High water_mark

The term is "high water mark."

RELATED_TERM = hurdle rate
TERM_CATEGORY = investment management

What Is High Water Mark?

A high water mark (HWM) in finance refers to the highest value or peak level an investment account or portfolio has reached. It is a crucial concept within the field of investment management, particularly in the context of performance-based fees charged by fund managers, such as those in hedge funds and private equity. The primary purpose of a high water mark is to protect investors by ensuring that fund managers only receive performance fees on new profits, and not on gains that merely recover previous losses.⁵⁶, ⁵⁷ This prevents investors from paying performance bonuses for the same returns multiple times.⁵⁴, ⁵⁵

History and Origin

The concept of a high water mark originated and is predominantly used in the hedge fund industry.⁵³ Hedge funds often employ a "2-and-20" fee structure, which typically involves a 2% management fee on assets under management (AUM) and a 20% performance fee on profits.⁵² The high water mark provision was developed to prevent managers from "double-dipping" on performance fees, meaning they would not be compensated for simply regaining lost value.⁵¹ This mechanism ensures fairness and aligns the interests of fund managers with those of their investors, particularly in volatile markets where fund values can fluctuate significantly.⁵⁰ For example, the leveraged buyout boom leading up to 2007 saw deals like Blackstone's acquisition of Hilton, sometimes referred to as the "high water mark" of that era, highlighting periods of significant market activity where such fee structures would have been highly relevant.

Key Takeaways

• A high water mark is the highest value an investment fund or account has reached.⁴⁹
• It serves as a benchmark for calculating performance fees, ensuring managers are paid only on new profits.⁴⁷, ⁴⁸
• The high water mark protects investors from paying performance fees on recovered losses or for the same performance twice.⁴⁶
• It is most commonly found in alternative investments like hedge funds and private equity.⁴⁴, ⁴⁵
• This mechanism aligns the interests of fund managers and investors by incentivizing sustained positive performance.⁴³

Formula and Calculation

The high water mark itself isn't a calculation in the traditional sense, but rather a reference point for calculating performance fees. The calculation of performance fees in conjunction with a high water mark involves comparing the current net asset value (NAV) of the fund to its historical high water mark.

The performance fee is generally calculated as:

$\text{Performance Fee} = \text{Performance Fee Rate} \times \max(0, \text{Current NAV} - \text{High Water Mark})$

Where:

• Performance Fee Rate: The agreed-upon percentage of profits the manager receives (e.g., 20%).
• Current NAV: The net asset value of the fund at the end of the performance period.
• High Water Mark: The highest NAV the fund has achieved historically. If the fund's current NAV exceeds the high water mark, a new high water mark is established at the current NAV. If the current NAV is below the high water mark, no performance fee is charged.⁴²

The high water mark is typically calculated by tracking the net asset value of a fund over time.⁴¹ The highest NAV achieved by the fund is considered the high water mark.⁴⁰ If the NAV falls below this mark, the fund manager is generally not entitled to performance fees until the NAV surpasses the previous high water mark.³⁹

Interpreting the High Water Mark

The high water mark is interpreted as a critical threshold that dictates when a fund manager earns incentive compensation. When a fund's value is below its high water mark, it signals that the manager has not yet recovered past losses, and therefore, no performance fees are due.³⁸ This provides investors with a safeguard against paying for unsatisfactory or cyclical performance.³⁷ Conversely, when a fund surpasses its high water mark, it indicates genuine new wealth creation for investors, justifying the payment of a performance fee.³⁶ This mechanism encourages risk management as managers are incentivized to protect past gains to ensure future performance fees.³⁵ Understanding the high water mark is key for investors to evaluate the true cost of investing in performance-fee structured funds and to ensure alignment with the fund manager's incentives.

Hypothetical Example

Consider an investor who puts $1,000,000 into a hedge fund that charges a 20% performance fee, subject to a high water mark.

• Year 1: The fund performs well, and the investment grows to $1,200,000.
  • The gain is $200,000.
  • The performance fee is 20% of $200,000 = $40,000.
  • The new high water mark is set at $1,200,000.
  • The investor's net value is $1,200,000 - $40,000 = $1,160,000.
• Year 2: The market experiences a downturn, and the investment value drops to $1,050,000.
  • Since the current value ($1,050,000) is below the high water mark ($1,200,000), no performance fee is charged. The manager must first recover the $150,000 loss before being eligible for a performance fee.
  • The high water mark remains $1,200,000.
• Year 3: The fund recovers significantly, and the investment value rises to $1,300,000.
  • The fund has surpassed the previous high water mark of $1,200,000.
  • The new gain above the high water mark is $1,300,000 - $1,200,000 = $100,000.
  • The performance fee is 20% of $100,000 = $20,000.
  • The new high water mark is set at $1,300,000.
  • The investor's net value (after Year 2's loss and Year 3's fee) is $1,050,000 + ($250,000 - $20,000) = $1,280,000.

This example illustrates how the high water mark protects the investor from paying fees on the same recovered gains and incentivizes the fund manager to achieve new peaks in value.³⁴

Practical Applications

The high water mark is primarily applied in fee structures for various alternative investments. Its most common applications include:

• Hedge Funds: High water marks are a standard feature in hedge fund compensation models to ensure that performance fees, typically a percentage of profits, are only levied when the fund's value exceeds its previous highest point.³², ³³ This is integral to the "2-and-20" fee structure, where the 20% performance fee is contingent on surpassing the high water mark.³¹
• Private Equity Funds: Similar to hedge funds, private equity funds often incorporate high water marks to protect investors and align manager incentives with achieving sustained, positive returns.³⁰
• Managed Futures Accounts: Investment vehicles that trade futures contracts may also employ high water marks to determine performance fees for their managers, given the often volatile nature of these markets.
• Certain Mutual Funds and Separately Managed Accounts: While less common than in alternative investments, some traditional investment vehicles may also use a high water mark to calculate performance-based fees.²⁹

The inclusion of a high water mark in investment contracts provides a degree of investor protection by preventing managers from collecting performance fees repeatedly for the same gains, particularly after periods of decline.²⁸ Regulatory bodies like the U.S. Securities and Exchange Commission (SEC) often review fee structures, including high water marks, to ensure fairness and transparency in investment offerings.²⁷

Limitations and Criticisms

While the high water mark generally serves to protect investors, it is not without its limitations and criticisms. One potential drawback is that a prolonged period of underperformance, where the fund remains below its high water mark, can disincentivize fund managers.²⁶ If a manager sees little prospect of earning performance fees because the fund is significantly below its high water mark, they might be tempted to take on excessive risk to try and reach it, or alternatively, become less engaged.²⁵ This could lead to a misalignment of interests, as the manager's incentive to earn fees might overshadow the investor's desire for consistent, moderated returns.

Another critique is that new investors entering a fund when its value is below the high water mark might receive a "free ride." They benefit from the fund's gains up to the high water mark without paying performance fees, whereas existing investors who endured the previous losses would have already paid fees on prior gains. However, some funds may have provisions to mitigate this "free ride" by charging performance fees on any positive performance, regardless of the high water mark.

Furthermore, in highly volatile markets, even with a high water mark, investors might still incur management fees during periods of loss, as these are typically calculated as a percentage of assets under management (AUM) irrespective of performance.²⁴ The high water mark only applies to the performance fee component.²³ Some academic studies have even suggested that despite mechanisms like high water marks, hedge funds as a whole may still underperform broader markets due to their complex fee structures and higher costs.²²

High Water Mark vs. Hurdle Rate

The terms "high water mark" and "hurdle rate" are both benchmarks used in investment management to determine performance fees, but they represent distinct concepts. The key difference lies in what they measure and how they protect investors.

While both mechanisms protect investors from paying for poor performance, the high water mark focuses on absolute capital recovery to a historical peak, whereas the hurdle rate focuses on achieving a minimum percentage return in a given period. Some investment funds may incorporate both a high water mark and a hurdle rate into their fee structures, requiring managers to satisfy both conditions before performance fees are paid.¹³

FAQs

What is the "loss carryforward" provision in relation to a high water mark?
The term "loss carryforward" is often used synonymously with a high water mark provision.¹² It refers to the clause in a fund's agreement that specifies that any prior losses must be recouped by the fund's performance before a manager can begin charging new performance fees.¹¹ This ensures that losses are "carried forward" and must be offset before new incentive fees are paid.¹⁰

Is a high water mark always applied to performance fees?
Yes, the high water mark concept is intrinsically linked to performance fees (also known as incentive fees or incentive allocations).⁹ Its primary role is to act as a threshold for these specific fees, ensuring they are only paid on genuine new profits that exceed the fund's historical peak value. It does not typically apply to fixed management fees, which are usually a percentage of assets under management and are collected regardless of performance.⁸

Can a high water mark reset?
The high water mark itself typically adjusts upward when the fund's net asset value surpasses its previous highest point, thus establishing a new high water mark.⁷ However, some fund agreements may include provisions for the high water mark to "reset" under specific circumstances, such as after a certain period or if investors redeem their capital. Such resets are less common and would need to be explicitly detailed in the fund's offering documents.⁶

Why is a high water mark important for investors?
A high water mark is important for investors because it protects their capital by ensuring they do not pay performance fees on recovered losses.⁵ It aligns the interests of the fund manager with those of the investor, as the manager is incentivized to achieve sustained growth beyond previous peaks to earn their performance-based compensation.⁴ This acts as a safeguard, particularly in strategies that may experience significant volatility, such as those employed by hedge funds.³

Are all investment funds required to use a high water mark?
No, not all investment funds are required to use a high water mark. It is most prevalent in alternative investment vehicles like hedge funds and private equity funds, which typically charge performance fees.² Traditional investment products like most mutual funds and exchange-traded funds (ETFs), which generally charge only fixed management fees, do not typically employ a high water mark.¹ The inclusion of a high water mark is a contractual agreement between the fund and its investors.