Question: What is the hedge fund high watermark?
Answer: The hedge fund high watermark is a mechanism that is implemented to make sure that managers do not take a performance fee when the fund has had negative performance over previous performance fee periods. The high watermark is the colloquial term for the mechanical application of a “cumulative loss account.” A cumulative loss account is a memorandum account which calculates any losses to an investor during a performance fee period (it does not matter whether the performance fee period is monthly, quarterly, or yearly); the cumulative loss account starts out with a zero balance and it is increased only if there are losses during the performance fee period. The cumulative loss account will increase by the amount of any loss any time there is a loss during a performance fee period. The cumulative loss account will decrease by the amount of any gain during a performance fee period, but the cumlulative loss account will never go below zero. So if a hedge fund has gains over three performance fee periods, then the cumulative loss account will be zero. An example of the mechanical application of the cumulative loss account and high watermark calculations are below:
Hedge fund NAV 01/01/04 1,000,000
Hedge fund NAV 12/31/04 1,200,000 (total after expenses, including the management fee expense)
Gain 200,000
Less Performance fee 40,000 [20% of 200,000]
Cumulative loss account 0
Hedge fund NAV 01/01/05 1,160,000
Hedge fund NAV 12/31/05 1,000,000 (total after expenses, including the management fee expense)
Gain (160,000)
Less Performance fee 0
Cumulative Loss Account 160,000
Hedge fund NAV 01/01/06 1,000,000
Hedge fund NAV 12/31/06 1,100,000 (total after expenses, including the management fee expense)
Gain 100,000
Less Performance fee 0
Cumulative Loss Account 60,000
Hedge fund NAV 01/01/07 1,100,000
Hedge fund NAV 12/31/07 1,300,000 (total after expenses, including the management fee expense)
Gain 200,000
Less Performance fee 24,000 [20% of 140,000]
Cumulative Loss Account 0
The concept of the high watermark is theoretically similar to the “claw-back” provision found in many private equity funds in that its purpose is to make sure that the manager is not overcompensated for underperformance. But the high watermark is distinctly different in the fact that it is a prospective in nature (whereas the claw-back is retrospective in nature); that is, the high watermark is applied on a going forward basis so that a manager will not be penalized for profits which were previously taken. The manager however, will need to get the fund’s account back up to the highwatermark before he can again take a performance fee.