High Water Mark

A high watermark in hedging means the level of or peak of the value of an investment has been achieved since its establishment which is useful for measuring incentives of the fund managers and as a protection for the investors, however, a too-high watermark may discourage the employees which may be a hurdle in achieving specified objectives.

Hedge Funds usually have a fee structure that includes Performance Fees, which is typically 20% of the profits generated by the fund. But the manager will get a share in profits only when the returns cross the High-Water Mark value.

• A high watermark in Hedging refers to the level or peak of an investment's value since its inception. It helps gauge fund managers' incentives and serves as a safeguard for investors. 
• However, a high watermark may discourage employees, hindering achieving specific goals.
• The High Water Mark mechanism motivates the hedge fund managers to perform better and raise the High Water Mark fund value to get performance fees.
• Managers could make needlessly hazardous bets to break the High Water Mark that put investors' money at unnecessary risk. Due to the manager's ambition, investors can end up losing money.

High Water Mark refers to the highest value that a fund has reached since its inception and is used as a threshold to measure the performance of a fund manager.

Every time the value of a fund crosses the maximum amount it has previously reached throughout its life, the high water mark changes to the new peak value. It is an essential concept and commonly seen in investments such as hedge funds, PE funds, etc.

A High Water Mark clause is an essential concept in the world of hedge funds. It protects the investors and motivates the manager to perform well. It is a stricter measure than the hurdle rate. But at the same time, it might cause the manager to take very risky bets and harm the investors.

Let us understand the concept of a high water mark hedge fund with the help of a couple of examples.

Example #1

Acctra funds started with $100 Million of capital. In the first year, the fund realizes a 25% return, and the value increases to $125 Million. Now, this peak value is the High Water Mark. In any year that the value of the fund is less than $125 Million, the manager does not get any performance fees.

If in the second year, the fund falls to $115 Million in value, the manager gets nothing. Even after that, the manager will get performance fees only after the value has crossed $125 Million and that too on the amount above this High Water Mark, which means if the fund increases to $130 Million in value, the manager gets performance fees only on the $5 Million that is above the HWM.

• From an investor’s point of view, this protects them from paying performance fees multiple times to the manager for the return that has already been realized in the past. It also keeps the manager motivated to outperform his past self and earn his/her performance fees.
• Investors may measure the fund value at any time intervals and change the High Water Mark value based on the fund performance. This is called the Crystallization Frequency.
• High Water Mark is sometimes confused with a Hurdle Rate. Hurdle Rate is a minimum rate of return that the manager must generate on the investor’s money to get the performance fees. Both measures are tied to the performance of the manager and are meant for the benefit of the investors.
• A manager might not cross the High Water Mark in a particular year but still travel the Hurdle Rate, thereby receiving the performance fees if the High-Water Mark is not applicable. Therefore, we can say that the High Water Mark is a relatively more strict measure.

Example #2

Wealth creators LLC started a hedge fund with an initial capital of $500 Million. The fee structure of this fund is 2/20, which means it charges 2% Management Fees and 20% Performance Fees. The manager of the fund is Adam Borges.

In the first year of its operation, the fund performs phenomenally and increases to $650 Million in value. But in the second year, the fund decreased to $550 Million because of a few bad calls. In the third year, the fund increases to $625 Million, and in the fourth year, it goes up to $700 Million. Calculate the total fees charged by wealth creators for all four years.’

Here are the details of the fees earned by Wealth Creators LLC for each of the four years:

In the first year, the managers get the management fees plus the 20% performance fees on the $150 Mn profit generated. The HWM is now $650 Million.

In the second year, since the fund has decreased in value, the total fees are only 2% management fees.

In the third year, even though the fund generated profit relative to the previous year, it does not get any performance fees since it has not yet crossed the HWM of $650 Million.

In the fourth year, the managers get 2% management fees and the performance fees of 20%. But the performance fees will be based on the additional profit the fund generated beyond the High Water Mark of $650 Million. Since the fund value has surpassed the High Water Mark, the new fund value of $700 Million becomes the new High-Water Mark.

Let us understand the advantages of adopting an approach to measure and act upon the highest possible profit by using the high water mark clause.

• #1 – Incentive for Manager – With the High Water Mark mechanism in place, the hedge fund manager gets the incentive to perform better and increase the fund value of the High Water Mark to earn the performance fees. This, in turn, benefits the investors because, ultimately, their investment is also growing in importance.
• #2 – Protection of Investors – The investors are protected in two ways: Firstly, they don’t have to pay performance fees for poor performance. And secondly, they don’t have to pay the performance fees for the same amount of understanding they have paid for earlier.

Even though a high water mark hedge fund is a boon in more ways than not, there are a handful of disadvantages that must be addressed. Let us discuss them through the explanation below.

• #1 – Too High Water Marks May De-motivate Investors – High Water Marks that are too high because of a particular event in the market may de-motivate the manager if he/she feels that the target is not achievable. This may cause complacency in the performance of the manager.
• #2 – Ambitious Calls May Harm Investors – Managers may take unnecessarily risky calls to break the High Water Mark and put the investors’ money at risk which is uncalled for. Investors may end up losing money because of the ambitious nature of the manager.

Both hurdle rate and high water mark clause act as metrics or benchmarks through which hedge funds can collect incentives from their clients. Moreover, these two metrics have been widely discussed and often misunderstood by one. Let us understand the concept through the comparison below.

High Water Mark

• A high water mark indicates the highest a fund has ever reached. Introducing this benchmark ensures that the fund manager is not paid extra even if the fund is not performing as well as it should.
• If the fund’s performance is poor and it is losing money, the fund manager is expected to drive the fund above the high water mark before a bonus or an increment can be accommodated.
• Once the manager can drive the fund above the high water mark, the figure becomes the new benchmark for the fund manager or future fund managers to beat before incentive fees are paid.

Hurdle Rate

• A hurdle rate is the bare minimum a fund must make to be able to charge an incentive fee.
• If a fund fixes 3% as its hurdle rate, it can charge an incentive fee only for periods where the funds crosses that benchmark.
• The hurdle rate is often a premium above the Weighted Average Cost of Capital (WACC).

This has been a guide to High Water Mark meaning. Here we explain its examples, advantages, disadvantages, and compared them with the hurdle rate. You can learn more about asset management from the following articles –

• Hedge Fund Interview Questions
• Hedge Fund Risks
• Top 10 Best Hedge Fund Books