Definition of High-Water Mark
An investment fund or account’s high-water mark is its highest value peak. They are often used in performance-based fund manager remuneration. The high water mark prevents managers from drawing hefty salaries for poor performance. During a loss, the manager must raise the funds above the high water level to get a performance bonus from the assets under management.
Understanding
A high-water mark assures that investors do not pay performance fees for bad performance and, more significantly, for the same performance twice.
A high-water mark is distinct from a hurdle rate, the minimum profit or return a hedge fund must make to charge an incentive fee.
High-Water Mark Example
Consider a hedge fund that charges a 20% performance fee, a standard industry practice. Suppose the investor invests $500,000, and the fund makes 15% in its first month. Thus, the investor’s first investment is $575,000. On this $75,000 gain, the investor pays 20%, or $15,000.
The high-water mark for this investor is $575,000, and they must pay $15,000 to the portfolio manager.
Suppose the fund loses 20% next month. The investor’s account drops to $460,000. Here, the high-water mark is essential. Profits from $460,000 to $575,000 are exempt from performance fees until the high water level. Suppose the fund suddenly makes 50% in the third month. This unexpected event raises the investor’s account value from $460,000 to $690,000. Without a high-water mark, the investor must pay the $15,000 charge plus 20% on the gain from $460,000 to $690,000, or $46,000 in performance fees.
Value
High-water marks avoid “double fee” situations. A high-water mark disqualifies earnings from $460,000 to $575,000, while gains above are subject to the performance-based charge. This investor pays 20% on gains from $575,000 to $690,000, adding $23,000 to the $15,000 performance-based fee.
With a high-water mark, the investor owes $38,000 in performance fees, $690,000 less than $100,000. Investors pay a $61,000, 20% performance fee on all profits without a high-water mark, below industry standards. Unquestionably, high water marks matter.
A high-water mark protects investors against double fees and drives managers to perform well to earn fees.
High-Water Mark and “Free Ride”
When an investor enters an underperforming fund, several things might happen. At Goldman Sachs Asset Management, investors who purchase a fund below the top-water mark will get the upside from the subscription NAV to the high-water mark without incurring a charge. This is a “free ride.” New investors can gain from buying an underperforming fund without hurting existing investors. Other funds may charge a performance fee for favorable results to avoid the “free ride.”
Conclusion
- High-water marks are an investment account’s or fund’s peak value.
- Investor performance fees may start at a top-water mark.
- The goal is to safeguard investors from paying fees for poor performance every time the fund profits.
- With a top-water mark, investors pay just the fund’s earnings between entrance and peak.
