ principal outstanding. This is payable to investors before the fund manager or GP can take any share in profits. Eg: - The above example of 100crs investment and 8% hurdle rate i.e., 8crs is preferred rate of return. If the same 100crs is used by the fund for 2yrs and returns to investors preferred return will be like this. Year 1st year 2nd year Opening Bal. 0 108 Investments Total 100 0 100 108 Hurdle rate 8% 8% Preferred return 8 8.64 Total 108 116.64 Generally, this return is calculated as annual basis so, the fund manager needs to pay more preferred return if they keep investor money for more time. If the fund collected late as possible as and return the money as soon as possible this part of return will be less so the chances of getting carried interest is high. The chances of getting more carried interest are high, if the same that uses this amount for 4yrs the preferred return payable will accumulate and the amount will be. Opening Investments Bal. 3rd year 116.64 0 th 4 year 125.97 0 Year Total 116.64 125.97 Hurdle Preferred Total rate return 8% 9.33 125.97 8% 10.08 136.05 28.10.2022 Calculate preferred rate of return form the below information. Fund name Commitments Investors Investments Hurdle rate Sequoia capital India fund LP 2000crs New York pension fund, Canadian pension fund, Kohli and Ambati CRED, Bounce bikes, 9 hospitals, what’s app, zoom 8% Date Paid 01.01.2021 Creed Mgnt. Fee and 9 hospitals Dividend What’s app Total 01.01.2022 01.01.2023 01.01.2024 0 Amount paid/ received 500 540 1000 1540 8% 123.2 1663.2 1663.2 1580.256 -200 5000 6300 1463.2 6580.26 8% 8% 117.056 526.42048 806.68 1580.256 7106.676 Opening Bal. Total Hurdle rate Preferred rate Total 500 8% 40 540 Preferred return payable as end of 2024 (31st dec 2024) is 806.68 outstanding principal as on that date is 6300crs received 6500crs and paid 200crs and that is considered to be principal repayment for waterfall provisions) Q) If the GP/ fund house wants carried incentive or carried interest in this fund how much cash they will should guarantee by selling all the investments in the fund? A) If there are any outstanding liabilities the fund like Mngt., fee, audit fee payable bank loan etc., fund should pay those liabilities first and then they can use the remaining cash for distribution to the investors. Assuming that there is no liabilities at this point of time fund should generate beyond the principal and preferred return outstanding that is 7106.68crs (6300+806.68) Assuming they sold 2 investments today and got 5000crs as all that amount will send to the principal amount for waterfall calculations. If all the investments are sold at the end of the time today 2024 through initial public offering/ sale this private equity to other private equity firms., and get as 9000crs the then distribution is as follows: - 6300 Cash available 9000 Cash paid 6300 806.68 2700 806.68 1893.32 161.34 1893.32 161.34 1731.98 Details Eligibility Principal Preferred return Catch up GP share 20% LP share 20% Carried interest Balance Cash 2700 346.40 1385.59 507.73 Note: - This carried interest is calculated on the catch up and GP share and catch up is calculated on the balance cash available. Q) If the fund gets Rs. 6500crs by selling all investments how that will be distributed? A) In that case 6300crs goes as principal and 200crs. Preferred return (806.68 – 200 = 606.68 balance) from GP. No there is no any guarantee return, if the fund make profits that is first paid to investors on propriety and any balance will be considered for profit share if there are no losses less than 8% per annum investors cannot demand form the GP/ fund house. Catch up: - This provision in the waterfall provision in a private equity fund given a right to the GP/ fund house as there same after paying principal and preferred return. Eg: - If investors invested Rs.100crs preferred return payable is 50crs of that day, fund will both these amounts when they sell investments, if the remaining 5crs they have to share in 20:80 ratio between GP and investors in a fund. 1cr for the efforts of the GP, that may be a small amount, if there is any catch up that is agreed at 20% on a preferred return catchup payable is 50crs preferred return * 20% = 10crs so all the remaining catch up to 10crs will go to GP. In this case remaining cash is 5crs all that amount will belong to GP. If there is carried interest/ incentive fee in the fund, that motivates the GP to put more efforts then may get less returns if the market is slow / if economy recession etc. In that case, if the returns are just above the preferred return, they may not be enough cash to pay as profit to pay GP than can satisfy the efforts of GP. So, GP can negotiate for this catchup. If catchup is their GP can take more portion of remaining cash exclusively for his. Since and then profit sharing can happen between GP and LPs. Most common percentage used to calculate catchup is 20% on preferred return and in some funds, it may have 25% also on preferred return. Eg:- If preferred return paid to investors is Rs. 100crs catch up eligibility to GP is 20crs or 25crs this is not paid form the preferred return, it there is extra cash after preferred return payment. 29.20.2022 Should we calculate preferred return and carried interest on regular basis like monthly, quarterly or yearly or only at the end-of-life time of fund/ when all investments are sold? The private equity fund prepares financial statements on accrual basis so any expense for that accounting period (monthly, quarterly, yearly) should be accounted with in that period. These funds prepare financial statements on monthly/ quarterly basis (un audited financials) at the end of the year financials are audited. So, they have accrued the carried interest or any expenses in the fund books when there is carried interest is payable at that fund. In most of the funds, carried interest payable situations arise where the assets value increase and NAV is also increased in that fund, that NAV is more than the principal and preferred return payable in that fund. Eg: - In the fund NAV is Rs. 500crs waterfall provisions calculations are like below: Details Amount (in crs.) Comments Remaining Principal O/S 200 Investors invested 300crs 100crs already paid by selling some investments Pref. return Payable 200 Total Payable to investors Bal. cash available in the fund, carried int. and NAV value Assuming 80% share to LPs Assuming 20% share to GP 400 Cumulative amount at the end of selling all investments 500 100 80 20 In this case the fund can accrue the carried interest entry will be like this (Journal entry) Carried interest exp. A/c Dr. 20 To Carried int. Payable A/c 20 Q) Can this carried interest expense calculate when (increase or decrease) in the fund books as it is same. Particulars 2022 Assets Investment 2027 2028 Amount (in crores) 300 0 100 0.00 Cash 100 0 Total Assets Liabilities 100 2022 Mngt. Fee Other Expenses 1 1 2 2 2 2 NAV 2 98 4 296 4 96 300 2027 Amount (in crores) 100 2028 If will change Market value of investments and NAV in the fund can change depends in the market conditions. Eg: - Companies share price in the market was very high in the year 2019 when business is good, and in 2020 share prices of the companies went down due to some circumstances. When NAV in the funds is also less like 98crs principal itself is 100crs (investors invested in the fund) so there is no carried interest in 2022. In 2027 NAV is 296crs where as principal and preferred return payable as 200crs and the remaining balance 96crs (296- 200) so, in this scenario the GP/ fund house can calculate carried interest at 20% on the remaining 96crs for accrued interest i.e., 96 x 20% = 1.96crs and in the above same example the NAV is went down to 96crs due to recession or due to slow down in the economy so, that expense of accrued interest can be reversed in the fund books. Q) Should the preferred return payable be also booked as an expense / income in the fund books? A) Not received based on any carry calculations that are done in the private equity fund books, only for external required in the books is carried interest expense if there is any eligibility for that fund the GP/ fund house. Where for preferred return, any profit in the books like any dividend decreased/ increased in the market value of the investment (unrealized gain/ loss) etc, anyhow belongs to investors only net profit/loss in the fund is also belongs to investors in closing balance/ NAV so no separate entry needed for this. Example shown in below table: Particulars Capital received Add: - Net profit NAV Amount 2022 100 10 110 By the end of the year 2022 if the carried interest calculation / waterfall provisions like below: Particulars O/s Principal Pref. return 8% at hurdle rate Total payable to investors Balance cash available in the fund GP share 20% LPs share 80% Amount 100 8 108 2 0.4 1.6 Now, fund house / GP will share in the profit after distribution of principal investment and preferred rate of return. So that after sharing the waterfall provisions the NAV of the fund will go down (110-0.4= 109.6crs). Claw back: - This provision is in the waterfall provisions given right to investors/ LPs to claw back any expenses carried paid to the GP/ fund house. E.g.: - During the life time of a fund carry amount of Rs. 10crs paid to GP/ fund house. After selling of all the investments by the 10th year when they check back all the calculations there will be a shortage of funds principal and pref. return. Total principal in the fund 100crs, pref. return payable after 10yrs is 100crs so total may go down to investors is 200crs towards this principal and pref. return. However, the cash available for the distribution in the fund to investors is 180crs only. So, these shortage of 20crs towards pref. return fund manager took 10crs already this can be happen mainly in American waterfall provision. Since amount is paid to the GP is deal by deal fund may made profit / loss on investments like cred, byjus. Now the fund house / GP need to give back that amount which is earlier taken by the GP. Q) The fund manager has paid income tax on that amount which taken early now he need paid the total amount which he has taken or not? A) The fund manager can pay the net amount what he has taken now after all the tax deductions on the early amount taken by him. 30.10.2022. Q) Calculation of private equity fund Fund name - Kotak pre-IPO fund Commitments - 1000crs Investments - Policy bazar, Udaan, Lens kart. Vintage year - 2021 Hurdle rate - 10% Carry - 20% Assume all the investments is made be 2023 June and we are in June 2025 as of today, there is no preferred return payable of 400crs fund sold all investments for 3000crs paid all the pending liabilities of 200crs, net cash available of Rs. 2800crs assuming the catch-up rate @ 25% on preferred return calculate incentive fee and carry payable to the fund house/ GP (Kotak). Sol: Details Principal O/s Preferred return Catch up Eligibility in crs. 1000 400 100 Cash available 2800 1800 1400 GP share 20% LPs Share 20% Carried interest = GP share + Catch up Cash paid 1000 400 100 Bal. Cash 1800 1400 1300 260 1040 360 Note: - If catch up is agree at 25% of preferred return GP will get 20% of total profits and fund has sufficient cash to cross all stage, if catch is 20% then the calculation will change, this is shown in the below table difference between 25% and 20% rates of catch up. Details Investments Net sales Profit Carry GP share in Profits If catchup @ 25% 1000 2800 1800 360 If catchup @ 20% 1000 2800 1800 344 20% 19.11% So, if the GP can influence the investors to pay 25% as catch up on preferred return, then the share will be 80% and 20% in overall profits. Details No carried interest Carried interest GP Advantage LP Advantage A A Hurdle rate A Soft hurdle rate Hard hurdle rate Catch up A A A Private equity fund launch Journal Entries in fund books: Kotak launched pre-IPO fund today and raised Rs. 1000crs Master fund, Feeder fund, is registered investors signed LPA. Sol: - No journal entry needed since no cash is received. If it is mutual fund and hedge fund, they collect cash from the investors in that case entry will be like this Bank A/c Dr. 1000 To capital Alc 1000 After 3 months fund called Rs. 300crs to invest money into one company shares Capital contribution receivable A/c Dr. 300 To capital A/c 300 Investors paid that money to the fund after 15 days entry will be like this. Bank A/c Dr. 300 To Capital contribution A/c 300 Fund called for Rs. 10crs for Mngt., fee as they are calling/ collecting on quarterly basis. Capital contribution receivable A/c Dr. To capital A/c 10 10 When money received for Mngt., fee entry will be like this Bank A/c Dr. 10 To Capital contribution receivable A/c 10 When fund received some cash towards interest or dividend as income then the entry will be like this. Capital A/c Dr. 25 To Distribution payable A/c 25 When the received income paid to investors then the entry will be like this. Distribution payable A/c Dr. 25 To Bank A/c 25 If the fund calculated management fee for Q1 2022 entry in the books to accrue the expenses is as follows. Mngt. Fee A/c Dr 10 To Mngt. Fee payable A/c 10 Fund will call from investors, collect the money and then pay to house entry for that will be like this. Mngt. Fee payable A/c Dr. To Bank A/c 10 10 Investment Strategies in Private equity funds: These private equity funds invest the money to make good returns to investors like 20% or more than that considering their style of investments like for long term, take control in the company, they sell for more profits. Below are some examples/ strategies for private equity funds are suitable. 1. 2. 3. 4. 5. 6. 7. 8. 9. PIPE – Private investment in Risk. Venture capital. Fund of funds. Real estates Infra structure. LBO – Leverage buyouts. Pre- IPOs. Credit strategy. Mezzanine strategy etc. LBO/ Leveraged buyout: Buyout means acquiring a major stake/ full stake in an existing company. This need huge amount of capital so if the fund uses borrowed money to acquire that company it is LBO. Ex. If the capital needs to buy a company is Rs. 50000crs the fund uses investors money for 10k crs and the bank loan 40k crs in this case, the fund will give the assets of the company (Which will be acquired with that capital) as security to the bank, if the fund made losses not able to execute the plan, the banker/ financial institution will sell the company and recover the money. Major gain for the investors if the idea is success, total investments made by the investors is only 10k crs in the above example though the total investments is 50k crs if the fund can sell the investments for 80k crs profit is 30k crs bank expects only interest and not profit share, assuming that 5k crs as bank interest and remaining 25k crs are the net profits for the investment of 10k crs so 250% return. (Similar to derivate contract where we invest lees money like 1 lakh to by 5 lakhs worth of shares and more profit if share goes up). Venture capital strategy: In this case the fund will invest into start-up companies, since the company is new and business idea is innovative idea, risk is very high, business might give huge return, if the idea is successful or the business may become total failure since customers did not understand the model or company did not predict the customer requirements, generally traditional sources for capital like bank, financial institutions, issue of shares, bonds, debentures to public etc will not work for start-ups since there is a huge risk in the investments of that type of companies. These venture capital/ private equity funds take that risk and invest into these businesses and they also guide the promoters to succeed in the business. The common sources for a start-up are. Age of Start up Source Money example 0-1 Boost strapping 10 lakhs 0-2 Angel investors 50 lakhs - 1 crs 1- 4 3+ yrs. - 10 yrs. Venture capital Private equity Comments start the business, find the pulse of customers. Individual investors like ratan tata who invest and guide the promoters if need. 1 cr - 10 crs VC firm (Owns capital of rich families) VC funds (pooled money form like sequoia invest for long term). 10+crs to 1000s crs Funds invested when the company is entering to growth stage from seed stage as they need huge capital like swiggy/ flipkart. Each time the start-up raise money they value the company and these funds take stake 5% to 10% each funding is called as series a funding. And named like Series B funding etc. Ex: - Byjus raised series D funding of Rs. 15k crs., the company valued these start-ups at 150000crs sequoia, soft bank etc participated in this round of funding. As a final stage of funding to the company, these start-ups go for initial public offerings (IPOs) or public issue and sell the share to public in this stage earlier investors like private equity funds or angel investors etc an sell to public and take their money or they can continue to hold the shares and later sell in stock exchange (When private equity funds invest also, earlier investors like angel investors can exit). Distressed strategy: In this case the fund will target to buy companies/ assets in distress/ financial trouble. Ex: - If a road contractor/ company took a loan form bank and unable to repay due to losses, that loan is non-performing asset to the bank/ lender. This fund can buy that loan/ control in the company or conduct the business of the company and recover more money than what they paid to acquire the assets main benefit in this case is the fund can buy assets/ company stake at cheaper valuations so if they receive the market price also, they get profit (buying worth of Rs.100crs assets at 60crs and sell at 100crs). 31.10.2022. Real estate strategy: - In this strategy these funds invest into assets like shopping malls, office parks, hotels, resorts, apartments, etc. They get rental income and appreciation on property. If they want more income with less risk, investment can be made and completed and rental yielding assets like office parks, where companies starting their offices in India like Goldman Sachs, JP Morgan, Amazon, State Street, etc., can pay rent to them, on consistent increase in rent can generate revenue for them. If these funds are okay to more returns by aiming for more like 20%+ they can tie up with builders like DLF/ Mitesh estates etc., and complete the projects like apartments, office parks, villas etc., which give more returns. Black stone is known for more real estate investments across the globe they won nexus malls in China and India and a major stake in Hilton hotels earlier, to maintain these funds fund managers takes help of different professionals or professional firms like asset managers, property managers etc., and they pay professional fee to them for taking their services. Asset managers helps them real estate funds to get tenants, negotiate rental terms and conditions etc., property managers help in the maintaining of their properties like shopping malls gardening, maintenance facilities like lifts etc., all these funds paid to them are accounted as expense in the books of this real estate funds. One of the practices followed by the asset managers to get the tenants to new properties like office parks, shopping malls etc., is to give rent free period like 6months or 12 months and agree for rental contract for 10yrs so, business like shops need not worry about these kind of rental terms and conditions and type of revenues in these funds also attract different accounting treatments based on local GAAP like US GAAP or INDIAN GAAP or FUND ACCOUNTING GAAP (Certain common practices are accepted due to nature of that business). Eg: - If the fund entered into the rental agreement with big bazar for 10yrs., for the first 6 months rent need not to be paid by the big bazar then the fund will spend that income for all the time 10yrs including 6 months rent free period by straight lining the rent and the rent per month is Rs. 1,00,000/-. Contract term - 10yrs/ 120 months. Rent free period - Jan to June 2022, (6 months). Effective rent - 114 months X1,00,000 = 114 lakhs. The fund will recognize that 114 lakhs in 120 months so, the rent per month will be 95,000/-. Entries in the fund books from Jan to June 2022 is will be like this. Rent free adjustment (Asset) A/c Dr. To Rental income A/c 95000 95000 In 6 months, amount is calculated for 5,70,000 (95000X6). July onwards it will be reversed so that asset will become zero by the end of the contract 120 months if the fund raising 1,00,000/- on rent from July, entry will be like this. Bank A/c Dr. 1,00,000/- To Rental income A/c To Rent free Adjustment (Asset) A/c 95,000/5,000/- Property accounting: - Most of the real estate funds first prepare their financials at property level like each hotel, shopping malls, etc., they prepare each trial balance for the single one and later on they go for consolidation. And second consolidation will be done at the fund level financials for the investors. In this case each fund known as real estate fund or PERE (Private equity real estate fund). Q) What are REITs? A) Real estate investment trust is an exit option for the private equity funds. If black stone has invested of Rs. 2000crs in two office parks it may not easy to get buyers from the market for the huge investments so they go for this REITs to sell their investments. It has process to sell their investments it is explained below: 1. Transfer their properties/ assets like shopping malls, office parks etc, to the trust. 2. Issue units/ shares to the public by dividing that asset value into small value of shares/ units. Eg. They convert 2000crs worthy property into 20crs shares/ units with Rs.100 each any investor can invest into this shares/ units if we invest Rs.10000/- we can get 100 units/ shares in IPO. 3. Investors can buy and sell their units/ shares with the help of stock exchanges to an on-going price. If that property market value is increases it will trade a premium like Rs. 110 each. 4. REIT will pay dividend to investors at a regular interval like quarterly from the rental income. Note: - These REITs are suitable for retail investors only so, they belong mutual fund category. Real estate funds belong to private equity funds only wealthy people can invest into this type funds. Infra structure funds: - These funds invest into the infra structure projects like roads, airports, sea ports, etc., they generate from toll charges, parking charges, etc., and any appreciation in the property/ asset they have only a span of 10 to 20yrs to collect the investments in the form of toll charges. INVIT? Similar to REIT these companies/ funds having infra-assets like telecom towers, gas pipe lines, internet cables, roads etc., can sell these assets to investors and list them in the stock exchanges like REITs. Eg: - NHAI, KKR etc did this planning to do this with national high ways. Reliance also did this for telecom towers owned by them. Fund of Funds: - In this case funds will not invest directly into shares or real estate, the fund will invest into another fund launched by Goldman Sachs fund of fund pooled money from 5 investors, Rs. 5000crs, invested into Fund name Amount Black stone Europe real estate fund 2000crs Black stone Asia real estate fund 3000crs In this case the fund manager is suing the expertise services/ knowledge of other fund manager or they use this route to invest in international markets. Eg: - If SBI can launch a fund of fund in India collects Rs. 100crs and invest that in JP Morgan fund manager know the American market better. One of the disadvantages of this strategy is more expenses since the investors has to bear the Mngt. Fee and other expenses in main fund and portfolio funds (expenses where this fund is invested). Eg: - If trump invested in Goldman Sachs fund, he may incur 2crs towards the expenses of that fund. All expenses of the black stone funds (under lying funds or portfolio funds) will be charged to those investors of that funds, one of the investors is GS fund so this fund also shares the expenses (if black stone Asia real estate fund expenses are 10crs, this GS fund has 50% ownership are allocated to GS fund). If trump is only the investor in GS fund has total expenses of Rs 7crs (2crs directly paid to GS fund, 5crs indirectly paid through GS fund to the black stone fund). This is one of the strategies in private equity funds, hedge funds and mutual funds. 01.11.2022 Journal entries related to investments. If Kotak pre-IPO fund raised to invest Rs. 100crs in policy bazar, they will call money from the investors receive that money and invest. Then entry will be like this. Investment in shares A/c Dr. 100 To bank A/c 100 (Fund invested in company shares) When the fund invests in any company, they have to value shares at each reporting time like monthly or quarterly if the value is increased then entry will be like this. Investment A/c Dr. 20 To unrealized gain/ loss in investment A/c 20 If there is decrease in the value of investments then entry will be like this. Unrealized gain/loss in investment A/c Dr. 10 To investment in shares A/c 10 (Value of the investment is decreased by 10crs) If that company declares dividend to investors this fund will also receive. Dividend receivable A/c Dr 2 To Dividend income 2 When the fund received that income. Bank A/c Dr. 2 To dividend receivable A/c 2 This investment policy bazar is sold for Rs. 130crs. Investment Cost – 100crs Unrealized gain recovered – 20 crs Market value reported in books – 120 crs Bank A/c Dr. To invest in shares A/c To realized gain/ loss A/c 130 120 10 Note: - Entry reported for unrealized gain/ loss 10crs indicative only. That will not pull the asset value of Rs. 130crs, purchased for 100crs and that value is increased for 20crs so, the market value of that asset is on sale for 120crs after the entry is realized gain is reported for 10crs only it shows gain as 30crs asset is purchased for 100crs and sold for 130crs. Unrealized gain/ loss on investment A/c Dr. 20 To realized gain/ loss on investment A/c 20 Alternative entry for same transaction can be. 1. We can reverse any unrealized gain/ loss on that asset which sold so the asset value will go back to cost in this case unrealized gain of 20crs so we can reverse that by debiting unrealized gain account Unrealized gain/ loss on investment A/c Dr. 20 To Investment in shares A/c 20 2. This will bring the investment value in books to Rs. 100crs which is cost/ original value, now the difference between cost and sale value will go to realized gain/ loss since this asset is sold for higher price, there is profit of Rs. 30crs so the entry is. Bank A/c Dr. 130 To investment in share A/c 100 To realized gain/ loss on investment A/c 30 Assuming this asset is sold for Rs. 80crs then entry will be like this As a first entry we will post the reversal of unrealized gain/ loss entry Unrealized gain/ loss A/c Dr. To investment in shares A/c 20 20 Now the investment value is reported at Rs. 100crs Sold at Rs. 80crs there is a loss of 20crs entry is Bank A/c Dr. 80 Realized gain/ loss on investment A/c Dr. 20 To investment ins shares A/c 100 02.11.2022 Q) How frequently these funds prepare financial statements and send to investors? A) Mutual funds: - Mutual funds prepare daily they have to prepare NAV calculations and report to investors. Hedge funds: - Most of the funds monthly, it depends on what they have agreed with investors at the time of launch of fund in sometimes quarterly also possible. Private equity funds: - Generally monthly or quarterly basis. Mutual funds prepare only NAV calculations on daily basis and financial statements are prepared for half yearly or yearly once. Hedge funds and private equity funds prepare financials on monthly/ quarterly basis they are unaudited so, less disclosures and they prepare full financials on year end it is audited with full disclosures of statements along with notes to accounts, later it will send to investors. Q) What are the sections/ contents in financial statements? Sections or contents in financial statements. Statement of Balance sheet having Assets and Assets and Liabilities. liabilities (SOA) Statement of Profit & loss A/c with details like Operations incomes, expenses, net profit/ loss etc. (SOO) Cash flow statement Explaining the sources of cash and sources of applications of cash in the fund. Schedule of investments (SOI) Details where fund is invested, market value of each investment % of investments vs NAV of the fund, country where the investment is made, securities like bonds/ shares are purchased in that company etc. Statement of changes in partners capital (SOC) Partner capital wise like GP & LPs opening balance, allocated income and expenses and closing balance/ NAV of that partner class. Notes to accounts/ Foot notes Details like risks in the funds like credit risk, market risk, liquidity risk, accounting polices followed how investments are valued (Fair value hierarchy) financial highlights like IRR, expense ratio, how mngt. Fee is calculated and incentive fee is calculated etc. Q) What is GAAP (GENERALLY ACCEPTED ACCOUNTING PRINCIPLES) in these funds follow? A) Depends on where the fund is registered, they follow local GAAP like US based funds follow US GAAP Europe based funds follow IFRS or local GAAP like UK GAAP/ LUXEMBURG (LUX) GAAP etc. If master fund is registered in US, that fund follow US GAAP, if master fund is registered in Luxemburg those funds follow LUX GAAP for the preparation of financials. Q) What is NAV life cycle or steps followed to prepare the financial statements? A) Like any other company’s financial statements preparation these funds, also follow below steps (few additional steps will be there due to outsourcing of work to fund admins etc). 1. Post all bank related entries like capital received form investors, investments by the fund, expenses paid, interest received, each fund like master and feeder fund separate bank accounts. 2. Post all adjustment entries like increase or decrease in investments values, expense payables, accruals like management fee payable, audit fee payable etc incomes earned but not received like dividends receivables, any related parties payables/ receivables etc. 3. Once all entries are posted, general ledgers will be ready after review/ checking those general ledgers can be closed all will reflect in trial balance. 4. This trial balance and supporting entries or calculations like management fee calculations incentive fee calculations etc will be included in monthly pack or quarterly pack and send to fund house for review. If state street prepares reported to black stone fund financials, now black stone will review the financials prepared by state street and it will send to investors. 5. Once trial balance is prepared fund administers will prepare the financial statements like SOA/ SOO/ SOI etc before that they prepare allocation file which will allocate the fund level income and expense to each investors so, they finalize NAV of each investor, those numbers in allocation file are used in capital statements (Partner capital statements P- caps). 6. Once financial statements are approved and auditor is okay with those financials will send to investors, regulators and bankers. Q) Do they prepare one set of financials for master or feeder investors like consolidate or separate sets? A) Depends on the structure it is decided, commonly separate set of financials are prepared for master or feeder. Feeder investors will get both the financials of master and feeder since the feeder funds are dose not give full details like where the fund is invested in the company, country name etc., in feeder books investment in master is shown in the books of accounts as one line item in the balance sheet. Where as in the private equity funds these financials are consolidated because of each property is registered as separate fund, first they prepare property wise financials and later on they will consolidate all financials into one consolidate statement of the fund and send to investors these audited financials. For the following fund post the journal entries and prepare the financial statements. Fund name Commitments Investors Vintage year Updating cycle Warburg India fund LP 16,000crs Provident fund of India, Singapore Pension funds. 2022 Each quarter end 03.11.2022 Q) On 1st Jan fund received commitments from investors for Rs. 16,000crs? A) No journal entry since there is no cashflow or payable. Q) After a month fund received to invest in Kalyan jewellers Rs.2000crs? A) Capital contributions receivable A/c Dr 2000 To Capital A/c 2000 (Being capital call notice sent to investors) Q) After 15days all investors sent money to the fund’s bank account? A) Bank A/c Dr 2000 To Capital contributions receivables A/c 2000 (Being money received from investors to invest in company) Q) Fund invested that money into shares of Kalyan Jewellers? A) Investment A/c Dr 2000 To Bank A/c 2000 (Being money invested in shares/ company) Q) By the end of march fund has to post all accrued and adjustment entries. Based on projected revenues of Kalyan jewellers they have valued the company/ this fund stock at Rs.2200crs. A) Investment in shares A/c Dr 200 To unrealized gain/ loss A/c 200 (Being unrealized gain/ loss booked) All incomes and expenses are to be accrued in the books of the fund to finalize books/ NAV. Incomes may not be there in Q1. Expenses will be there like Mngt. Fee, audit fee, custodian fee etc. Mngt. Fee is based on commitments so, fee is 16000X2%X90/365 = 78.90 Same way all other expenses will be accrued based on the agreement with those parties on yearly basis. Mngt. Fee A/c Dr To Mngt. Fee payable A/c Audit fee A/c Dr To audit fee payable A/c Custodian Fee A/c Dr To Custodian fee payable A/c Fund administrator fee A/c Dr To fund administrator fee payable A/c RTA fee A/c Dr To RTA fee payable A/c Tax consultant fee To tax consultant fee payable A/c 78.9 78.9 2 2 2 2 3 3 0.5 0.5 1 1 (Being all expenses for the Q1 2022 are accrued) Syndicate Cost: - This is common cost of all funds like registration expenses, due diligence cost, travel cost of the research staff to negotiate with companies etc., paid the fund house like KKR/ Warburg Pincus on behalf of all these funds managed by them. Common practice in the industry is, these are first paid by the investment manager/ fund house and the send the invoice to each. Eg: - Warburg Pincus incurred 10crs as travel cost etc on Kalyan jewellers investment before making investment to meet the management team of that company, recorded as syndicate cost in fund books. If the expense is incurred on behalf of Indian fund and American fund, India fund invested 2000crs in that company and American funds invest 3000crs, this expense also allocated as 10X2000/5000 = 4crs to Indian fund and 6crs to American entries in the books if that invoice received in the journal entry will be. Legal expense A/c Dr To payable to affiliates A/c 4 4 Particulars Mngt. Fee Mngt. Fee payable Investment in Share Unrealized gain/ loss Capital contributions Due to affiliates Legal expense Capital contributions receivables Audit payable Audit fee Custodian fee Custodian fee payable RTA fee RTA fee payable Tax consultant fee Tax consultant fee payable Total Dr 78.9 Cr 78.9 2200 200 2000 4 4 0 2 2 2 2 0.5 0.5 1 2288 1 2288 Statement of operations for the period 01.01.2022 to 31.03.2022. Details Amount Interest 0 Dividend 0 Other income 0 Management fee -78.9 Professional fee and other -12.5 fee Interest expense 0 Net realized gain/ loss 0 Net unrealized gain/ loss 200 Net realized gain/ loss 0 from F/x trans. Net unrealized gain/ loss 0 from F/x trans. Total 108.6 Details of Assets on Investments Cash and cash equivalents Dividends receivables Capital contributions receivables Total Assets (A) Management fee Capital distributions payables Due to affiliates Accrued expense and other liabilities Total Liabilities (B) Total (A-B) Capital Add: - Accumulated profits Total Total Assets Liabilities (A) Capital and accumulated profits Total liabilities Amount 2200 0 0 0 2200 78.9 0 4 Statement and Liabilities as 31.03.2022. 8.5 91.4 2108.6 2000 108.6 2108.6 2200 91.4 2108.6 220.0 Q) If one investor has 10% ownership in the fund, what will be that investors NAV of 31.03.2022. 2108.6 X10/100 = 210.86 Generally, if the fund NAV is 100 an investor has 10% ownership in that fund his NAV will be 10, however in private equity or hedge funds there can be expectations like some investors do not pay management fee/ incentive fee like GP, some of the investors pay lower fee than others so their investors can have better NAV so, they conduct the process the called as allocations where each income and expenses is allocated to individual investors. Calculated NAV of each investor then prepare capital statement of each partner (P- Cap) and send that to each investor along with financial statements. 04.11.2022. Journal entries for the Q2 April to June 2022. Fund decided to invest in airtel company shares for Rs. 4000crs so, they have called money from investors while calling that money they have called for pending payables in the fund. For Rs. (In crs) Investment in shares 4000 Mngt. Fee payable 78.9 Syndicate cost payable to affiliates 4 Custodian fee 2 Fund admin fee payable 3 Total called from investors 4087.9 Capital contributions A/c Dr 4087.9 To Capital A/c 4087.9 (Being call made for investments and expenses) When amount received from investors. Bank A/c Dr 4087.9 To capital contributions A/c 4087.9 (Being amount received from investors) Note: - If there is any default by investors for some amount like 50crs etc that amount will remain in the contribution’s receivables account. No separate entry required however, fund generally collects delinquent interest (default interest) from those defaulting investors, if yes that will be income. Mngt. Fee paid to GP/fund house entry will be like this. Mngt. Fee payable A/c Dr 78.9 To bank A/c 78.9 Other expense paid. Payable to affiliate A/c Dr 4 Custodian fee payable A/c Dr 2 Fund admin fee payable A/c Dr 3 To Bank A/c 9 (Being all accrued expenses due is paid by investors) Amount received from investors and invested in airtel company shares. Investment in shares A/c Dr 4000 To Bank A/c 4000 (Being investment made in company shares) By the end of the quarter all adjustment entries to be posted are common like previous quarter. (Contd…. Particulars Mngt. Fee Mngt. Fee payable Investment in Share Unrealized gain/ loss Capital contributions Due to affiliates Legal expense Capital contributions receivables Audit payable Audit fee Custodian fee Custodian fee payable RTA fee RTA fee payable Tax consultant fee Tax consultant fee payable Total Dr 78.9 Cr 78.9 6500 500 6000 4 4 0 2 2 2 2 0.5 0.5 1 1 6588.4 6588.4 Statement of operations for the period 01.01.2022 to 30.36.2022. Details Interest Dividend Other income Management fee Professional fee and other fee Interest expense Net realized gain/ loss Net unrealized gain/ loss Net realized gain/ loss from F/x trans. Net unrealized gain/ loss from F/x trans. Total Net profit Amount 0 2 0 -157.8 -25 0 0 500 0 0 319.2 Statement of assets and liabilities of 30.06.2022 Details Investments Cash and cash equivalents Dividends receivables Capital contributions receivables Total Assets (A) Management fee Capital distributions payables Due to affiliates Accrued expense and other liabilities Total Liabilities (B) Total (A-B) Capital Accumulated profit Total Amount 6500 0 2 0 6502 78.9 0 0 12 90.9 6411.1 6087.9 323.2 6411.1 Alternative presentation is Assets = Liabilities Total Assets = 6502 Liabilities = 909 Capital and accumulated = 6411.1 Total Liabilities = 6502 Difference =0 Other entries in the books of a fund. TDS/ WHT related entries: - Tax deduction at source/ withholding tax mean while making payments by a company/ fund etc., to any professional service provider like auditor/ fund house etc these funds should deduct income tax at certain rate like 10% and pay to government. Eg:- If fund is paying Rs. 10lacs as audit fee to KPMG, they can pay Rs. 9lacs to KPMG and remaining 1lac to government. KPMG will adjust the entry in the fund books is. Audit fee A/c Dr 10lacs To TDS A/c 9lacs To WHT A/c 1 lac (Being audit fee expense and TDS payable is accounted) After some like end of the month this fund will pay that amount to government so, the entry is. TDS/WHT payable A/c Dr 1 lac To Bank A/c 9lacs (Being TDS deducted on audit fee is now remitted to government) Master and feeder fund entries: - When fund called money from feeder with other investors, any separate entry in master books? No separate entry (Capital contribution receivable to capital A/c the entry) When master asks money feeder also asks/ calls money from feeders investors (If Dhoni invested in feeder registered in Cayman, that feeder fund will send cap call to Dhoni) 1. Master fund in America send cap call notice to feeder in Cayman. 2. Cayman fund issue cap call notice to Dhoni. When received from investors feeder post the entry as. Bank A/c Dr 500 To Capital contributions receivables 500 When feeder send money to master fund entry is Investment in master fund A/c Dr 500 To Bank A/c 500 (Being money invested in master fund) Note: - If master fund reported profits added that profit to investors NAV of all investors will increase if that master reported NAV of feeder as 520crs (Invested 500crs) that 20crs is reported as unrealized gain from investment. Investment master A/c Dr 20 To unrealized gain/ loss A/c 20 If the distribution money to investor on sale of investments. Capital A/c Dr 600 To Capital distribution payable A/c 600 If the funds NAV is greater than outstanding principal and preferred return as of that day, there will be carried interest payable in that fund so, entry is Carried interest A/c Dr To carried interest payable A/c 10 10 Allocation in the private equity funds (also in hedge funds): To prepare the capital statements of each partner, the fund admin needs the finalized numbers of each partner in the fund. So, this allocation file is prepared in this process all expenses and incomes of the fund is allocated to each partner in their ownership ratios. There finalized numbers are used to prepare the capital statement of each investor that gives NAV of that investor however there are some exceptions to be noted while allocating fund income and expense. There exceptions are: 1. GP/ LP employees of the fund house etc will not pay any management fee carried interest so they should not allocate those expenses. 2. Discovered free investor: - Some investors in the fund may pay 2% so, we have to calculate their number separately and allocate their portion of fee rather than allocating it based on their ownership. 3. Partner transfers: - One investor may be transferred the stake to another investor in between accounting period like 30th June to allocate that year experience we have to keep 50% allocation to partner A and balance new partner. If there is not expenses in that fund on loan taken from July 2022 that should be allocated to only new partner and not 50% each to old and new partner. Since these expenses is incurred in 2nd half of the year. Once their allocations are approved, they prepare the capital statement of each partner (PCap) the proforma of their capital statement is below. Capital statement of Saina for the year ended 31.12.2022. Particulars Opening Bal Contributions Distributions Allocation of Income and Expenses Mngt. Fe Prof. fee Unrealized gain/ loss Realized gain/ loss Carried interest Forex Gain/ loss Closing Capital Bal. (NAV) Amount 100 25 -10 -2 -2 25 10 -2 -2 142 History to date (HTD) numbers form 01.01.2018 to 31.12.2022 Particulars Commitment Contributions Unfunded commitment Distributions Returns/ Return multiples Total estimated value (TEV) Contributions Multiple on invested capital/ MOIC Amount 125 75 50 -40 182 75 2.43 Valuation hierarchy/ fair value hierarchy in private equity funds and hedge funds: - Most of these funds (mainly private equity funds) invest into illiquid assets (assets having no active market) so knowing the market value of these assets is not easy. These funds has to know the market value of the assets in the below scenarios/ times. 1. When the fund is investing or buying the assets. 2. When the asset is sold/ exit time. 3. To prepare the financial statements/ finalize the NAV (Net asset value). To know the market value of the asset there are various sources each source has different risk to that number/ valuation. Ex: - If the market value of the Infosys shares is reported using the traded price of that share in NSE/ any stock exchange the risk is less, same/ similar value can be received by the fund by selling that asset in the market tomorrow/ that day if the fund invested Rs.1000crs in a shopping mall/start-up company etc., and reported the market value as Rs.1500crs based on their calculations since there is no active market to that assets, risk is more, the fund may get only Rs. 500crs tomorrow when they went for actually sell. To highlight these risks, these funds have to report the sources for market value in the financial statements (US GAPP/ IFRS/ any other gaps) so investors can understand if the profit/ loss reported in the fund and NAV reported in reliable or subject to major changes. All these valuations sources are grouped or categorized in to 3 and reported in the financials. 1. Level -1: - Market value of the investments is considered as Rs.1000crs these values are based on the price in the active market like stock exchange, commodity exchange etc., since this price is derived in the market based on thousands of participants, reliability is more. If the fund wants to sell these assets tomorrow, they will get Rs.1000crs near to that. Ex: - Shares of listed companies like apple, reliance, commodities like Gold etc comes in this category. 2. Level – 2: - Market value of investments is Rs. 500crs in this level, the source is one of the below. A) Based on the similar asset value in active market. Ex: - Fund invested in the filpkart shares which are not traded in market but similar company like amazon is trading, based on charge in amazon market price, this fund can calculate the market value of flipkart shares. B) Based on similar asset market value in other than active market. Ex: - Fund invested in shopping mall in Bangalore similar shopping mall is sold by somebody for 20% appreciation in this month compared to tis values a month back so same 20% appreciation applied to this shopping mall owned by this fund. 3. Level – 3: - Fund valued the investments based on their assumptions. Ex: - Black stone fund reported total market value of all investments at Rs.10000crs, level 3 investments are 2000crs these investments are start-ups like byjus, Rapido bike etc., since these shares or similar company shares are not traded in the market fund calculated the market value based on the projected revenues of the company for future years and valued company at Rs.500crs or Rs. 50 per share earlier this share is reported at Rs. 40, now they have reported profit of Rs. 10 per share based on these projections. If a fund reported more investments in level 3, risk is more they have to give more additional details to investors like the source for these calculations (If they used discounted rate at 10% how they decided/ factors influencing that etc.) Few terms related to financial reporting: Escrow account: - This is the cash in restricted account for the fund. Ex: - If the fund sold an investment for Rs. 1000crs, buy might pay 950crs immediately and deposit Rs.90crs in separate bank account, fund can use that money only after fulfilling some conditions after a period like 6 months. Governments also keep like this to release money to road contractor etc after 3 months by ensuring there is no damage to the roads completed by the contractor. Management offset: - At times, at directions of GP, funds may offset/ reduce the management fee in a fund. Ex: -Fund life time is 10yrs but extended 2 more years since the investment are not able sold so GP may not charge fee for these 2yrs. Or the fund got some additional income like placement fee (Fee paid by another fund house to this fund for placing investors money in that fund, assume you have invested in KKR fund, they invested that money in JP Morgan fund, JPM pays placement fee to KKR) so that fund (KKR) reduces the fee to the extent of that additional revenue. Broken deal/ dead deal: - Deal means a fund making investment to a company/ asset. Sometimes these investments are failed in last minute due to failed negotiations on price etc., all the cost incurred till that time is considered as broken deal cost and accounted as expense in the fund. Ex: - KKR team travelled to India to meet the Byjus team to negotiate on valuations to make investments, they have incurred 10crs finally they decided not to invest so accounted 10crs as broken deal cost (If success, this cost is included in cost of investment). Due diligence cost: - Before taking any major stake in a company, these funds conduct extensive research like understanding the financials of the company, discuss all the potential risks for that business including any court cases pending on that company etc., is known as due diligence. 06.11.2022 DCF Method (Discounted cash flow method): - 01.01.2022 made an investment. Invested Sold on 31.12.2002 Profit Return 1,00,000 1,20,000 20,000 20% If my expectation is 20% return, when I know a share/ asset will give 1.2 lacs in 12 months iam ready to pay/ invest 1 lac today. And if an asset will give me 1.44 lacs at the span of 24mts or 2yrs I am ready to invest 1 lac today that is giving 20% of return. Opening balance 1,00,000 1,20,000 Return @20% 20,000 24,000 Closing balance 1,20,000 1,44,000 There are many methods to value the investors most commonly used method is DCF. In this case they project the values/ investors of that assets for the future current future highlights in the books (financial statements) for investors can compare two different funds commonly by reported FIHS (financial highlights) are 1. IRR (Internal rate of return) and 2. Expense ratio. IRR: - It is the revised return calculated to report the performance of the fund. Date Cash flow Date 01.01.22 100 01.01.22 31.12.22 10 31.12.22 31.12.23 110 31.12.23 Return 10% Return Cash flow 100 0 120 9.6% In the above example the first fund paid 10crs at the end of the first year and the 110crs in the second year then the return is 10% and the fund paid same amount and 20crs return by cash flow are paid late in 2nd year so, IRR is 9.6% of that fund. If you invest in fund A on 01.01.2022 of Rs.100crs that fund, give back of Rs.110crs on 31.12.2022 that return is 10% so, if we discount future cash flow at that day on10% return on the investment of 100crs. If there is risk if we invest 100crs today at 10% return the cash flow is 110crs in first year, 121 in second year etc. Opening Return@10% bal. 1 100 10 2 110 11 3 121 12.1 Year Total Comments 110 121 110*10%= 11 133.1 121*10%=12.1 So, same to giving 133.1 at the end of 3rd year also equals to 10% rate of return (ROI). Expense Ratio: - Generally this is calculated as total expenses in the fund/ NAV in the fund. Eg: -Mngt. Fee – 100 Other expenses – 50 Total - 150 If the NAV is 1000crs, expenses ratio is 150/100. Rebalancing and equalizations: - It means the fund adjusting the capital balances/ closing balances/ NAV of the investors between old and new partners where any new partner is coming into the fund. When fund has subsequent close like 2nd and 3rd closes new investors will come and invest in the fund ownership ratio of investors will change so, capital balances of old investors also will change since the entire the fund ownership ratios will change after entering the new partners into the fund. Eg: - If Kotak bank launched fund two investors invested Rs.100crs each, they have 50% ownership each in the fund, if the fund made no investments but accrued expenses like audit fee/ custodian fee/ etc are paid by the fund it will leads to loss in the fund if total loss in the fund is 2crs it will share to each partner as 1cr and 1cr now the NAV is -1cr each. If two investors came into the fund in Jan 2023 committed to Rs.1000crs each total fund size become 4000crs each partner ownership will be 25% so the fund allocate the loss into 0.25% to each partner in the fund, and all the profits and losses are shared between the partners in the ratio of 25% each. In equalization of the fund there some more points to be added 1. Fund has more than one close like 2nd and 3rd closes. 2. Old investors had paid some money. In this case old investors expect some income/ interest on the invested capital since they have already invested on behalf of new partners. Eg: - If old investors A & B paid 10crs each to invested money in flipkart company, they have contributed 50% each in total of 20crs, if new investors also in 1st year these old investors investment could have been paid 5crs only (25% of each partner) so, these investors expect some income on that excess 2.5crs paid on behalf of new partners, new partners have to pay 1. This portion back to old investors whereas C and D are the investors will pay 2.5 each A and B. 2. New investors will about to pay some interest like 10% per person on fund amount to old investors (A & B). Eg: - C & D will bring 2.5crs + 0.25crs = 2.75 crs and paid to old investors A & B next time fund need 10crs all of them will have to pay Rs. 2.5crs each. 07.11.2022 MUTUAL FUND Vs HEDGE FUND Vs PRIVATE EQUITY FUND: Details Mutual fund Private equity fund Types of Investors Mainly retail investors. Only wealthy investors and HNIs or institutions investors. Hedge fund Only wealthy investors and HNIs or institutions investors. Types of These funds can only These funds can These funds investments/ invest in listed invest in anywhere, generally invest investment securities or generally these in listed strategies securities with low funds invest in securities, crypto risk and liquidity. start-up companies currencies, and real estate etc. derivatives etc. Risk Generally, it has low These funds have The risk capacity risk capacity. medium to highof these type risk capacity. investments is high to very high. Return Return is very low in Being a moderate Same as private India we can except 8 risk funds we can equity returns but to 15%. expect 15 to 25%. the risk meter is very high. Generally, these Most of the funds These funds are Structure of funds are open ended are closed ended also open-ended the funds funds and registered funds registered as funds and as trusts. Limited registered as partnerships. LP’s. No. of Here we can see no. Mostly these funds Mostly these Investors of investors there is have 1 to 100 funds have 1 to no restrictions to investors. 100 investors. investors. Regulations These funds have Mostly less Mostly less more regulations regulations to these regulations to compare to P/E and funds. these funds. HF funds. NAV On daily basis On the basis of On the basis of Reporting monthly/ quarterly. monthly/ quarterly. Life time/ Closed ended funds The tenure of these There is no span of the have mostly 3 to funds has mostly specific span to funds 7yrs, whereas open 10yrs and these entry and exit ended funds there is funds are launched from the fund. no specific time to in the closed ended exit from the fund. funds. Difference between Open ended and closed ended funds. Details Meaning Open ended funds This type of funds allows the investors to entry and exit at any time from the launching of funds. Capital amount Varies/ changes since new investors can come or old investors can exit from the fund. More suitable/ opted by Entry load and exit load Mutual funds and hedge funds. Applicable to discourage frequent entry/ exit to reduce the fund costs. Advantage to Investors since they have liquidity option. Closed ended funds In these type of funds investors is not allowed to entry and exit from the fund as the investors need. Fixed like 5/ 10yrs investors money will be paid back as completion of the tenure. Private equity or venture capital funds. Not applicable since investors are not allowed to entry/ exit in the fund as they wish. To fund manager since no pressure to provide money to investors when they want to exit. Interval funds: - These funds are not much popular, these funds work like closed ended funds for most part of the year but kept as open approximately for 10 days in a year or 6 months. Eg: - If HDFC launches an interval fund in 2020 with 10yrs life time, each year from 1st July to 10th July the will kept open where existing investors can exit from the fund and mean while new investors can invest into the fund which is launched by HDFC with in these 10 days only and all remaining days the fund will keep close so there is no issue of new units or redemption of old units after the completion of interval gap of the fund. Note: - In case of mutual funds to retail investors these closed ended funds are listed in stock exchange so an old investor can sell and new investor can buy form the units directly in stock between them. Fund house like HDFC etc., will not involve in this case. Note: - If mutual funds are closed ended, they list the units of the fund in stock exchange so investors can buy and sell between them (Fund manager will not pay the money investors can sell to others in exchanges). If private equity funds or hedge funds is closed ended, they will not list. Since investors not required that option/ liquidation. 08.11.2022 Introduction of Hedge funds: - These funds pool money from the wealthy investors they can invest money in assets classes like equites/ fixed income securities/ real estate/ derivatives etc., since the investors are accredited investors and they can take risk. Generally, they invest in listed securities since they have liquidity and fund can sell them if the investor wants to invest in another opportunity or to arrange money for investors who is leaving the fund as most of these funds are open ended. Most of the times these funds invest in short term and exit from that investment to made profit based on information on those assets for that period. Eg: - If fund manager got information that Infosys company will report more profits in this quarter results will be announced by tomorrow, they can buy more stocks and sell them in a week/ two days since share price goes up based on reports announced / financial statements released by the company. Investing in short term is risky since they may invest all the capital in that investment opportunity with specific return in mind if the desired result is not achieved in the short term like week/ month they may have to book huge losses and exit from that position/ trade. Eg: - If the fund manager research says that US dollar will go up in the next week by 10% since there is US federal reserve announcement a hike in interest rates, if they announce that news related to hike in interest rates in US by US fed then US dollar will go up in the market, to get quick profits these fund managers will go and invest in futures and options; if US fed not increased the interest rate US dollar will go down in a week and fund will get huge losses. To get more returns in short term with less capital these funds use futures and options etc. Eg: - If gold is trading at Rs.5000 per gram today fund manager is expectation is the price will go down by Rs. 4800 per gram in month since equity market is going up due to some goods from the government like decrease in tax rates etc., the fund manager can use futures contracts now sell 100crs worth of gold by paying only 20crs as future contracts need only 20% of margin approximately. If the gold price decreases by 10% fund will make 10% on 100crs that is 10crs of profit only thought the investment is only 20crs if the gold price increase by 10% fund will make loss by 50% gain or loss on 20crs investment. So, derivatives can get more returns and give more losses too. These funds are considered as aggressive version of mutual funds as they also invest in listed securities (mostly) launched on open ended funds with unlimited life time. Mutual funds can only take long trade (buy today and sell when price is high) however hedge funds are short traded funds (sell today at high price and buy when price is low) usage of more leverages like more derivatives and applying different strategies like short only used by trading etc can be done by the fund houses which are restricted to mutual funds since the risk of these funds keep some restrictions on investors like: A) Investor can exit only after 12months or they can only take 20% of amount per annum. B) Investor should confirm the exit date before the month of they want to exit or they can exit only in the month ends etc., these kinds of restrictions will be posed on investors these are called as gates. Some features of hedge funds are same as like private equity funds like A) Charge incentive fee. B) Keep structure like Master and Feeder funds. Generally, they invest more money into liquid securities lie share of listed companies etc. So, they can easily buy or sell based on market situations to make profit or they can arrange money to investors if investor want to out, but some funds invest in shares of start-up companies etc. Depending on the strategy of the fund, fund can be open ended or closed ended generally these funds are also registered as limited partnerships (LPs) where investors are called as limited partners and the fund manager as general partner (GP). Like private equity funds these funds also pay incentive fee like 20% to GP/ fund house if the fund operates good returns to the investors to give more returns to investors, they follow different strategies. Some of them are unique to hedge funds they are, 1. 2. 3. 4. 5. 6. Long or short strategy. Short only strategy. Quantitative strategy. Macro strategy. Arbitrage (Merger or convertible arbitrage etc) strategy. Funds of funds strategy. 1. Short only strategy: - In this case the fund manager finds over valued stocks or assets and sell them today with an intention to buy later at cheaper price. Eg: - If Infosys stock is trading at Rs.1500 per share if the fund manager feels that stock will go to Rs.1300 in a month they can borrow share today and sell at Rs.1500 buy at Rs.1300 after a month and return the same shares to other party, they can gain Rs. 200 per share this is risky strategy for long term so they have to close the trade in short term and for that they have to accurate in predicting the prices in near term for that stock/ currency commodity etc. 2. Quantitative Strategy: - In this strategy hedge fund manager use more quantitative methods/ techniques to decide on where to invest when to invest/ sell. So, mostly statistics and companies are used to fund the investment opportunities fund houses like renaissance, DE shaw, AQR etc use this strategy more. Some of the mutual funds are also using this strategy, in India also some funds are launched with this strategy. 3. Long/ short strategy: - In this strategy hedge fund manager will buy undervalued stocks and sell over valued stocks so the portfolio has long positions and short positions. Long position means purchasing the stock today at lower price and sell later at high price to make profit. Eg: - Buy reliance shares in 2022 oct at Rs.2500 per share and sell later like in Nov 23 Jan etc at 3000 to 4000 per share. Short position means sell today at higher price and buy later at lower price to make profit. Eg: - Sell Infosys stocks today at Rs 1500 and buy later at Rs.1200 after a month. So, Rs.300 profit. In this strategy they care using some money like 50crs to take long positions and 40/ 50crs to take short positions. So, if the market is up long positions will give profit and if the market is down, short position will give profit since they make more profit if the stock price is falling more. Macro strategy: - In this strategy hedge fund manager follow macro-economic indicators like interest rates, inflation, unemployment data, fiscal deficit etc., and predict the market in the upcoming data and take investment decisions. Eg: - If crude oil prices are increasing in international markets or if interest rates are low in India due to Covid (to make money available easily to all they keep interest rates low) Inflation can increase since petrol and diesel price is high or there is more borrowing (if interest rates are low) this can make the life of poor people hard, they may not be able in a position to buy food also, to control this RBI/ central banks will increase interest rates so, less number of people borrow so, demand will decrease so inflation will go down since, the interest rates are high companies interest cost will go up and sales will go down (since people are not buying houses/ cars etc., will go down due to high interest rates) so, less profits to companies this will pull the stocks prices down shares of auto mobile industry etc., same time gold can price can go up since these funds sell the share and buy safe assets like gold. So, fund manager can buy more gold and sell stocks to benefits, from the above. 09.11.2022 Fund of funds strategy: - Same as in the private equity funds these funds also follow the fund of funds strategy where one hedge funds will invest in another hedge fund. Eg: - JP Morgan hedge fund will BNY Melloan and invest in Morgan stately hedge fund/ reccainssance hedge fund etc. Arbitrage strategy: - Arbitrage means profit based on the price difference between two markets. Eg: - If a stock is trading at Rs.100 in one stock exchange like BSE(Bombay stock exchange) and the same stock is trading at Rs.105 in another stock exchange like NSE (National stock exchange) since that is same stock but the price difference is should be temporary due to demand in the market where price is low, price will increase it will gone to Rs.100 from Rs.103 and due to selling and supply in the market when price is high, price will go down from Rs.105 to Rs.103, now these trades can be closed and make some profits in the both the markets. Side pocket: - If there is any trouble income of the portfolio company and sell that assets there is no liquidity to for that investment (they are illiquid) so, the fund manager will keep that they will list that fund asset separate from the fund, hence this is known as side pocket. Eg: - A fund invested in debentures/ bonds of reliance and king fisher, if king fisher is get default and unable to repay the debts to the investors now investors in the market sense some trouble and began to sell the shares of that company and the NAV of the fund will go down so, investors think that to exit from the fund and tries to sell main investments in the fund hence the total fund will collapse due to that one default company in the portfolio in this situation the fund manager will calculate the default company NAV as separate and the main fund NAV separate so that investors will not exit from the fund. Incentive fee/ performance fee: - Same as private equity funds this hedge funds will also collect the incentive fee/ performance fee from the investors by the GP/ fund house manager. Q) Is it common in hedge funds to share profits with GP or fund manager? A) Yes, generally they share around 20% of profits with fund manager. Q) There can be a hurdle rate in hedge funds? A) Yes, if the fund crosses a specific return like 8% per annum, investors are ready to share the remaining profits with the fund manager. Q) Most of these hedge funds are open ended means investors can invest/ exit any time so, can the fund manager wait for a long time like 8+ years in the private equity funds or they can take more frequently this incentive fee? A) These funds can take incentive fee frequently they don’t need to wait 8+ years like to give principal to investor etc (like water fall provisions) since these funds invest in liquid assets they can also sell and give cash back to investors so investors can leave the fund with in 3 months/ one year etc. So, incentive fee is also settled a frequent interval like 6months or one year once. This time interval is called as: “Crystallisation period or Crystallisation date”. Eg: - If renaissance launches a hedge fund on 1st Jan 2022, kept crystallisation as half yearly, they will take this incentive fee on 30th June and 31st of December every year. Assume they have issued one unit at Rs. 100 issued 1cr units and pooled Rs.100crs on 1st Jan and the NAV per unit is Rs.150 by 30th June (fund NAV is 150crs) there is profit of 50 crores. If no hurdle rate, GP can take 50X20% = 10crs as incentive fee that day. 10.11.2022 Q) What is high watermark in hedge funds? A) HWM (High watermark) means the price at investors have paid incentive fee already or the price at which the fund is started as value per unit. Ex: - If the fund is started on 1st Jan pooled Rs.100crs from investors by issuing units/ shares at Rs.100 each per unit, that HWM in the crystallization period / date is 30th June 2022 by the time of that time the value per unit is at Rs.120, fun made profit so, this will collect fee on that Rs.20. So, the incentive fee for the fund house/ GP is 20X20% = 4. Now, HWM is Rs.120. Next crystallization date of the fund is 31st December at that time this HWM will change to Rs.150 by that time. If the value made loss and the value for per unit Rs.110 per unit old HWM is Rs.120 remain in the fund. So, if the fund reaches to beyond that value of HWM there will be incentive fee otherwise there is no incentive fee to the fund house/ GP. Incentive fee calculation is (HWM value present on that date) X 20% Q) What is GAV/ GNAV also what is NAV? A) NAV stands for Net asset value. Ex: - Assets of the fund Liabilities of the fund Net asset value (NAV) 100 10 90 If the fund is at moment of close/ liquidate then the NAV of the investors is at Rs.90crs (they will settle all assets at Rs.100 and pay liability of Rs.10 so net cash available for investors is 90) that will be distributed to investors. If the fund pooled money by issuing of 1cr shares/ units at Rs.100 each per unit they have started with 1cr units, let 50 lacs units are issued and 80 lacs units are redeemed (investor took money and exit from the fund) so, the net outstanding units in the fund are 1+50- 80 = 70 so for that NAV is 90/0.70 = 128.57 if an investor’s 10 units and he want to exit from the fund he will be paid Rs.128.57 (10X128.57) in hedge funds this value should be calculated before deducting the incentive fee and their incentive fee is calculated on profits up to that level, that is called GAV/ GNAV. Ex: - If NAV = 128.57 incentive fee changed in that is 20% then GAV is 128.57+ 20 = 148.57. GAV= NAV+ Incentive (or) NAV= GAV – Incentive fee. Q) How to adjust the incentive for new investors in the fund or investor leaving the fund? A) Date 01.01.2022 30.06.2022 31.07.2022 31.12.2022 GAV Investors 100 ABC 150 ABC 120 D came (202207 series) 200 Profit to incentive fee 50 80 In this example investors ABC are at the beginning of the fund so, their calculation of incentive fee is normal. D came into the fund in July 2022 when the GAV is 20. If the GAV as of 31.12.2022 the next crystallization time investor came into the fund and his incentive fee is Rs.80 profit. If he also charged like other on Rs.50 Profit (200-50) he still needs to pay incentive fee on Rs.30 profit so that can be Rs. 30X20%=6. Assuming he has 100 units he needs to pay extra 600rs as incentive fee. If the NAV per unit as of dec is 200 fund will redeem 600/200 =3units so he will have 97 units in the future. (Other method is asking investor that extra incentive fee at the entry point itself. It D is coming into fund. Fund can ask Rs.6 incentive fee so he will also be charged next time on profits above Rs.150 though his entry point is at 120.This is less popular method). 11.11.2022 Investment strategies in HEDGE FUNDS: Fixed income securities: - These hedge funds can also invest into fixed income securities like Bonds, Debentures, Commercial papers, Treasury bills, Certificate of Deposits, Mortgage-backed securities, Asset backed securities etc., idea of fund can be. 1. Earn income like 7% per annum as interest. 2. Predict the price movements of these securities in the market and take long position if they feel the prices will increase in near future and take short position if the price movement is expected to negative.’ 3. Some of these securities are available at low cost at Rs.100 face value security is available at Rs.30 in the market since market participants are expecting that company to default on repayment etc., (In this case the fund will get 7% to 8% etc interest as agreed through they have purchased at Rs.100 bond for Rs.30) ISSURE Face value Interest rate Payment frequency Tenure GOI (Government of India) 1000 12% 30th June and 31st December of each year. 5 years Common characteristics of these securities are: 01. Principal amount (Face value of the security) will be returned to investor once like time/ tenure of the investment is over. Ex: - GOI/RIL company need money of Rs.100crs, they can issue 1cr bonds/ dentures at Rs.100 each. This amount will be returned in 5/10yrs if the tenure is agreed as 5/10yrs. 02. Coupon rate/ Interest rate: - The issuer like GOI/RIL etc will pay fixed amount of interest like 10% per annum till the repayment or maturity of that security. Accounting in the fund books for these securities: Since these securities pay fixed income fund accrue the income, they don’t need to wait for actual receipt of the income. Ex: - If Renaissance hedge fund invested in GOI bonds with below conditions, interest income to be accrued for Jan 23 will be. In this case the fund will get Rs.120 (1000X12%) as interest income per annum Jan interest will be accounted in the books is 1000X12%X31/365 = 10.19 and entry will be like this, Interest received A/c Dr To interest income A/c 10.19 10.19 Q) Can we consider all months are same and Rs.10 per month so, 120 per year as interest from the investment? A) Industry follows difference day conventions like actual Actual (act/ act), 30/360 etc, based on the documents like loan agreements or based on regular/ consistence practice they have to choose the right approach. In the above case we have to choose right approach. In the above case we have followed act/ act so, calculation was 1000X12/31/365. If it is 30/360 days convention calculation will be 1000X12%X30/360 = 10. So, all these months accrual is Rs.10 and yearly is Rs.120. Q) What is DIRTY & CLEAN price in these bonds/ income securities buy/sell transactions? A) If a bond/ fixed income security is sold in market/ purchased in market, the price agreed can be including the accrued interest or excluding the accrued interest. If interest is included in the prices, it is called as DIRTY PRICE. Ex: - If the above security face value of Rs.1000 and accrued interest is Rs.10 is sold for Rs.1100 as dirty price the calculation is like this, Slae price – 1100, Interest Accrued – 10 (since the company/ issued paid interest in dec, as of Jan accrued is for 1 month only), market price of bond – 1100- 10 = 1090. So, there is gain of Rs.90 on sale of Rs.1000 investment sold for 1090 entry is Bank A/c Dr 1100 To int. receivable A/c 10 To Realized gain A/c 90 To Investment in bonds A/c 1000 If the sale price is excluding the accrued interest, it is clean price. If the clean price is 1100, calculation is. Sale price – 1100 Accrued Interest – 10 Payable for Sale - 1110 So, the profit on sale is 100, entry will be Bank A/c Dr To Investment in bonds A/c To realized gain on invt. To interest receivable 1110 1000 100 10 Note: - If it is clearly mentioned as clean price, we have to take accrued interest in addition to the sale price as total consideration if it is not mentioned as clean price (or) dirty price, assumption so, we can add accrued interest total consideration. Q) Zero Coupon bond and how to accrue interest on that? A) Zero coupon bonds are deep discount bonds, the issuer will repay the face value difference between issuer price and the redemption value is interest income. No income is paid in addition so they are called as zero-coupon bonds. Ex: - If GOI of India need money for 3 months they can issue a bond at Rs.98 and repay at Rs.100 after 3 months the difference is the interest rate. In this case entries will be like this. Investment in bonds A/c Dr 2 Total income A/c 2 (When interest is accrued) When they received Rs. 100 Bank A/c Dr To Invest. In bond 100 100 Popular fixed income securities: Debentures: - Issued by companies, there are many types of debentures like convertible, non-convertible, secured/ unsecured bonds callable, puttable etc. Bonds: - Issued by governments, in other countries if company issued bond, they call it as a corporate bond. (So, no term like debenture). Commercial paper: - Issued by a company, unsecured instrument with the tenure of less than 365 days. Certificate of Deposits (COD): - It is mainly issued by banks for short term money requirements. Mortgage-backed securities and asset backed securities (MBS and ABS): These are not securities issued by company or governments etc to barrow money, they are created by converting some other assets into securities. Ex: - If ICICI bank issued home loan to Dhoni he will pay interest and principal repayment, for next 20 years. If that bank need money they can sell that loan to intermediaries like investment bankers, they will convert these loans into securities they can convert Rs. 1cr loan to 1lac mortgage-backed securities at Rs.100 each security, pay 6% interest on that in this case bank will get that interest form Dhoni and will go to investors in MBS. ABS: - Similar to MBS in this case instead of home loan other loans like car loans/ credit card receivables of banks are converted into securities. 12.11.2022 Other securities that are used in Hedge fund: CDS (Certificate of Deposits): - It is a derivative contract buyer of the contract pay the premium and transfer the credit risk to the seller of contract. Ex: - If you have invested Rs.1cr in mortgage-backed securities you will receive Rs.10 lacs as interest in each year, if the interest is at 10%. If you got doubt on that MBS quality is less and credit risk is more you may not get interest and principal in future due to made by home loan taker like Dhoni, you can enter into this CDS contract. Terms and conditions of this are as follows: Buyer: - You will pay the premium to seller of the contract like Rs. 1lac for securing 1cr MBS. Sellers of CDs: - Company like AIG (American Insurance Group) they take premium like 1lac and give assurance to pay that investor will get back if there is default on MBS. This CDs contract will give a right to you (As a buyer) to claim the damage if there is a default so, seller (like AIG Company) will pay you that money like 1cr. In this case credit risk on MBS (default risk) is swapped (transfer) will seller of CDs so, it is called credit default swap. Call option: - These are derivative contracts where the buyer of the contract (holder of the contract) will pay the premium, buy the contract and GET A RIGHT to buy an underlying asset at a specific price, they don’t have any obligation to buy at that price (Since have already paid premium and got the right, they can use the contract if the contract is beneficial to them else, they can ignore. Ex: - BPCL company need to buy US dollar in each month to buy crude oil from other countries they need 1cr dollars in Jan 2023 so, they need Rs.82crs based on todays rate of 1 US dollar = 82rs. They are expecting the price to go up to Rs.85 by that time so, they need to spend Rs.85crs to avoid this problem/ risk due to change in market rates, they can buy call option contract today at Rs.0.50 per dollar as premium and get a right to Buy a dollar at Rs.82.50, if the market price is 83/84/85 etc., (Above Rs.82) they can use the contract and buy at Rs.82 only since that is agreed price as per the contract. If the market price is less than Rs.82 per dollar like Rs.80/79/78 etc., they can lapse/ ignore the contract and buy in the market for Rs.78 premium at Rs.0.50 per dollar is the loss. So, these call option contracts (or put options) are like insurance contracts where a party can buy the contract and get the right to buy (Right to sell in put) if the contract is beneficial, they will use, if not they will ignore. These options contract, work like Insurance contracts. If you have a bike and expecting that bike can be stolen/ damaged, you can pay insurance premium and get the damage claim right. If damage happens claim that amount can be Rs. 2 lacs through premium paid is only 10k (unlimited gain/ more gain from the contract like 2 lacs through cost is 10k) if no damages all that premium is loss, no refunded. In options also, buyer of the contract (holder) pays the premium and get the right to sell (put option) right to buy (call option). Steps are: 1. Have a view on the underlying like the price will increase or decrease. 2. Use the right option for that scenario. Ex: - You think the price will fall, you need a right to sell at high price/ current price/ strike price of Rs.1500 so, you will get right to sell at Rs.1500. 3. On the expiry date if the market price is below Rs.1500 exercise/ use the contract and sell at Rs.1500. Ex: - If the market price is Rs.1400 you make Rs.100 profit (Excluding premium already paid) if the market price is 1000 you made 500 gain since you can sell at Rs.1500. If the market price is 1500/1502/1600/2000 etc., ignore/ lapse the contract and sell in the market only your maximum loss is Rs.20 per share (Assuming premium paid is Rs.20). 4. So, max loss can be premium paid only so, it is LIMITED LOSS. Max gain from contract can be UNLIMITED. (If price falls to 100 gain is 1400) to the holder/ buyer of the contract. If your view is the price will increase from 1500 to 1600/1700 BUY CALL OPTION, that will give you a RIGHT TO BUY at Rs.1500, if the market price is above Rs.1500, exercise contract or lapse the contract if the market price is below (You can buy at low price in market). Underlying Asset View CMP (Current market price) Contract date Target price Action Premium Quantity/ Lot size Total premium SBI equity share Insurance/ go up/ Bullish view Rs.600 12.11.2022 Rs.700 Buy call option (Long position) Pay the premium at Rs.13 per share 1500 shares. 1500X 13 = 19,500/- Details Amount in Crores Market price 750 Buy price 600 Profit 150 Less premium paid 13 Net profit/ Pay off per share 137 Q) If the stock price of SBI is Rs.500 on Nov.24.2022 (Like the day of contract price is expiry) will you exercise the contract or lapse it is a buyer of the contract/ holder of the contract? A) Lapse it since the contract price is Rs.600 so, you need to pay Rs.600 to buy the stock. You can buy in the market itself for Rs.500 since that is cheaper your loss is Rs.13 per share/ Rs.19,500 per contract. Q) Assuming the market price is Rs.750 on 24. Nov.2022 what your Profit and loss from this contract? A) You can exercise the contract a buyer and buy the share at Rs.600 itself as agreed. So, the gain is as below. So, for buyer/ holder of the contract, loss will be limited like Rs.13 per share, even if the price fall at Rs.100 per share, loss is only Rs.13 however, gain is unlimited if can be Rs.100/200/500 etc., if the underlying asset price like SBI share price is increasing more and more the profit will be more. Q) Who can use the call options? A) Any one can use these options contracts like call option and put option. Since all call option gives a right to buy at specific price people having BULLISH view on the price of that asset can use these call options. Ex: - BPCL company or any other company importing goods will have problem if dollar price is increasing from Rs.82 per dollar to Rs.85 per dollar. Same way if you are a gold merchant like Kalyan jewellers expecting the gold price will increase from Rs.5000 per gram to Rs.6000 per gram in the coming 3 months you can use these call options get a right to buy at Rs.5000 per gram. Same a fund manager expecting the stock prices/ index like nifity 50 will increase can buy these call options. On the other side any party expecting the market/ gold/ stock price will fall can sell the call option, they are called as option seller/ writer if buyer/ order makes gain, that is loss to other party/ opposite party (seller). If buyer makes 1oss of Rs.100 that is gain to writer/ seller. Q) What is put option contract? A) These put option contract gives a RIGHT TO SELL to the holder/ buyer of the contract. Ex: - If a hedge fund manager invests Rs.100crs in Infosys shares, if that fund will make a loss of Rs.10crs when the stock price falls by 10% so, that fund can buy a put option, pay premium like Rs.10 per share get a RIGHT TO SELL the shares at Rs.1500 per share. If the stock price falls below Rs.1500 may be to (Rs.1400/1490/1300 etc.) use these contracts and sell at Rs.1500 only. So, there is no loss due to fall in price. Some way if Kalyan jewellers already brought of 100 kgs of gold at Rs.5crs per kg., expecting the price will fall, they can buy a put option pay on Rs.1 lac premium per kg., get a right to sell at Rs.5crs per kg., if price falls to 4crs per kg. Sell at Rs.5crs only so, gain is Rs.1cr due to contract. If market price is 5.5crs/ 6crs etc., sell in market and lapse this contract. Q) Difference between call option and put option? A) Details Call option Put option Holder will get Right to buy Right to sell Writer will have Obligation to sell Obligation to Buy Exercise If spot price is more than If spot price is less than strike price strike price Example If you have to buy at Rs.1320, market price is 1321 and above will exercise. If you have right to sell at Rs.100 if market price is 99 or below you will exercise this contract. 13.11.2022 Put Option: Underlying Asset - HDFC CMP (Current Market Price) - Rs. 2,650 View - Bearish/ Go down Target price - Rs.2,400 Premium - Rs.19 Per share Lot Size - 300 Shares Total Premium - 19 X 300 (Premium X Lot size) = 5,700 You will get a RIGHT TO SELL at Rs.2,650 per share, if the market price as expiry date of the contract (24th Nov.2022) is Rs.2000 you can still sell at Rs.2,650 so, gain of Rs.2650 – 2000 = Rs.650 premium already paid so, net gain is Rs.650 – 19 =Rs.631 per share. Q) If the stock falls to Rs.2500 tomorrow, this contract premium is increased to Rs.119 can you sell and exit or you need to wait to expiry date? A) You can exit any time before the contract expires. If you sell at Rs.119 gain is Rs.100 since you have purchased at Rs.19 and sold at Rs.119. Q) Can you buy or sell contracts? Or You can only become buyer? A) Generally, retail investor buys these option contracts like call or put options pay premium and get to buy or right to sell, they have limited loss possibility. However, anyone can buy and sell, hedge fund manager sells these contracts when they that is profitable opportunity. Ex: - If HDFC is trading at Rs.2,700 on 24th Nov 2022 if all investors are expecting it will not go up or go down, they can sell call option, receive Rs.30 premium. If market price is below the contract price/ strike price of Rs.2650, call option holders will buy in the market that stock and lapse this contract so, all that Rs.30 premium us gain to the seller/ writer of the contract. Though risk is more for writer/ seller of option contracts, they make profits in most of the cases. Q) Difference between Holder (Buyer) Vs. Writer (Seller) of option contracts? Details Premium Buyer/ Holder Pay 1) Has right to sell in put option. Right/ Obligation 2) Has right to buy in call option. Gain Loss Seller/ Writer Receive 1) Obligation to buy in put option. 2) Obligation to sell in call option. 1) Unlimited 1) Limited 2) If stock falls more, more gain in put option. 2) Only premium gain, if stock go up in put option. 3) If stock goes up more gain in call option. 3) Only premium gain, if stock decreases in call option. 1) Limited to premium, if stock goes up in Put option. 1)Unlimited if stock goes down in Put option. 2) Limited to 2) Unlimited if premium, if stock stock goes up in goes down in Call Call option. option. Q) What is the meaning of derivative contract and why they are used? A) Derivatives are contracts that DERIVE the value from the underlying asset. They are not security like shares/ bonds that are issued by a company to rise money. These contracts are mainly used by a market participants like imports and exports companies to fix the dollar rate/ price, traders/ investors to fix the stock price etc., these contracts can be used by any of the below underlying assets stocks, commodities like GOLD, CURED OIL, DAL, SUGAR, etc., Index like Nifty 50/ Bank nifty/ Sensex 30 etc., currencies like Dollar and Euros etc. These contracts are mainly use for: - Hedging, speculation or for arbitrage. Hedging means the contracts for REDUCING THE RISK of making loss due to change in market prices. Ex: - You are a farmer cultivating Rice, cost of producing 1 ton of Rice is Rs.10,000 you want to sell at Rs.13,000 after 3 months however, price may go down by that due to more supply in market so, you can enter into derivative contract like PUT OPTION and get right to sell at Rs.13,000 per ton or you can use forward contracts with below terms. Underlying asset Rice Buyer Big bazar Seller Farmer Contract date 13th Nov. 2022 Contract price Rs.13,000 per ton Quantity 100 tons Since farmer have trouble is the price decrease to Rs.5000 in 3 months, he wants to fix sell price today in November, contract expires at 15th march 2023. Since, Big bazar is expecting the rice price will increase by Rs.20,000 by march, they want to fix the buy price for Rs.13,000. Q) If the price is Rs.16,000 in the market price on 15th March contract expire date, who made profit/ loss in this contract? A) Farmer expected the price will fall so he agreed to sell at Rs.13,000 per ton now market price is Rs.16,000 still be need to sell Rs.13,000 per ton as per contract. So, farmer made Rs.3000 loss. (Rs.16,000 -13,000 = Rs.3000). So, big bazar made of Rs.3000 per ton even though the market price is Rs.16,000. Speculation means using these derivatives contract to make profit based on prediction on market price of underlying asset. Ex: - If SBI share is Rs.600 per day expecting it will go to Rs.700 in today, you can buy call option, pay to Rs.10 as premium if the stock price goes to Rs.700 this call option premium will increase at Rs.90 to 100 etc assuming it went to Rs.100 you will make Rs.90 gain in this case, you have no intention to buy SBI stocks, made profit by predicting the price so, you have used derivative for speculation. Q) What us the mean of OTC derivatives and exchange traded derivatives? A) There are many types of derivatives in the market, all of them can be grouped in 2 categories. 1. OTC- Over the counter contracts. 2. Exchange traded / Listed derivatives. OTC contracts mean those contracts can be used/ entered into any place, there is no need to have stock exchange etc., popular examples for these contracts are FORWARDS and SWAPS. Other examples of these are included swap options and contract of difference between credit default swaps etc. Exchange traded funds Traded / used Trade only in Mean anywhere. exchange. High we can find Low/ Nil Liquidity many buyers and cannot (Convert sellers for the transfer or asset in Cash) contract. So, it sell to others. can be sold. Terms Customized. Standardized. Less/ Nil stock More, counter exchanges act as Risk parties risk is intermediaries to more. settle the contract so less risk. Details OTC Q) You are in the export business like Infosys company you have agreed to sell software at USD 1cr you will receive that money in Jan 2023, price is fixed in Oct based on today’s foreign currency exchange (F/x Rate) on Rs.82 you will get to Rs.82crs. Your cost of developing software of Rs.70crs so, profit estimated of Rs.12crs however if the F/x rate changes to Rs.75 per dollar by Jan 2023 you will get Rs.75crs so, it is not worth developing software and sale can derivatives help you in this to get Rs.82crs even in Jan? A) Yes, any derivative contract can be used for this purpose to reduce the risk. Futures: - These are traded in the exchanges like NSE, BSE, etc., you need to have De-mat account to use that. You can sell today at Rs.82 and buy at Rs.72 in Jan 2023 if the market price is Rs.72 that day so the gain is Rs.10 per dollar due to contract. So you will get the effect so selling at Rs.82 per dollar (Contract may be with Amitabh so he will pay you Rs.10 per dollar, actual dollars you can sell in market to a bank and get Rs.72 so effective slae price is Rs.82, generally opposite party like Amitabh don’t care the dollars, they receive or pay difference between agreed/ contract price and the actual market price). Forwards: - Agree to sell at Rs.82 per dollar with a bank like HSBC and get Rs.82crs in Jan 2023. This OTC contract between company and Bank so the quantity to sell date of contract expiry etc can be decided based on the requirements (Customization of contract). Put option: - In this case, you can buy a put option to sell one dollar at Rs.82, if the market price is below Rs.82, use the contract and sell at Rs.82 if market price is above Rs.82 like 83/92/100 etc., lapse the contract and sell in the market only. These option contracts will give a right but not obligation so you can use the contract if need/ benefit is there from the contract or ignore/ lapse if market is better, to get that right to sell at Rs.82 per dollar you need to pay premium like Rs.2 per dollar. Q) On 31st march 2023 market price (spot price) is Rs.2000, what is gain/ loss to seller in the above contract? A) For buyer it is LOSS Buy price 2449.2 Sell price 2000 Loss -449.2 Lot size 250 Total loss -1,12,300 The opposite party or seller of the contract will make a gain Rs. 449.2 per share or total gain of the other party is Rs. 1,12,300 per lot. Q) Today you bought the futures at Rs.2449, tomorrow it is trading at Rs.2500 you need money, can you sell and exit? A) Yes, the contract is more than one month of expiry, we can sell any time difference between buy and sell price is the profit/ loss. In this case buyer will make a profit on Rs.51 i.e. (Rs.2500- 2449) per share. Q) You bought the future contract at Rs. 2449 today and the stock price is Rs.1000 on march/ contract expiry date, what is loss? Whether margin is sufficient margin is sufficient for the stock exchange to recover your loss? A) Details Buy price Sell price Loss per share Lot size Total loss Initial Margin (Pending) ₹ Amount 2,449 1000 -1449 250 -3,62,250 1,36,971.51 Forward contracts Vs Future contracts? Forward contracts are available anywhere, no need to buy and sell them in exchange only so, they ae OTC contracts. Mainly imports and exports companies use these currency forward contracts to hedge the risk against change in FX trade rates. These forward contracts are a contract between 2 parties to exchange an underlying asset at a specific price on a future date. Ex: - Farmer example to exchange rice at Rs.13,000 per ton or private equity fund example to exchange dollars. Future contracts similar to forward contracts, they can be used to fix the price for a future date on contract date/ today so, any fluctuation in prices of underlying assets will not create trouble to users of the contract. Main differences between these two is forwards are only available outside the exchanges like NSE/ BSE. These future contracts are available in exchanges only so, they are called as listed derivatives/ Exchange traded funds. Details Traded Contract terms Counter Party risk Margin payment Settlement Liquidity Can be used Mark to Market Forwards OTC Futures In exchanges Customized Standardized Is there Not there Not required Required On contract expiry date Less/ Nil Daily settlement More On any asset/ security On Asset/ Security as decided stock exchanges loan popular stocks, popular commodities available No there Applicable, daily extra margin (MTM Margin) payable if you make loss based on daily movement in price Futures exercise: Underlying Asset - Wipro CMP (Current market Price) - ₹ 400 Target price - ₹ 300 Action - Sell futures today at ₹ 400 If you sell at ₹400 today to close the contract you have buy that contract before expiry. If the market price is ₹ 300 after a month, you can buy at ₹ 300 gain is ₹ 100 per share so, futures are used like stock where you can buy today if the price is expected to increase and sell today if the expected price is decrease difference between profit and loss is the action of buy and sell. Q) If you sell Wipro futures contract to sell ₹ 400 on expiry date of the contract is 24th Nov. 2022 stock price is ₹ 550 what is gain/ loss? - ₹ 400 on 13th Nov 2022 A) Sell price Buy price/ square off Price - ₹ 550 on 14th Nov 2022 Loss - ₹ 150 Since sell price is low, loss of ₹ 150 Q) Calculate gain/ loss based on below RIL features contract? Underlying Asset A) View RIL Lot size 250 Contract 6,12,300 value 2443.5 Margin 22.37% Margin 3000 1,36,971.51 amount 31st March 2022 2,449.2 Bullish/ +ve CMP Target Contract expiry date Price Q) On contract expiry date the market price is ₹ 2900 per share what is gain/ loss to buyer? A) Sell price - ₹ 2900 Buy price - ₹ 2449.2 Gain price - ₹ 450.8 Lot size - 250 shares Total gain - 250X 450.8 = ₹ 1,12,700 Q) If the market price on 31st March (Spot date) is ₹ 2000 what is gain/ loss in the above contract? (Pending) 14.11.2022 SWAP: - These are like multiple forward contracts entered into by two parties at a time. In swaps, parties agree to exchange SERIES of CASH FLOWS between them. Ex: - You have purchased RIL bonds, to receive 8% per annum as interest, since you thought investing in equity shares of that company is risk. After 3 months you have realized equity shares of RIL is better and they can give around 15% return. Your friend invested in shares already, he has an opinion that investment in bond is correct. Now, both of you can entered into swap contract where on monthly basis, any return on bonds like INTEREST + APRRECIATION/ DEPRECIATION will be paid to your friend he will pay any income from shares like DIVIDEND + APPRECIATION / DEPRECIATION. This is called TOTAL RETURN SWAP. Other swaps popular in market are as follows: Interest rate swaps, currency swaps. Interest rate swaps: - Interest rate swaps income from fixed rate bond by exchanging floating rate bond interest (Or give floating and take fixed are). Ex: - Today repo rate is at 5.75 BPS, you are expecting it will go up so, you have invested in floating rate bonds where RIL company is pay repo rate + 2% interest. After 3 months you are in the opinion, rates go down so, better to invested in fixed rate bond paying 8% interest. You can enter into interest rate swap; you can pay floating rate into opposite party and take fixed rate. Swaption: - Swap + option, if you have equity shares of Tata motors you will continue to hold these shares if the company is expected to perform well and declare profits in the books. If the company will declare results after 10days, you have a doubt that results may be bad, then you can enter into TRS today with your friend. So, you can give equity returns to your friend and take return on debentures from your friends if you are not sure on how the results will be after 10days then you can use swaption contract. You can pay some premium like ₹5 per day share today, get the right to enter to swap or not after 10days. If the company results are good, shares price will go up so, ignore the swaption contract and hold the shares. If results are bad, use the swaption contract enter into swap agreement so you get return can debt and your friend tales return on equity. CFD (CERTIFICATE FOR DIFFERENCE): - These are similar to forwards, futures with small differences as mentioned below: 1. Most of these CFDs ae OTC contracts value. 2. Parties need to pay small margins like 5 to 10% as contract value. 3. These are settled by paying the difference rather than physical settlement. Ex: - You agreed to sell 10 tons of wheat at ₹10,000 per ton if the market price is ₹5000 you will still sell the wheat at ₹10k per ton and make ₹5k profit in forwards you will actually delivers the wheat and opposite party pay total amount in CFD, since you made ₹5k profit per ton, can sell in the market ₹5000 and get total of ₹10k per ton but there is no actual delivery between the parties. CORPORATE ACTIONS These are actions taken by companies (Listed like apple/ RIL etc) that impacts all STAKE HOLDERS these stake holders can be shareholders, debentures holders etc. If a company made more profits, they will distribute these profits to owners/ shareholders. All shareholders can account that an income in their books, they will receive that one day (payment date) all funds, mainly hedge funds and mutual funds invest more in these listed companies so, they have to trade all these corporate actions/ corpactions in the market, so. 1. They can understand the corpactions and its impact on stock price and take a decision like buy/ sell that security. 2. Account the impact like dividend income in the books in the right time so, NAV is correct. If NAV is incorrect for one day, some investors might have come into the fund/ left the fund that day, their settlement price are incorrect since the investor’s accounts are settled based on NAV applicable for that day. Ex: - If HDFC large cap fund NAV is ₹100 today, they will take ₹ 1000 from you if you buy 10 units that day. If they ignored that account dividend income on that date, that NAV is incorrect of they consider that dividend, NAV can be ₹10 so, you have paid ₹10 less for 10 units. To ensure all corpactions (C.A) are captured in the and processed accurately etc., these companies (Mainly fund accounting companies) classify these C.A. into 3 categories they are as follows: Mandatory C.A. Dividend Bonus issue Stock split Spin off/ Demerger Mergers Acquisitions Name change Reserve stock split/ consolidation of stocks Voluntary Mandatory with C.A. Choice C.A. Right issue Dividend as stock/ cash Buy back of share Record date: - This is the date on which a company will take the list of shareholders names as per records and process/ pay the corpactions benefit to them. Ex: - If record date for dividend is 15th Oct., your name should be there in records (Share holder register) on that day to get that dividend. Ex-date: - This date is more important for fund accounting reason sine these funds will account the impact/ benefit of Corp action on this day. Ex-date means the date on which the stocks are traded without/ excluding the benefit of crop action. Ex: - If record is on Wednesday, Ex-date will be Tuesday that stock is trading excluding the benefit of crop action, if you buy the stock on that day, you will not get that benefit of C.A. that is already declared. (Pending what’s app screen shots) 15.11.2022 Q) If Nykaa decided to issue bonus shares and fixed record date as 11th Nov 2022, Friday what is ex-date? A) 10th Nov Thursday since it takes 2 working days/ business days to settle the trades in stock markets as of now in (India). Q) If stock exchange settles the trade settlements in T+1 days, what will be ex- date? A) Then the ex- date is also 11th that means, if you buy shares on 10th Nov, your name will be update in de-mat accounts/ records as the shareholder by 11th itself. So, any one buying on 10th or before will get the bonus shares, buying on 11th and later will not get the bonus shares. Q) In current system T+2 settlement, if the record date 11th Friday and date is holiday, what will be ex- date? A) 9th Nov Wednesday will be the ex- date, any public holidays should be excluded for T+2 settlement since stock exchange will not work on those days. Q) If your fund has 1cr shares in Nykaa on ex- date morning, fund sold their shares do, they get bonus shares? A) Yes, the fund will still get the bonus shares since their name is recorded from shareholder register Friday/ record date. So, there is eligibility for bonus shares is not impacted due to sake on ex- date. Fund can update the quantity in the books on Thursday to 6crs (Company issued 5 free shares for every 1 share) and use the market value on that date to update the portfolio value for NVA calculations. 1. What is Dividend? A. This is the amount paid by company to their investors (owners) out of the profits in that company, if a company makes profits using the capital received from investors, they can either distribute that money to the investors or reinvest that money into the business this can be interim dividend (paid out of quarterly profits) or final dividend (aid out of year end/ annual profits). Now a days, these companies have to declare this dividend in rupees rather than % (earlier if a company says they pay 10 2. What is Bonus shares? A. These are free shares issued by a company to investors (existing investors) by converting reserves (accumulated profits/ profits of previous years) in fund accounting we update the quantity of shares in the books when this is done. If it is 1:1 bonus issue, if the fund has 100 shares, they will update the 100 more shares in quantity. 3. What is stock split? A. Stock face value reduced from ₹10 per share to ₹5/2/1 etc so, more shares are created in that company. 4. What is spin off? A. One company is divided into many companies or 2 companies by spinning off/ demerging one division to a separate company. 5. What is Buy back of shares? A. In this case the company buy back some shares from investors, share price will increase in this case since no. of shares are reduced. 6. What is Right issue? A. Issue of shares to existing shareholders when company need more capital. Generally, they sell at discount to old investors, it is right to old investors, if they are not interested company will sell to others and raise money. INDUSTRY RELATED TERMS (ASSET MANAGEMENT INDUSTRY): Types of Investors: - HNIs (Hight Net Worth Individuals) these investors who has more earning capacity and more assets so, they can invest these private equity funds and hedge funds. Common definition/ understanding of this term is an investor having NET ASSETS of more than 1 million (10 lacs) US dollars at ₹82 per dollar F/x rate will be ₹8.2crs net assets person should have to invest in these funds. Institutional investors: - These are institutions (Not individuals) who are making investments in markets/ funds etc. Ex: - Insurance companies, provident fund houses, pension houses like New York pension fund, Canadian pension fund, Norway pension fund) provident fund house organization like EPFO (EMPLOYEE PROVIDENT FUND ORGANIZATION INDIA) etc., invest in markets, in private equity and hedge funds. If EPFO collects PF contribution from employees they have to pay interest around 8% to the employees who contribution money to them, these organizations earn that interest or more by investing that money into various assets like government bonds, shares, these private equity funds and hedge funds. Sovereign Wealth Funds (SWF): - These are funds owned by governments like Govt. Singapore, Govt. of Dubai etc., governments with surplus money will invest in these private equity funds or hedge funds since these funds can generate good returns to them like 15% or more in most of the cases. Alternative investments/ Alternative investment fund (AIF): Alternative investments are other than traditional investments, traditional investments like shares, bonds, debentures etc., any investments made by investors into other than traditional investments are called as alternative investment funds. Examples are: - Private equity funds, hedge funds, crypto currencies, Gold, Crude oil, Paintings, Vintage cars, Whisky, Musical instruments etc. Many companies like State Street, Goldman Sachs, BNY Mellon etc use this world in job opportunities/ descriptions in their communications like the job is in alternative investments divisions or the name as alternative investment services division etc. SEBI also classifies all these alternative funds into 3 categories AIF1 (Venture capital funds) AIF2 (Private equity funds) AIF3 (Hedge funds). AUM (ASSETS UNDER MANAGEMENT): - It means, based on this AUM, industry decides which company is bigger company is bigger company I that business like Mutual funds, Private equity funds and Hedge funds or all including. Below are the big companies by AUM in India AUM in NAME Lac Crs. SBI 6 ICICI 4.6 HDFC 4.3 NIPPON 2.5 AXIS 2.6 Top 5 Companies in the world on AUM AUM in US NAME Lac crs. Trillions Black 820 10 Rock Charles 664.2 8.1 Schwab Vanguard 664.2 8.1 Fidelity 352.6 4.3 UBS 344.4 4.2 How this AUM is calculated? Industry practice is considering the amount on which the fund house is earning the income as AUM (Assets Under Management) by Assets managed by the fund house. Ex: - In a mutual fund they earn fee on NAV of the fund. If the fund NAV is ₹10k crores, they report that as AUM; if SBI manages 20 mutual funds and total of those funds NAV is ₹6 lacs crs. i.e., reported as AUM of SBI AMC. In private equity funds, if the fund charges management fee/ incentive fee on commitments these commitments are consider from AUM calculations. If a fund house like State Street has MF, P/e, and Hedge funds they have to add AUM of all the funds like NAV of funds or Commitments of the funds etc., and report NAV. These fund house report AUM increase in % in their financial statements and any communications to their investors etc., the AUM is also used to report their growth of Asset Management Industry in a country like Indian mutual funds AUM is ₹40 lacs crores. Assets Under Custody (AUC): USD Company Trillions BNY Mellon SST JPM Northern Trust Citi Indian Rupees Trillions 45 3375 43.3 20.5 3247.5 1537.5 14.8 1110 13 975 Custodian keeps the assets of the fund in their custody. Ex: - If a mutual fund buys RIL company shares, these share certificates will be in the custody of the custodian company like Citi all these fund houses has to appoint a custodian for each fund (external party) so the decisions on where to invest is made by the fund manager/ AMC and the assets are in the custody of different party so investors can have more faith on the funds operations and there is less scope to manipulate/ misuse investors money. These custodians are in also responsible for participating in trades clearing and settlement in stock exchanges on behalf of the fund houses/ institutional investors. Ex: - If HDFC mutual fund appoints Citi bank as custodian, that fund purchases Infosys shares today in stock exchange, the fund will get the shares in two days. In these two days, stock exchange coordinate between the parties like buyer/ seller, stock brokers, custodians, depositories etc and transfer the shares from seller de mat account to buyer de mat account. On behalf of the fund, this custodian participates in this clearing and settlement of trades. Ex: - HDFC mutual fund invested in Wipro company shares, Wipro company announced bonus shares to all investors. So, the fund also received 100 free shares/ bonus shares, this custodian company will account for this benefit and increase the shares in their books. If the custodian updated the quantity of shares as 100 before, they will now update the quantity to 200 shares. Since, bonus shares are issued by the company. These custodians are paid custodian fee, generally as % on NAV or commitments like 0.2% on NAV of the fund this is accounted as custodian fee in the books of the fund. AUA- (Assets under Administration): - Fund administrators take care of all administration’s activities of the fund like preparation of financials, making payments on behalf of the fund, provide audit support etc., so the fund house can concentrate on managing the fund/ investments. Generally, these fund houses appoint the same party/ company as custodian and fund administrator. Ex: - If Goldman Sachs launches a hedge fund/ Private equity fund they will appoint Citi or SST or BNY Mellon as fund admin and custodian. To know/ measure which company has more assets with them, they use AUA if fund administrator like Apex charges this fee on NAV of the fund, NAV is ₹100crs then AUA is ₹100crs sum of the NVA of all the funds they act as fund admins is the AUA of that company. Top FUND ADMINS BY AUA: 1. SSC, 2. SST, 3. Citco, 4. Assure, 5. Inter trust, 6. Morgan Stanley, 7. SEI, 8. Northern trust, 9. Apex. 16.11.2022 Reconciliations: - It means comparing the data between two sources and finding any differences between sources. Ex: - Bank reconciliation process, accountants compare the closing cash balance reported in accounting books Vs closing balance as per the bank statement and any differences will be rectified so, the balance sheet numbers is correct. In fund accounting NAV process is done by the participation of various parties like custodian, AMC, stock brokers, RTA, etc. So, there can be differences between the data of two parties so, they conduct these reconciliations. Ex: - Goldman Sachs hedge fund has below parties so, they conduct these reconciliations. Goldman Sachs: - General partner/ Investment manager who launched the fund, managed the fund responsible to send NAV to investors and regulators etc. State Street: - Fund administrator who prepares the financial statements and NAV, operating bank accounts of the fund like make payments on behalf of the fund, provide audit support etc. BNY Mellon/ State Street: - Custodian who keep the assets of the fund like shares in the custody. They also update the crop- actions like bonus shares in their accounts so, number of shares owned by the fund is correctly reported. HSBC Securities/ Goldman Sachs Securities: - Prime broker, like a stock broker they help these fund houses to open de – mat accounts, trading accounts place order in the stock exchange on behalf of fund houses. There is a regular dependency, coordination between these parties to manage the fund, to report NAV. There can be discrepancies in the data between two parties. All line items/ important line items in the balance sheet will be reconciled between the parties to ensue they are correct. Ex: - If the investment manager like Goldman Sachs prepares management fee and incentive calculations, they will compare or review similar way they reconcile all other important line items like bank loan, investments, cash etc. Most important line items or line items having more balance in a fund are investments and cash. Ex: - If the fund has total assets ₹500crs, investments can be in the ₹450crs, cash in ₹30crs and ₹20crs of other assets to ensure these 2-line items this recon will be out sourced to other company where many team members will do this a separate task (if GS out sourced fund accounting to SST, they may give this recon, to HCL state street these teams main work is to complete recon of 100s of funds. So, fund admin can use that finalized numbers in NAV calculations). To reconcile investments and cash the below reconciliations are done by these recon teams: 1. Position Reconciliation: - To ensure the position of investments or value of investments is correct between two sets of data. Ex: - In Goldman Sachs hedge fund, apple company shares reported by GS are 1000 and the balance of apple shares in fund admin books are 950. Similar way they can be difference between prime broker and fund admin books. Reason can be as follows as: GS/ Investment manager asked to buy 1000shares of apple at ₹500 prime broker placed the order for 1000 shares, they are able to buy only 950shares at that price of ₹500 per share, market price went up to ₹520 that day so, there are not able to buy the balance shares are update by custodian on the same day but fund administrator and investment manager forgot to update the quantity so, one source (custodian) is reporting 200 shares and others are reporting only 100 shares. In this case custodian data is correct, others have to update. Cash reconciliation: - This is to ensure the cash balance of each fund is correct. Ex: - As per primer broker who buy and sell shares on behalf of the fund, the closing balance of Goldman Sachs hedge fund is ₹10crs as per fund administrator books, it is reported as ₹9crs. Reasons for differences can be: A) One trade (purchase of investments) is made in US Dollars and paid in 1000 US dollars, and it is updated as paid in ₹1000 by one party. B) One trade is completely missed by one party so, cash balance is not update. This reconciliation if made between two sets of data, is from two different companies, they call it as external reconciliation, if that recon is done between two teams in same company it is called as internal reconciliations. Ex: - If data of GS and SST is reconciled it is external recon. If data of front office GS (where trades are accepted and placed into stock exchange) and back office (where contact notes are prepared, profits are calculated on trades), it is internal reconciliation. Q) What is trade blotter? How does that is helpful in reconciliation in fund accounting? A) Trade blotter: Scrip/ Quantity Amount Exchange Security 01.01.2022 Apple 100 20,000 USD 01.01.2022 RIL 1000 1,00,000 INR Date This is file containing details about trade in a fund if a fund purchases or sell some shares. Those are reflected in this document/ file. Q) What is contract note? A) This a document sent by stock broker to the investor/ trader who purchased or sold any security in the market through their platform. Ex: - You have a trading account with zerodha, you have purchased 100 shares of Infosys and 2 option contracts on nifty 50 day through that trading account, zerodha will send this contract note by end of that day, this will have all details related to that trade like qty purchased sold, price paid, brokerage charges on that trade, STT (SECURITIES TRANSACTION TAX PAID ON THAT) etc. Trade life cycle: Pre-Trade: - Place the order by the buyer to buy the securities or seller to sell the security. Ex: - Buy 100 shares of RIL at ₹2200 per share order will reach to the stock broker like Zerodha who will verify the order and place to stock exchange systems stock exchange like BSE/ NSE will receive buy and sell orders and display the orders to all participants. Ex: - Tata motors. BUY SELL Quantity Price Price Quantity 10 440 441 25 100 439 441 50 1 439 442 25 5 438 443 3 6 435 444 1 Stock exchange will display top 5 buy orders (highest price quoted amongst the buyers) and top 5 sell orders (lowest price out of all sellers) in the order book. Once the price of the buyer wants to buy at ₹439.5 so trade will happen assuming both agreed at 440 (buyer increased to ₹440 and seller decreased to ₹440) trade will happen at ₹440 per share. Post trade: - Once trade happened at stock exchange, these stock exchange will send all the trade details to clearing house. Ex: - If 1 lac trades in RIL and 2 lac trades Infosys happened today, all these buyers and sellers details will be sent to NSE clearing LTD (clearing house) by tomorrow morning. Clearing corporation takes responsibility to settle all the traders so buyer will get securities and seller will get money into their accounts for this clearing house will reach out to all respective parties for confirmation so settlement (Clearing and settlement process) is error free clearing house will send all trade details to stock brokers to confirm their net obligations. Ex: - Zerodha client purchased 1 lac shares and sold 50k shares. Once the stocks brokers confirm the details clearing house will send the instructions to them to settle the net obligation CC (clearing corporation) will instruct the clearing banks to arrange the money. CC will instruct the depositories to arrange for the securities like (NSDL/ CSDL will have all the securities ownership details). Pay IN of money: - Clearing bank send the money to the clearing corporation. Pay in a Securities: - Depositories will send the securities to the CC. Pay of money: - CC will instruct the clearing bank to transfer the money to the seller. This total process of clearing and settlement takes two days, if you buy the shares on Monday, you will receive the shares by Wednesday (T+2 settlement) trade day + 2 days. It is planned to have 11 T+1 settlement in Indian exchanges from Feb 2022 each month 100 stocks are moved into this system from lowest market cap first lowest mid cap/ small companies are moved and later top companies. Mutual Funds: Q) If you have ₹10,000 A) Details New fund JM mid cap fund Old fund Invesco India Midcap fund NAV Launch year 10 2022 104.4 2013 Based on NAV, we cannot say new fund is cheaper since it is only ₹10. This ₹10,000 invested by you will go to shares like Bata/ Apollo hospitals etc and if those shares go up by 10% both funds reported same 10% increase (NAV of 10 will become 11 and NAV of 104.4 will become 114.86) so, the performance of the fund depends where that money is invested for that we can see types of funds (Mid cap/ Small /cap) fund manager back ground like return generated earlier/ experience etc. Q) Can we calculate the NAV on profit and loss approach or always on balance sheet approach? A) Today fund is launched and collected ₹100crs by issuing 10crs of units. (B/s Approach) One Details Today month over Bank 100 0 Investments 0 150 Total assets 100 150 Liabilities 0 5 Net assets 100 145 No of units 10 10 NAV 10 14.5 Profit and loss approach Details NAV opening bal. Dividend Interest Un realized gain Realized gain Management fee Other expenses NAVclosing bal. No of units NAV per unit Amount ₹ 145 10 5 50 40 -5 -10 235 20 11.75 Note: 1. 2. 3. 4. Any income or gain will increase the NAV. Any expense or loss will decrease the NAV. Any Subscriptions will increase the No of units. Any Redemptions will decrease the No of units. Q) Fund invested in Infosys company, that company declared dividend of ₹5crs, today is the ex-date. Fund accountant missed to record that amount, what is the impact of NAV? A) NAV reported less so any investor transaction settled will be incorrect for that day. Q) One fund started on 01.01.2010, that has NAV of ₹100 other fund started today, NAV is ₹10 which is better to invest? A) Only due to NAV we cannot say which is good fund to invest. If you are investing ₹10 lacs you will get more units in new fund and less units in old fund but the value of you invest is ₹10.10 lacs after a month if both the funds invested that money in RIL shares and that share went up by 10%. So, performance is driven by underlying asset in first fund your NAV will become ₹110 and in second fund it will become ₹11, either way it is 10% return. Q) A fund has ₹100 as NAV as of today one investor came into fund and purchased 1 lac units will that change NAV after recording that transaction? A) This will increase the cash balance so asset value increases no change in external liabilities so net assets will increase. Ex: - If net assets earlier is ₹10 lacs this investor brings ₹1 lac cash, then net assets will become ₹11 lacs however, net asset value per unit will not change since no of units will also increase due to this subscription if 1000 units are added now, NAV per unit will again be ₹100 (If entry load income is collected the it will NAV slightly like ₹100 NAV will become to ₹100.01). Types of mutual funds/ Investment strategies of Mutual funds: Equity based funds Debt based funds Hybrid funds Large cap/ Mid Long duration Aggressive cap/ Small cap funds Hybrid funds funds Sectoral funds Fund of Funds Focused funds Short duration funds Money market funds Liquid funds Conservative Funds Balanced funds Others Commodity funds like gold, silver, crude oil etc. Index funds ETF REIT INVIT Equity Funds: - These funds invest in shares of listed companies these are riskier compared to debt funds, bank fixed deposits etc since they can also give loss when share prices went down or bearish market situations. Depends on where they are investing, there can be many categories like Large cap funds: - These types of funds are likely to invest in blue chip companies or top 100 companies in the market cap trading in the exchanges. Formula for market cap: Market capital = No of shares in that company X Market price of that company. Ex: - RIL is the biggest company in India by market cap with approx. 16 lacs crores market cap, if the share price is ₹2000 company has 800crs shares then market capitalisation is 16 lacs crores (2000X800). Mid cap funds: - These types of funds are targeted to invest in the companies like ranked by the exchanges at the level of 101 to 250th rank-based companies in the market cap. Small cap funds: - These types of funds are mainly focused to invest in the sector funds like HDFC, ICICI, Apollo Hospitals etc. These are ranked by the exchanges below the 250th rank (251 to 5000, assuming in Indian stock exchanges) and focused funds invest in less companies like 25 to 30 than investing in 60 companies (portfolio of companies in that fund is less). Debt funds: - They invest in debt/ fixed income securities like dentures/ bonds, investors will get interest at 6 to 10% generally and get the principal back on maturity like after 5yrs so they are more secured/ less risky. Q) Difference between ETF and Index funds? Details Meaning ETF Same as Index fund, also this is traded like a stock where price changes in real time. Example HDFC launches Nifty 50 fund, Portfolio is same like invest money into all stocks in Index fund; units of the that Index. If exchange remove fund is traded in NSE/ one stock and add new stock, BSE where investors can this fund also does the same. directly buy/ sell there. Liquidity More fund house will arrange Less these are traded in money when investor need, exchanges. Investors can settlement happens at NAV of buy/ sell there only. the day. J - CURVE Index funds Money of the fund is invested in Index stocks like Nifty 50 Stocks.