High-Water Mark in Hedge Funds

Hedge funds represent alternative investments where investors pool funds and employ different strategies. The goal with hedge funds, as with any other investment, is to earn active returns. Hedge fund managers gather funds from investors and invest them according to a promised strategy. However, hedge funds are mostly available to affluent investors only.

In exchange for managing hedge funds, hedge fund managers get paid by the investors. Usually, their payments include a combination of fixed and performance-based fees. This structure allows managers to benefit from making the right decisions while also getting compensated for their management.

There are two benchmarks that hedge funds can use to collect incentive or performance-based fees from investors. These include the high-water mark and the hurdle rate.

What is High-Water Mark in Hedge Funds?

A high-water mark represents the highest peak that investments have reached in value. The high-water mark in hedge funds shows the peak value that the funds achieve since their initial establishment. Hedge funds use the high-water mark as a measure for incentives for fund managers. However, it can also work as a protection for investors.

As mentioned, hedge funds include both fixed and performance-based fees for managers. Usually, these include 20% of the profits the managers help generate for investors. While it provides managers with an incentive to increase profits, it does not protect investors. Investors will want to establish a benchmark for managers below which they will not receive an incentive.

Investors use the high-water mark as that benchmark. While hedge fund managers will receive a profit-based incentive, they only get it if the fund's total value exceeds the high-water mark. This way, managers don't get paid when they demonstrate poor market performance. Only if they succeed to increase profits beyond the high-water mark, they will receive an incentive.

How does the High-Water Mark work in Hedge Funds?

The high-water mark ensures that investors do not compensate hedge fund managers for poor performances. More importantly, however, it allows investors to avoid paying incentives twice for the same results. It is because investors will only pay for increases in hedge fund performance. If there is a drop or decrease in hedge fund value, investors can avoid paying a fee for subsequent increases.

The high-water mark is similar in function to the hurdle rate. A hurdle rate in hedge funds represents the minimum amount of profits that managers must achieve to get performance-based incentives. However, managers cannot receive any incentives if the performance does not exceed the high-water mark level. It means that managers may still generate a minimum return on hedge funds and achieve the hurdle rate. However, the high water-mark is more important.

What are the advantages and disadvantages of High-Water Mark?

A high-water mark provides an incentive for managers. With a high-water mark level in place, hedge fund managers must perform at a level to increase the fund's performance. However, the high-water mark is ultimately more beneficial to investors. Not only does it help them maximize their wealth, but it protects them as well. It does so in two ways. Firstly, it protects investors against paying for poor performances. Similarly, it helps them avoid paying double incentives.

However, setting an unrealistic high-water mark level can also be demotivating for managers. If managers can't achieve the level despite their maximizing profits, it can have an adverse effect. Similarly, the high-water mark can expose investors to significantly high risks. When trying to achieve the high-water mark level, managers may take unnecessary risks that can cause significant losses.

Conclusion

Hedge funds are fund pools where managers collect funds from investors and invest them according to a specific strategy. Hedge funds come with two benchmarks for management incentives, which include high-water mark and hurdle rate. The high-water mark represents the highest peak that a hedge fund performance must reach in value for managers to receive incentives.

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