Updated June 20, 2023
What is a High Water Mark?
Fund managers frequently utilize the terminology of a high water mark in their performance-based compensation to ensure that they do not receive a large sum of money if they fail to grow the fund’s value under their management. The term “high water mark” refers to the investment fund’s peak value from its inception to the latest reporting date.
Explanation
Typically, the fee structure of a hedge fund includes performance-based fees, which in most cases are fixed at 20% of the return generated by the fund. The fund manager will only be entitled to the performance fees if they surpass the high water mark value of the fund. In this way, it ensures that the investors don’t pay performance fees to the fund managers due to their erratic performance, i.e., the growth rate of fund value oscillates on either side of zero. The fund managers do not pay performance-based fees more than once to achieve the same value as the investment fund.
Examples of High Water Mark
Example #1
Let us take the example of a fund that starts with a capital of $100 million. The fund value grew by 20%, 10%, and 15% in the 1st year, 2nd year, and 4th year respectively, with an intermittent decline of 10% in the 3rd year. Determine the high water mark of the investment fund at the end of each year.
The fund grew by 20% in the 1styear to reach a value of $120 million (= $100 million * (1 + 20%)). Therefore, at the end of 1st year, the high water mark will be $120 million.
The fund grew by 10% in the 2ndyear to reach a value of $132 million (= $120 million * (1 + 10%)). Therefore, at the end of 2ndyear, the high water mark will be $132 million.
The fund declined by 10% in the 3rdyear to reach a value of $118.8 million (= $132 million * (1 – 10%)). Therefore, at the end of 3rdyear, the high water mark will still be $132 million.
The fund grew by 15% in the 4thyear to reach a value of $136.6 million (= $118.8 million * (1 + 15%)). Therefore, at the end of the 4thyear, the high water mark will be $136.6 million.
Example #2
Let us take another example to illustrate how performance is calculated based on high water marks. Let us assume that an investor has placed $100,000 into a hedge fund, wherein the manager will be paid 20% of the return as a performance fee. The value of the hedge fund grew by 10% and 20% in the 1st year and 3rd year, respectively, while it declined by 15% in the 2nd year. Determine the performance fees the fund manager earns each year and the money saved by the high water mark policy during the three years.
The hedge fund grew by 10% in the 1st year to reach a value of $110,000 (= $100,000 * (1 + 10%)). At the end of the 1st year, we will reach a high water mark of $110,000 and earn $2,000 in performance fees, which is calculated as 20% of the difference between $110,000 and $100,000.
The hedge fund declined by 15% in the 2nd year to reach a value of $93,500 (= $110,000 * (1 – 15%)). Therefore, at the end of the 2nd year, the high water mark will still be $110,000, and the fund manager will not receive any performance fees as the fund value is less than the high water mark.
The hedge fund grew by 20% in the 3rd year to reach a value of $112,200 (= $93,500 * (1 + 20%)). Therefore, at the end of the 3rd year, the high water mark will reach $112,200, and the performance fees earned will amount to $440, calculated as 20% of the difference between $112,200 and $110,000. In the absence of the high water mark, the fund manager would have earned $3,740 (= 20% * ($112,200 – $93,500)), indicating a savings of $3,300 (= $3,740 – $440).
How to Find High Water Mark?
- Step 1: Firstly, note the value of the fund on day 1, denoted by Vi, and is the high watermark on day 1.
- Step 2:Next, ascertain the fund’s value on the given day, Vf denotes.
- Step 3: Next, compare the values of Vi and Vf. If Vf> Vi, Vf is the new high water mark, or Vi continues to be the high water mark.
- Step 4: The same process continues at the end of each reporting period.
Advantages
Some of the significant advantages are as follows:
- The investors benefit from incentivizing the fund managers to perform better and increase the fund value.
- Fund managers do not repeatedly charge performance-based fees for erratic performance.
Disadvantages
Some of the major disadvantages are as follows:
- The fund manager may sometimes feel that the target can’t be achieved as it is too high and becomes demotivated.
- Fund managers may take needless risky calls to achieve it, which may put the investors’ money at high risk.
Conclusion
So, it can be seen that it is a handy tool for tracking the performance of fund managers. It not only inspires the managers to perform well but also protects the investors from the managers’ poor performances.
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