Riding the High-Tides of Investment: Understanding the High-Water Mark
Financial High-Water Mark: Explanation and Illustrative Cases
In investment circles, the high-water mark is a crucial concept. Essentially, it represents the pinnacle of a fund's or account's value. This is particularly significant when it comes to fund manager compensation, as it's performance-based. The high-water mark is a safeguard against managing teams raking in hefty paydays for subpar performance. If a fund manager suffers losses over a period, they must elevate the fund above the high-water mark to receive a performance bonus from the assets under their management (AUM).
The Gist:
- The high-water mark is a demarcation point used for determining performance fees that an investor must pay.
- Its primary purpose is to shield investors from paying a fee for shoddy performance and preventing repeated fees for the same performance gains.
- With the high-water mark in place, the investor pays a fee that covers only the amount the fund earned between the point of entry and its highest level.
High-Water Mark: Not Your Average Tide Line
A high-water mark differs from a hurdle rate. The latter refers to the lowest amount of profit or returns a fund has to earn to start charging an incentive fee.
Example Time:
Imagine you've invested $500,000 in a hedge fund that charges a 20% performance fee. After the first month, the fund yields a 15% return, boosting your investment's value to $575,000. Here, you owe a 20% fee on the $75,000 gain, amounting to $15,000. This marks the high-water mark.
Fast forward to the following month when the fund experiences a 20% loss. Your account dwindles to $460,000. In this scenario, a performance fee doesn't apply to the gains between $460,000 and $575,000; payable only after the high-water mark amount is crossed. And with some luck, if the fund surprises everyone with a 50% profit in the third month, your account value could soar to $690,000.
In such a situation, a high-water mark prevents you from having to pay the original $15,000 fee again and an additional fee on the $230,000 gain between $460,000 and $690,000. The investor, in this case, would owe an additional $23,000 on the gains above the high-water mark. Without a high-water mark, you'd pay $61,000 in total fees, $38,000 less with the high-water mark in place. Unarguably, the high-water mark adds significant value.
Important Info:
A high-water mark not only safeguards investors from double fees but also spurs fund managers to deliver exceptional performance to earn fees.
The High-Water Mark and the "Free Ride"
When a new investor joins a fund during poor performance, a high-water mark might lead to what's known as a "free ride." This means the investor enjoys the upside from the subscription NAV to the high-water mark without being charged a fee. Other funds opt for charging a performance fee for any positive performance to avoid the "free ride."
- The high-water mark, a crucial concept in investment circles, ensures investors only pay performance fees for gains made above the initial investment value, acting as a safeguard against repeated fees for the same performance gains.
- In the realm of decentralized finance (DeFi) and cryptocurrency trading, ico (initial coin offering) investors may find the high-water mark concept relevant, as it could help them avoid paying mining or management fees on initial losses and only pay for gains above the high-water mark.
- If an individual invests in a DEFI business focused on yield farming or liquidity mining and experiences losses initially, the high-water mark could help them avoid paying performance fees on these losses. Once the high-water mark is surpassed, performance fees would be charged only on the returns made above this level. This incentivizes the business to deliver exceptional performance to maximize returns for investors.
