CFA, Finance, FRM

How is High-Water mark clause used?

Understanding High-Water Mark Clause

High-Water Mark Clause is a concept that’s very crucial to understand in the Hedge Funds domain and in the context of fund manager compensation. It makes sure that the manager does not get paid large amounts of the sum after bringing in poor performance. High-Water Mark Clause is used to set a threshold below which the investors can be assured that they won’t be charged a performance fee.

So, if you’ve invested with a Hedge Fund, there are usually two kinds of fees that you’ll be required to pay. Both of these fees are usually in terms of percentages based on your investment.

Common Structure and Practices

The most common structure is that of “2 and 20” which means 2% management fees and 20% performance fees.

  • The management fees are something that’s always paid to the fund manager for managing the investment irrespective of how the fund is performing.
  • The performance fees in contrast, are only paid out to the fund for generating positive performance. There can be a lot of variation in how this is actually calculated by the fund.

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Let’s start with an example.

XY Capital Management is a Hedge Fund with $100 million in Asset Value. It follows a 2/20 fee structure; the hurdle rate is 6% and is calculated on gains net of the management fees.

  • In the first year, the NAV goes up to $130 million.
  • In the second year, the NAV goes down to $120 million.
  • In the third year the NAV goes up to $160 million.

The presence of a high-water mark aligns the interest of the investors with those of fund managers. Because the absence of the same would mean that the fund manager could very conveniently show poor performance in one year and then perform substantially good to rake in large performance fees while also earning the mandatory management fees.

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In the above example, the incentive fees for the 2nd year was nil because the fund had reported negative returns and dropped in value. For the 3rd year, the NAV went up to $160 million, reporting high positive returns. The incentive fee was calculated by seeing how much the NAV has gone above the High-Water Mark, i.e. the earlier highest NAV. In this way, it served as a threshold and greatly reduced the performance fees.

The above diagram depicts in a nutshell how High-Water Mark works. The red line shows the Gross Asset Value and the horizontal dashed blue line shows the High-Water mark. The High-Water Mark is updated every quarter. In the first quarter, the HWM goes up to $111, stays there in the 2nd and 3rd quarter, and then moves up to 114 by the end of the 4th quarter.

 

Author: Aman is an Economics and Finance graduate with a budding interest in Strategic Management and Investment. An avid reader of all things Behavioral and Data Science –I strongly believe in solving problems with creative solutions backed up by quantitative rigor.

 

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