High-Water Mark
A high-water mark is the peak value a fund must surpass before charging performance fees again, ensuring investors never pay fees on recovered losses.
What Is a High-Water Mark?
A high-water mark is the highest value that an investment fund or portfolio has reached at any point in time. This benchmark is crucial for calculating performance fees: a fund manager can only charge performance fees on new profits that exceed the previous peak value. If the fund declines in value, the manager must recover those losses and surpass the old high-water mark before earning additional performance fees.
How Does a High-Water Mark Work?
When a fund achieves a new peak in value, that level becomes the high-water mark. If the value drops, no performance fees are charged on gains until the fund’s value rises above this mark. For example, if a fund grows from $500,000 to $575,000, the high-water mark is set at $575,000. If the fund then falls to $460,000 and later recovers to $690,000, performance fees are only charged on the gains above $575,000, not on the recovery from $460,000 to $575,000.
Why Is a High-Water Mark Important for Investors?
The high-water mark protects investors by ensuring they never pay performance fees twice for the same gains or for simply recovering prior losses. It aligns the interests of fund managers and investors, incentivizing managers to generate consistent long-term returns rather than taking excessive risks to earn fees after a loss. This mechanism is especially common in hedge funds and private equity structures.
Example: High-Water Mark in Practice
Suppose an investor’s account rises from $100,000 to $150,000, setting a high-water mark at $150,000. If the account drops to $120,000 and then recovers to $140,000, no performance fee is charged. Only when the account exceeds $150,000 say, reaching $160,000 does the manager earn a performance fee, and only on the $10,000 gain above the previous high-water mark.
When Should You Use a High-Water Mark?
High-water marks are essential:
When structuring performance fee arrangements in hedge funds, private equity, and other alternative investments
To ensure fairness and transparency in fee calculations
As part of operational due diligence and investor protection measures
Whenever aligning manager and investor interests is a priority in active management strategies
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