What Is a High-Water Mark?
Let me tell you directly: a high-water mark is the highest value that an investment fund or account has ever reached. You'll often hear this term in discussions about fund manager compensation, which ties directly to performance. The high-water mark makes sure managers don't pocket big fees for subpar results. If the manager loses money in a period, they have to push the fund back above that high-water mark before claiming any performance bonus from the assets under management (AUM).
Key Takeaways on High-Water Marks
You need to understand that a high-water mark acts as a clear line for deciding when investors pay performance fees. Its main goal is to shield you from fees on weak performance and to stop you from paying repeatedly every time the fund turns a profit. With this in place, you only pay a fee on the gains from your entry point up to the fund's all-time high.
Understanding the High-Water Mark
Here's the core of it: a high-water mark guarantees you won't pay performance fees for poor results, but crucially, it stops you from paying those fees twice for the same gains. Some fund managers get extra pay based on hitting these marks—it's all about aligning incentives. Remember, this differs from a hurdle rate, which is the minimum profit a hedge fund needs to hit before charging an incentive fee.
High-Water Mark Example
Let's walk through a straightforward example to make this clear. Suppose you invest $500,000 in a hedge fund with a 20% performance fee—standard in the business. In the first month, the fund gains 15%, so your investment hits $575,000. You owe 20% on that $75,000 gain, which is $15,000. Now, that $575,000 becomes your high-water mark.
Then, imagine the fund drops 20% the next month, leaving you with $460,000. Here's where the high-water mark matters: no fees on gains from $460,000 back to $575,000—only above that. If the fund surges 50% in month three, reaching $690,000, without the high-water mark, you'd pay another $46,000 on top of the original $15,000, totaling way more than necessary.
The Value of a High-Water Mark
The high-water mark stops that double-dipping. In our example, you ignore gains up to $575,000 and pay 20% only on the $115,000 above it, adding $23,000 to the initial $15,000—for a total of $38,000. Without it, you'd owe $61,000 on all gains. This setup protects you from excessive fees and pushes managers to deliver real performance to earn their cut.
A High-Water Mark and the 'Free Ride'
Things get interesting if you join a fund during a down period. At places like Goldman Sachs Asset Management, if you buy in below the high-water mark, you get the upside to that mark without fees—it's called a 'free ride.' This lets new investors benefit from an underperforming fund without hurting existing ones. Some funds charge fees on any positive performance to avoid this, but the high-water mark keeps things fair overall.
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