High-Water Marks and Hurdle Rates [Stowell Chapter 11]: A high-water mark relates to payment of performance fees. Hedge fund managers typically receive performance fees only when the value of the fund exceeds the highest net asset value it has previously achieved. For example, if a fund is launched with a net asset value (NAV) of $100 per share and NAV was $120 at the end of the first year, assuming a 20% performance fee, the hedge fund would receive a performance fee of $4 per share. If, however, at the end of the second year, NAV dropped to $115, no performance fee would be payable. If, at the end of the third year, NAV was $130, the performance fee would be $2 instead of $3, because of the high-water mark—that is, ($130 − $120) × 0.2. Sometimes, if a high-water mark is perceived to be unattainable, a hedge fund may be motivated to close down. See Chapter 15 for more discussion of high-water marks. In addition, some hedge funds agree to a hurdle rate whereby the fund receives a performance fee only if the fund’s annual return exceeds a benchmark rate, such as a predetermined fixed percentage, or a rate determined by the market, such as LIBOR or a T-bill yield.
High-Water Mark [Stowell Chapter 15] A hedge fund high-water mark is a mechanism that is implemented to make sure that managers do not take a performance fee in the current period when the fund has had negative performance over previous performance fee periods. The high-water mark is the colloquial term for a “cumulative loss account.” A cumulative loss account starts with a zero balance at the beginning of any performance period (monthly, quarterly, or yearly, as determined by the firm), and it records net losses during that period. See Exhibit 15.1 for an example of high-water mark calculation.
It is estimated that only one in ten hedge funds received performance fees during 2008 because of losses and application of high-water marks. This created significant compensation pressures for many funds since their management fees were insufficient to keep the business going, which resulted in significant downsizing of headcount and office space.
The high-water mark is designed to benefit investors by preventing a manager from taking a performance fee on the same gains more than once. However, the high-water mark also creates a perverse incentive for the hedge fund manager to either take extra risk to generate returns high enough to deplete the cumulative loss account so that a performance fee will be paid, or to close down the fund and start again. Both actions could be damaging to investors, forcing them to either request redemptions at inopportune times, or continue with their investment with a potentially higher risk profile. If a hedge fund manager shuts down a fund, the investor might suffer disproportionate losses as assets are sold in a fire sale environment. However, to keep money invested in the fund under a higher risk profile may also not be in the investor’s best interest. Moreover, taking money out to invest with another manager might subject the investor to the same high-water mark issue.
As a result of this conundrum, in some cases, it might make sense for investors to consider modification of the high-water mark. An alternative to the standard hedge fund high-water mark is a modified high-water mark: resetting the high-water mark to the current fund level under circumstances where to do so better aligns everyone’s interest, amortizing losses over a several-year period to enable some modest level of performance fees during this period, or rolling the high-water mark over a more extended period.
A modified high-water mark may create value for investors by keeping a manager in the game and reducing the incentive of the manager to take excessive risk. As a quid pro quo, some hedge fund managers may be willing to accept lower performance fees.
An example of the mechanical application of the cumulative loss account and high-water mark calculation follows:
Hedge fund NAV 01/01/06: $1,000,000
Hedge fund NAV 12/31/06: $1,200,000 (total after expenses, including the management fee expense)
Less performance fee: $40,000 [20% of $200,000]
Cumulative loss account: $0
Hedge fund NAV 01/01/07: $1,160,000
Hedge fund NAV 12/31/07: $1,000,000 (total after expenses, including the management fee expense)
Less performance fee: $0
Cumulative loss account: $160,000
Hedge fund NAV 01/01/08: $1,000,000
Hedge fund NAV 12/31/08: $1,100,000 (total after expenses, including the management fee expense)
Less performance fee: $0
Cumulative loss account: $60,000
Hedge fund NAV 01/01/09: $1,100,000
Hedge fund NAV 12/31/09: $1,300,000 (total after expenses, including the management fee expense)
Less performance fee: $28,000 [20% of $140,000]
Cumulative loss account: $0
The concept of the high-water mark is theoretically similar to the “claw-back” provision found in many private equity funds in that its purpose is to make sure the manager is not overcompensated for underperformance. However, the high-water mark is distinctly different in that it is prospective in nature (whereas the claw-back is retrospective in nature). The high-water mark is applied to a hedge fund manager on a going-forward basis, so the manager will need to get the fund’s account back up to the high-water mark before a performance fee can be taken.