High Water Mark

What is a High Water Mark?

The term “high water mark” refers to the peak value the investment fund achieved from its inception to the latest reporting date. The terminology is frequently used in fund managers’ performance-based compensation. The underlying principle of a high water mark is that the fund managers shouldn’t be rewarded with a large sum of money if they fail to grow the fund’s value under their management.

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. However, the fund manager will be entitled to the performance fees only if the value of the fund under their management crosses the high water mark value. 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. It ensures that the fund managers don’t get paid the performance-based fees more than once to achieve the same value as the investment fund.

Examples of High Water Mark

Different examples are mentioned below:

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 1^st year, 2^nd year, and 4^th year respectively, with an intermittent decline of 10% in the 3^rd year. Determine the high water mark of the investment fund at the end of each year.

Now, the fund grew by 20% in the 1^styear to reach a value of $120 million (= $100 million * (1 + 20%)). Therefore, at the end of 1^st year, the high water mark will be $120 million.

Now, the fund grew by 10% in the 2^ndyear to reach a value of $132 million (= $120 million * (1 + 10%)). Therefore, at the end of 2^ndyear, the high water mark will be $132 million.

The fund declined by 10% in the 3^rdyear to reach a value of $118.8 million (= $132 million * (1 – 10%)). Therefore, at the end of 3^rdyear, the high water mark will still be $132 million.

Now, the fund grew by 15% in the 4^thyear to reach a value of $136.6 million (= $118.8 million * (1 + 15%)). Therefore, at the end of the 4^thyear, 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 1^st year and 3^rd year, respectively, while it declined by15% in the 2^nd year. Determine the performance fees earned by the fund manager each year and the money saved by the high water mark policy during the three years.

Now, the hedge fund grew by 10% in the 1^st year to reach a value of $110,000 (= $100,000 * (1 + 10%)). Therefore, at the end of 1^st year, the high water mark will be $110,000, and the performance fees earned will be $2,000 (= 20% * ($110,000 – $100,000)).

Now, the hedge fund declined by 15% in the 2^nd year to reach a value of $93,500 (= $110,000 * (1 – 15%)). Therefore, at the end of the 2^nd 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.

Now, the hedge fund grew by 20% in the 3^rd year to reach a value of $112,200 (= $93,500 * (1 + 20%)). Therefore, at the end of 3^rd year, the high water mark will be $112,200, and the performance fees earned will be $440 (= 20% * ($112,200 – $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?

The high water mark for a fund can be determined by following the below steps:

• Step 1: Firstly, note the value of the fund on day 1, denoted by V_i, 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 V_i and V_f. If V_f> V_i, V_f is the new high water mark, or V_i 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 fund managers are incentivized to perform better and increase the fund value, which benefits the investors.
• The investors are not required to pay the performance-based fees more than once in case of the erratic performance of the fund manager.

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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