A High-Water Mark is the highest peak in value that an investment fund or portfolio has reached, used to determine performance fees and ensure investors do not pay fees on previous losses.
The High-Water Mark is a performance measurement metric used primarily in the alternative investment industry, including hedge funds and private equity funds. It represents the highest value that a fund's net asset value (NAV) or an investment portfolio has reached. When calculating performance fees or incentive fees, fund managers typically charge fees only on profits above this peak value, ensuring that investors are not charged performance fees on gains that merely recover past losses. In finance and wealth management, the High-Water Mark serves as a benchmark to align the interests of fund managers and investors by incentivizing managers to generate returns beyond previous highs. It prevents a manager from collecting fees on the same profit twice and promotes accountability for maintaining portfolio growth. This concept is especially relevant when performance fees are a significant part of the compensation structure for active management strategies. High-Water Marks are also relevant in family office settings or when managing private portfolios where incentive-based fee structures are common, helping to transparently track performance milestones and manage expectations around fees.
The High-Water Mark is critical in structuring performance fees to protect investors from paying fees on lackluster or recovering performance. This mechanism motivates investment managers to strive for returns that exceed all previous peaks before earning incentive fees, thereby aligning their interests with those managing significant family wealth. It plays a key role in governance by ensuring transparency and fairness in fee structures. From a tax planning and reporting perspective, the High-Water Mark helps in the clear identification of taxable gains and the timing of fee deductions, which can affect after-tax returns. For portfolios managed under a performance fee model, the High-Water Mark ensures that families or wealth managers can monitor fee accruals accurately and assess the true value generated by the manager, supporting informed investment decisions and stewardship.
Consider a hedge fund with a High-Water Mark of $100 million in NAV and a 20% performance fee. If the fund's NAV falls to $90 million, no performance fee is charged until the NAV exceeds $100 million again. Once NAV rises to $110 million, performance fees apply only on the $10 million gain above the High-Water Mark, resulting in a performance fee of $2 million (20% of $10 million).
Hurdle Rate
While a High-Water Mark sets the previous peak for performance fees, a Hurdle Rate defines the minimum rate of return a fund must achieve before performance fees are paid. Both mechanisms protect investors but operate differently — the High-Water Mark prevents fees on recovery of losses, whereas the Hurdle Rate sets a baseline return that must be exceeded.
What happens to performance fees if the portfolio loses value?
If the portfolio experiences a loss and the NAV falls below the High-Water Mark, no performance fees are charged until the portfolio value exceeds the previous highest NAV (the High-Water Mark), ensuring investors are not paying fees on recovering losses.
Can the High-Water Mark be reset or adjusted?
The High-Water Mark is typically reset only when the portfolio value reaches a new peak. Some agreements may allow adjustments in special circumstances, but generally it remains the highest attained NAV to protect investors and ensure fairness in fee calculations.
How does the High-Water Mark differ from a Hurdle Rate?
A High-Water Mark is the highest prior portfolio value used to determine performance fees, ensuring fees are charged only on new profits. A Hurdle Rate is a minimum rate of return the manager must exceed before earning performance fees. Both provide investor protections but address different aspects of fee structuring.
