high watermark | Hedge Fund Law Blog

There are many news stories out covering what may be a worst case scenario for many hedge funds – the distinct possibility of no performance fees this year. This seems to be a major topic of conversation for many people within the industry and just yesterday I received the following comment with a link to a Wall Street Journal article discussing this issue.

The comment:

Regarding performance fees: the underlying hedge funds naturally also have high performance fees. But in the current climate, they aren’t making them. “Just one in 10 hedge funds is currently receiving performance fees from their funds.” See: http://blogs.wsj.com/deals/2008/09/22/fee-slump-hits-hedge-funds/

Unfortunately, with the current market conditions, many funds are going to be feeling the pressure of little to no performance fees at the end of the year. For many hedge fund managers, the problem is compounded by the fact that their asset management fee is simply not enough to keep the business going. Many managers cannot keep operations going with only the management fee. Without performance fees, hedge fund managers may have their operations disrupted for a number of reasons, including the fact that for some, the traders will be expecting bonuses no matter the performance of the fund as a whole. If these traders don’t receive bonuses, then some hedge funds could see talent drain, to the extent that such traders thought they could receive greater compensation at other firms or by starting their own fund.

Still worse, managers who have negative performance numbers at the end of the year will have another issue to deal with – the high watermark. The high watermark is a concept designed as an investor-friendly provision that essentially prevents a manager from taking a performance fee on the same gains more than once. The high watermark is a similar concept to the clawback provision in a private equity fund.

When a fund suffers a significant drawdown during a performance fee period, the high watermark will actually create a perverse incentive for the investment manager – either take extra risk to generate higher returns so that there will be a performance fee in the next performance fee period or close down the fund and start again. Both of these potential actions would be taken to the detriment of the investor, and the investor may only have the choice of making a redemption or letting the investment ride.

If the manager does shut his doors, the investor is going to have his assets at risk as the hedge fund wind-down takes place. Depending on the hedge fund’s strategy, the wind-down could subject the fund to a fire sale of its assets which will reduce the value of the investment even further. If such investor was to move into another hedge fund, he would step into the new fund with a high watermark equal to his investment and would be subject to performance fees on those assets anyway. Because such a turn of events is detrimental to such an investor, it might make sense for such investors to allow for some sort of modification of the high watermark.

Some potential alternatives to the standard hedge fund highwatermark might include the following:

No high watermark – this is probably not a viable solution as it would afford investors absolutely no protection from paying two sets of performance fees on the “same” gains. Additionally, without the threat of the high watermark, there would be little deterrent for a manager to improperly manage risk. Additionally, because the highwatermark provision is one of the most uniform provisions in the hedge fund industry, it is unlikely to simply disappear. (Although I have seen a couple of funds which actually did not have the provision.)

Modified high watermark – I have seen all types of variations within the performance fee structure and the withdrawal structure, but the high watermark is one provision which is generally resistant to modification. The high watermark could potentially be modified in many ways including the following:

Reset to zero – under certain circumstances, that if stated in the offering documents prior to investment, the investment manager can be given the ability to reset the high-watermark to zero.

Amortization – one potential way could be to “amortize” the losses over a 2- or 3-year period so that some performance fees can be earned on a going forward basis. Additionally, if the investor chose to withdraw before the end of the high watermark amortization period, there could be some sort of clawback.

Rolling – the high watermark can be taken under certain circumstances over a rolling period. The concept is that the high watermark will be determined for a certain window so a drawdown would in essence be erased after a certain amount of time has elapsed. This might work better for those funds that have a monthly or quarterly performance fee period.

Resetting to zero and an amortization reduction method could be both potentially valuable to investors as it will keep a manager in the game and it will reduce the incentive for a manager to abandon risk management procedures. Also, management companies may be willing to decrease fees if investors agree to keep their investment in the fund for a certain amount of time after the reset or amortization.

[HFLB note: any new investors coming into a fund during a performance fee period will have an initial high watermark that is equal to the initial investment value; depending on the time of the contribution and when the fund made its losses, there may be some performance fees paid even during a down year for such incoming investors.]

Further Resources

Another good article and some good comments on the article can be found here.

For an interesting academic paper on this subject, please click here. The paper is by William N. Goetzmann, Yale School of Management. The abstract for the paper states:

Incentive or performance fees for money managers are frequently accompanied by high-water mark provisions which condition the payment of the performance fee upon exceeding the maximum achieved share value. In this paper, we show that hedge fund performance fees are valuable to money managers, and conversely represent a claim on a significant proportion of investor wealth. The high-water mark provisions in these contracts limit the value of the performance fees. We provide a closed-form solution to the high-water mark contract under certain conditions. This solution shows that managers have an incentive to take risks. Our results provide a framework for valuation of a hedge fund management company.

We conjecture that the existence of high-water mark compensation is due to decreasing returns to scale in the industry. Empirical evidence on the relationship between fund return and net money flows into and out of funds suggest that successful managers, and large fund managers are less willing to take new money than small fund managers.

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.

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