Chapter 6: Fee Structure of Alternative Investment Funds

Fund Economic Architecture: The "2 and 20" Paradigm

The economic relationship between the Investment Manager (General Partner/AMC) and the Unit-Holders (Limited Partners) is designed around a dual compensation framework:

1. Management Fees: Predictable, recurring fee intended to cover operational overhead, investment team salaries, due diligence research, office infrastructure, and fund administrative costs.
2. Carried Interest (Performance Fee): A share of net portfolio profits (typically 20%) awarded to the Manager only after returning investor capital plus a contractual preferred rate of return (hurdle).

Fund Cash Flow & Compensation Engine:
[Committed Capital] ──> [Gross Returns] ──> [1. Return Committed Capital to LPs]
                                        ──> [2. Return Preferred Hurdle (8% p.a.) to LPs]
                                        ──> [3. GP Catch-up (Manager)]
                                        ──> [4. 80/20 Carried Interest Split]

Management Fee Calculation Bases

Management fees in Category I and II AIFs range between 1.5% and 2.5% per annum and transition across the fund's lifecycle:

Setup Costs and Operating Expense Caps

• Organizational / Setup Expenses: Expenses incurred in establishing the fund (SEBI registration fees, merchant banking fees, legal drafting of Trust Deed and PPM, tax structuring opinions). Capped in the PPM (typically between 0.5% and 1.5% of fund corpus) and amortized over 3 to 5 years.
• Operating Expenses: Routine costs charged directly to the fund (custody fees, RTA fees, statutory audit fees, valuation charges, legal enforcement costs). Under SEBI regulations, all operating expenses charged to the fund must fall within strict caps explicitly disclosed in Part A of the standardized PPM.

Preferred Return (Hurdle Rate) Principles

The Hurdle Rate (also known as the Preferred Return) is the minimum annual internal rate of return (IRR) that unit-holders must receive on their invested capital before the Investment Manager becomes entitled to receive carried interest. In Indian Category I and II AIFs, hurdle rates typically range between 8% and 12% per annum (compounded annually).

1. Soft Hurdle with Full Catch-up

Under a Soft Hurdle, once the fund performance crosses the hurdle threshold, the Investment Manager is entitled to receive carried interest on all profits generated from the very first dollar, rather than just the profit generated in excess of the hurdle rate. This is achieved via a GP Catch-up clause:

Soft Hurdle with Catch-up Sequence:
1. LPs receive 100% of capital contributions.
2. LPs receive 100% of preferred return (e.g., 8% IRR).
3. GP Catch-up: Manager receives 100% of subsequent distributions until Manager's carry 
   equals 20% of total profits distributed under (2) and (3).
4. Residual Split: 80% to LPs, 20% to Manager.

2. Hard Hurdle (No Catch-up)

Under a Hard Hurdle, the Manager earns carried interest strictly on profits generated above and beyond the hurdle rate. The hurdle rate serves as an absolute floor:

• Total profit up to 8% IRR belongs 100% to the LPs.
• Only the excess profits above 8% IRR are split (e.g., 80% to LPs and 20% to the Manager).

Comparison of Manager Carried Interest Payouts:
Total Profit = $10,000,000 | Hurdle Amount = $6,000,000 | Excess Profit = $4,000,000
• Soft Hurdle (with 100% catch-up): GP Carry = 20% of $10M = $2,000,000.
• Hard Hurdle: GP Carry = 20% of $4M (excess only) = $800,000.

High-Water Mark (HWM) in Open-Ended vs Close-Ended AIFs

While pervasive in Category III AIFs where fees are assessed periodically against mark-to-market NAV fluctuations, in close-ended Category I and II AIFs, the High-Water Mark ensures that performance fees are never assessed against unrealized paper peaks if cumulative capital losses remain unrecouped.

The Distribution Waterfall Mechanics

The Distribution Waterfall defines the contractual cash-flow priority hierarchy governing the distribution of liquidation proceeds, dividends, and interest income generated from portfolio company exits.

                         ┌────────────────────────────────────────┐
                         │      Net Distributable Cash Flow       │
                         └───────────────────┬────────────────────┘
                                             │
                                             ▼
┌─────────────────────────────────────────────────────────────────────────────────┐
│ STAGE 1: Return of Capital (ROC)                                                │
│ 100% of cash flows distributed to LPs until cumulative distributions equal all  │
│ capital contributions drawn down to date.                                       │
└────────────────────────────────────┬────────────────────────────────────────────┘
                                     │
                                     ▼
┌─────────────────────────────────────────────────────────────────────────────────┐
│ STAGE 2: Preferred Return (Hurdle)                                              │
│ 100% of cash flows distributed to LPs until LPs achieve contractual hurdle      │
│ (e.g., 8% p.a. compounded IRR on drawn capital).                                │
└────────────────────────────────────┬────────────────────────────────────────────┘
                                     │
                                     ▼
┌─────────────────────────────────────────────────────────────────────────────────┐
│ STAGE 3: GP Catch-up                                                            │
│ 100% (or 80%) of cash flows distributed to Manager until Manager receives 20%   │
│ of aggregate profits distributed in Stage 2 and Stage 3.                        │
└────────────────────────────────────┬────────────────────────────────────────────┘
                                     │
                                     ▼
┌─────────────────────────────────────────────────────────────────────────────────┐
│ STAGE 4: Final Carried Interest Split (Residual)                                │
│ All remaining proceeds distributed 80% to LPs and 20% to Manager (GP).          │
└─────────────────────────────────────────────────────────────────────────────────┘

European (Whole-of-Fund) versus American (Deal-by-Deal) Waterfall

Carried Interest Escrow and Clawback Provisions

In structures where carry is paid prior to fund liquidation (such as modified American waterfalls), a Clawback Clause is mandatory:

• Clawback Obligation: If at the final winding-up of the fund, the cumulative return delivered to LPs is less than their invested capital plus the preferred hurdle (due to losses on later investments), the Manager is legally obligated to return (claw back) excess carry received in earlier years.
• Escrow Mechanism: To guarantee clawback solvency, 20% to 30% of each gross carry distribution is escrowed in an interest-bearing escrow account until final fund liquidation.