High water mark: Meaning, Criticisms & Real-World Uses

What Is High-Water Mark?

A high-water mark is the highest value an investment fund or portfolio has reached. It is a critical concept within investment management, particularly concerning the calculation of performance fees for fund manager compensation. This principle ensures that investors are not charged incentive fees on gains that merely recover previous losses. Essentially, a fund manager only earns a performance fee if the fund's net asset value (NAV) surpasses its all-time highest value. The high-water mark protects investors from repeatedly paying for the same level of performance, particularly after periods of market downturns.

History and Origin

The concept of the high-water mark originated in the hedge funds industry, evolving alongside the "2 and 20" fee structure. This fee model, consisting of a 2% management fees on assets under management (AUM) and a 20% performance fee on profits, gained prominence with the establishment of the first modern hedge fund by Alfred Winslow Jones in 1949. Jones's pioneering approach to investment management included this innovative fee structure, which incorporated performance-based compensation. The high-water mark provision became integral to this model, designed to align the interests of managers and investors by ensuring that managers were only rewarded for new profit generation.⁵ Over time, the high-water mark has become a standard feature in many alternative investment vehicles, preventing managers from earning performance fees on the recovery of losses.

Key Takeaways

A high-water mark is the peak value an investment fund has achieved, serving as a threshold for performance fee calculation.
Its primary purpose is to protect investors from paying performance fees on recovered losses rather than new profits.
Fund managers only receive performance fees when the fund's value exceeds the established high-water mark.
The high-water mark encourages managers to achieve consistent positive returns and recover losses efficiently.
It is a common feature in the fee structures of hedge funds and some private equity funds.

Formula and Calculation

The high-water mark itself is not a calculation in the traditional sense but rather a reference point for fee calculations. The calculation revolves around whether the current fund value (typically represented by its NAV per share or total AUM) has exceeded the previous high-water mark.

The performance fee is generally calculated as a percentage of the gain above the high-water mark. If a fund's value drops below its previous high-water mark, no performance fee is charged until the value surpasses that mark again.

Let's define the terms:

(\text{HWM}_{\text{prev}}) = Previous High-Water Mark (highest value fund reached before current period)
(\text{NAV}_{\text{current}}) = Current Net Asset Value of the fund (at the end of the performance period)
(\text{Fee Rate}) = Agreed-upon percentage for performance fees (e.g., 20%)

The profit on which the performance fee is based is calculated as:

\text{Performance Profit} = \max(0, \text{NAV}_{\text{current}} - \text{HWM}_{\text{prev}})

Then, the Performance Fee = (\text{Performance Profit} \times \text{Fee Rate})

If the (\text{NAV}{\text{current}}) is less than or equal to (\text{HWM}{\text{prev}}), the Performance Profit is zero, and thus no performance fee is charged. The new high-water mark becomes the current NAV if it exceeds the previous high-water mark.

Interpreting the High-Water Mark

Interpreting the high-water mark involves understanding its implications for both investors and fund managers. For investors, the presence of a high-water mark clause offers a layer of protection, ensuring they only compensate managers for genuine growth beyond prior peak performance. This safeguards investors from being double-charged for the same appreciation in portfolio value. For example, if a fund drops in value and then recovers, investors would not pay performance fees on the recovery up to the previous high.

For fund managers, the high-water mark creates a strong incentive to not only generate positive returns but also to make up for any losses incurred. If a fund's value falls below its high-water mark, the manager must work to bring the fund's value back above that mark before being eligible for future performance fees. This aligns the manager's financial interests directly with the long-term profitability and success of the investment fund.

Hypothetical Example

Consider an investment fund that charges a 20% performance fee, subject to a high-water mark. The fund starts with an initial assets under management (AUM) of $100 million.

Year 1:

Initial AUM: $100 million
Fund performs well, ending the year with AUM: $125 million
Gain: $25 million
Performance Fee (20% of $25 million): $5 million
AUM after fees: $120 million
New High-Water Mark: $125 million (the highest value reached before fees)

Year 2:

Starting AUM (after fees from Year 1): $120 million
Fund experiences a downturn, ending the year with AUM: $90 million
Gain: -$30 million (a loss)
Performance Fee: $0 (since AUM is below the high-water mark of $125 million)
High-Water Mark remains: $125 million

Year 3:

Starting AUM: $90 million
Fund recovers significantly, ending the year with AUM: $140 million
Gain: $50 million
The previous high-water mark was $125 million. The fund must first exceed this level.
Profit above high-water mark: $140 million - $125 million = $15 million
Performance Fee (20% of $15 million): $3 million
AUM after fees: $137 million
New High-Water Mark: $140 million

In this example, the fund manager did not earn a performance fee in Year 2, and in Year 3, the fee was only on the new gains above the $125 million high-water mark, even though the total gain for Year 3 was $50 million. This demonstrates how the high-water mark protects investors from paying for the recovery of prior losses.

Practical Applications

The high-water mark is predominantly applied in alternative investment vehicles where performance fees are a significant component of the compensation structure.

Hedge Funds: The most common application is in hedge funds, where the "2 and 20" (or similar) fee model is prevalent. The high-water mark protects investors by ensuring that managers only receive their incentive fees on new profits, preventing them from being paid for merely regaining lost value. A survey by the Alternative Investment Management Association (AIMA) indicates that 97% of fund managers incorporate a high-water mark in their performance fee calculations.⁴
Private Equity Funds: While less common than in hedge funds, some private equity funds may also utilize a high-water mark provision, particularly in structures that include an ongoing performance-based component.
Managed Accounts: Individual managed accounts, especially those with aggressive or opportunistic strategies, may also include high-water mark clauses to align the interests of the investment adviser with the client's capital preservation.
Structured Products: Certain complex structured financial products or specialized derivatives portfolios might incorporate elements of a high-water mark in their payout or fee mechanisms.

The high-water mark acts as a built-in incentive for managers to achieve positive risk-adjusted returns consistently and to manage downside risk, as a significant downturn can delay their ability to earn performance fees for an extended period.

Limitations and Criticisms

While the high-water mark is designed to protect investors and align manager incentives, it also has certain limitations and criticisms.

One primary criticism is that after a significant loss, a fund manager might face a substantial period where they cannot earn performance fees, known as being "under water." This could, in extreme cases, disincentivize the manager, potentially leading to a resignation or the closure of the investment fund if the high-water mark seems insurmountable.³ Conversely, some argue that the pressure to overcome a high-water mark might encourage managers to take on excessive risk to try and reach the previous peak faster, rather than focusing on prudent, long-term growth.

Furthermore, the high-water mark might not fully address issues related to benchmarking. If a fund's performance is not measured against an appropriate benchmark index, investors might still pay fees for performance that lags behind the broader market or an appropriate risk-adjusted return, even if the high-water mark is surpassed. Research suggests that funds with performance fees may underperform other funds, particularly when a clear benchmark is not specified or when the benchmark is easily beaten.²

Regulatory bodies, such as the SEC, continuously evaluate fee structures, including those related to performance and disclosure. Recent efforts by the SEC to mandate increased hedge funds and private equity fee disclosures have faced legal challenges, highlighting ongoing debates about transparency and investor protection in alternative investment spaces.¹

High-Water Mark vs. Hurdle Rate

The terms "high-water mark" and "hurdle rate" are often discussed together in the context of fund manager compensation, as both are mechanisms to determine when performance fees are earned. However, they serve distinct purposes.

A high-water mark ensures that a fund manager does not receive performance fees for merely recovering past losses. It sets the highest historical value of the fund as a benchmark, requiring the fund to surpass this peak before any new performance fees can be levied. Its focus is on the fund's absolute historical value.

In contrast, a hurdle rate is a predetermined minimum rate of return that an investment fund must achieve before the fund manager becomes eligible for a performance fee. This rate can be a fixed percentage (e.g., 5% annual return) or tied to an external benchmark index (e.g., LIBOR plus a spread). The hurdle rate ensures that investors only pay performance fees for returns that exceed a certain acceptable level of profit, regardless of the fund's historical peaks and troughs. If a fund returns 10% and the hurdle rate is 7%, the performance fee is typically applied only to the 3% excess return.

While both aim to align interests and protect investors, the high-water mark looks backward at historical performance peaks, preventing double charging for recovered losses. The hurdle rate looks forward, setting a minimum return threshold that must be cleared, regardless of whether the fund is at an all-time high. A fund may employ both a high-water mark and a hurdle rate, requiring managers to clear both conditions to earn incentive fees.

FAQs

What is the primary purpose of a high-water mark?

The primary purpose of a high-water mark is to protect investors from paying performance fees on gains that simply restore prior losses. It ensures that the fund manager is only compensated for achieving new, higher levels of value for the investment fund.

Is the high-water mark common in all types of investment funds?

No, the high-water mark is most commonly found in alternative investment vehicles such as hedge funds and certain private equity structures. It is generally not a feature of traditional mutual funds, which typically charge only management fees based on assets under management, regardless of performance relative to previous highs.

How does a high-water mark affect a fund manager's incentives?

A high-water mark significantly influences a fund manager's incentives by linking their compensation directly to sustained positive performance. If a fund experiences losses, the manager must work to bring the fund's value back above the high-water mark before they can earn incentive fees again. This encourages managers to recover losses efficiently and to manage risk carefully.

Can a fund have both a high-water mark and a hurdle rate?

Yes, an investment fund can indeed have both a high-water mark and a hurdle rate in its fee structure. In such cases, the fund manager would need to satisfy both conditions—meaning the fund's value must exceed its high-water mark, and its returns must surpass the specified hurdle rate—before any performance fees are paid.