Introduction:
In the intricate world of hedge funds, we encounter a concept known as the ‘high-water mark’ which relates to the GP’s compensation structure (e.g. often 2% management fee / 20% performance fee). A typical clause in a hedge fund limited partnership agreement relating to the high-water mark, will often be found in full in the allocations section, and is summarized as follows in the PPM:
“The Fund maintains a loss recovery account (a “Loss Recovery Account“) for each Capital Account of a Limited Partner that tracks the losses that must be recouped before an Incentive Allocation can be made with respect to such Capital Account of a Limited Partner (i.e., tracks the “high water mark” of such Capital Account). The balance in each Capital Account’s Loss Recovery Account is adjusted at the end of each Fiscal Year to reflect the aggregate net capital depreciation with respect to such Capital Account, if any, and is adjusted as necessary to account for net capital appreciation and intra-year withdrawals. Solely for purposes of determining an adjustment to the balance of a Capital Account’s Loss Recovery Account, net capital appreciation and net capital depreciation for any applicable period will be calculated by taking into account the amount of the Management Fee, if any, debited to such Capital Account for such period. Additional capital contributions do not affect the balance of any Loss Recovery Account. The Incentive Allocation is not made with respect to a Capital Account until the balance of such Capital Account’s Loss Recovery Account has been reduced to zero.”
This financial mechanism plays a crucial role in aligning the interests of fund managers and investors. In this blog post, we will demystify the high-water mark, exploring its function and impact on investment returns, accompanied by a real-world example.
What is a High-Water Mark?
A high-water mark is a performance benchmark used in hedge funds to ensure fairness between fund managers and investors. Essentially, it represents the highest value that an investor’s capital has reached in the past. The purpose of this benchmark is to ensure that fund managers only earn performance fees on profits generated beyond the previously achieved peak.
How Does it Work?
The high-water mark operates as a form of “clawback” mechanism, preventing fund managers from charging performance fees on the same profits multiple times. Here’s how it works (assuming a simplified scenario where only the performance fee is charged):
- Establishing the Initial High-Water Mark:
- Imagine an investor allocates $1 million to a hedge fund.
- The fund’s value increases to $1.2 million (on which the first performance fee is charged), creating a new high-water mark of $1.2 million.
- Performance Fee Calculation:
- Subsequently, gains will only be charged on a fund net asset value exceeding the high-water mark.
- If the fund’s value increases to $1.5 million, the performance fee is calculated on the $300,000 gain (i.e., $1.5 million – $1.2 million).
- Resetting the High-Water Mark:
- After the performance fee is deducted, the high-water mark is reset to the new peak value of $1.5 million.
- Protection for Investors:
- If the fund experiences a subsequent decline in value, say to $1.3 million, no further performance fee is charged until the fund surpasses the highest value reached ($1.5 million in this example).
Real-World Example:
- Let’s consider a hypothetical scenario:
- Investor A puts $2 million into a hedge fund, and the fund’s value grows to $3 million, establishing the initial high-water mark.
- The fund manager charges a 20% performance fee on the $1 million profit, amounting to $200,000.
- The fund’s value drops to $2.5 million due to market fluctuations.
- No further performance fees are charged until the fund surpasses the previous high-water mark of $3 million.
- Once the fund climbs back to $3.2 million, the manager charges a performance fee on the $200,000 gain from the previous high-water mark.
Conclusion:
High water marks are a crucial element in hedge fund structures, aligning the interests of fund managers and investors. This mechanism ensures that investors are not paying performance fees on previously earned profits, fostering a fair and transparent relationship. Understanding how high-water marks operate is vital for investors navigating the waters of hedge fund investments, providing a valuable tool for evaluating fund performance and aligning incentives for long-term success.
