No Performance Fee Until the Losses Are Made Back
A high water mark stops a manager charging performance fees twice on the same gains. It also creates an incentive problem for a manager sitting far below it, with no realistic prospect of earning anything.
The Problem It Solves
A performance fee pays the manager a share of gains, commonly twenty percent. Without a constraint, the arithmetic is unfavourable to investors in a volatile fund.
Suppose a fund gains twenty percent, then loses twenty percent, then gains twenty percent again. The investor is roughly back where they started. The manager charged a performance fee in year one and again in year three, on gains that in aggregate did not exist.
A high water mark prevents this. The manager may charge a performance fee only on gains above the highest net asset value previously achieved for that investor. Losses must be recovered before any further fee is earned.
| Year | Net Asset Value | High Water Mark | Fee Charged |
|---|---|---|---|
| 1 | 120 | 120 | On the gain to 120 |
| 2 | 96 | 120 | None |
| 3 | 115 | 120 | None, still below |
| 4 | 130 | 130 | Only on 120 to 130 |
The high water mark is per investor, not per fund, because investors subscribed at different times and different prices. Two people in the same fund can have entirely different fee positions on the same day.
The Incentive It Creates
A performance fee is economically a call option on the fund performance, granted to the manager. The high water mark is the strike price.
When the fund is above the mark, the option is in the money and the manager earns on further gains. When the fund is far below it, the option is deeply out of the money, and the manager is working for the management fee alone with no realistic prospect of performance income for years.
Standard option intuition then applies, and it is uncomfortable. The value of an out of the money option increases with volatility. A manager with no chance of reaching the mark through steady returns has a financial incentive to take more risk, because only a large move produces any payoff.
That is the well documented incentive problem with the structure, and it is real.
What Managers Actually Do
In practice, several responses occur when a fund falls substantially below its mark, and they are worth recognising.
Increasing risk is the theoretical prediction and it does happen, though it is constrained by risk limits, investor scrutiny, and prime broker margin.
Closing the fund and returning capital, sometimes followed by launching a new vehicle with a fresh high water mark. This is legal and it is precisely what the provision was meant to prevent, achieved by starting again rather than by charging twice. Investors regard it poorly and it happens anyway.
Losing the team is the outcome that most damages investors. Portfolio managers and analysts compensated from performance fees leave for firms where they can earn, and the fund loses the people who might have recovered it.
That last effect is why some funds negotiate modified arrangements after a large drawdown, reducing the performance fee rate temporarily in exchange for resetting or partially lowering the mark. Investors dislike it and the alternative is frequently watching the team disperse.
The Variants
Several structures modify the basic provision.
A hurdle rate requires the fund to exceed a minimum return, either an absolute figure or a benchmark, before performance fees apply. A hard hurdle charges only on the excess above it; a soft hurdle charges on all gains once the hurdle is cleared, which produces a discontinuity at the threshold.
A clawback requires the manager to return fees previously paid if later losses occur, which is standard in private funds where performance is measured over the life of the fund and rare in hedge funds.
A reset provision allows the mark to decay after a defined period, on the argument that a manager permanently unable to earn will not stay, and investors are better served by an economic relationship than by a theoretical protection.
The Related Fee Question
Because the performance fee is calculated per investor and the fund is a pooled vehicle, funds use equalisation mechanics to ensure that investors subscribing at different times bear the correct fee.
The methods, including equalisation credits and series accounting, are administratively complex and mostly invisible to investors. They matter because a fund that does not handle it properly can charge one investor for gains that occurred before they invested, which is the same error the high water mark exists to prevent.
The Bottom Line
A high water mark stops a manager being paid twice for the same performance, which is a necessary protection in any volatile strategy. It also grants the manager a call option whose value rises with volatility, which creates a risk taking incentive when the fund is far underwater, and it drives away the people who might have recovered the position. Investors face a genuine dilemma at that point, between holding a protection that is working exactly as designed and keeping a team that has no reason to stay.