What is a high water mark?
A highlight is the highest peak in value reached by a fund or investment account. This term is often used in the context of compensation for fund managers, which is performance-based. The high water line guarantees that the manager is not paid large sums for poor performance. If the manager loses money over a period, he must place the fund above the high water mark before receiving an asset management bonus (AUM).
High water mark
Break the high water mark
A high-high mark ensures that investors do not have to pay performance fees for poor performance, but, more importantly, ensures that investors do not pay performance-based fees twice for the same amount of performance.
High tide in practice
For example, suppose an investor is invested in a hedge fund that charges a 20% performance fee, which is fairly typical in the industry. Suppose the investor invests $ 500,000 in the fund and, in its first month, the fund generates a 15% return. Thus, the investor’s initial investment is worth $ 575,000. The investor owes a 20% fee on this gain of $ 75,000, which is equivalent to $ 15,000.
At this point, the highest threshold for this particular investor is $ 575,000, and the investor is required to pay $ 15,000 to the portfolio manager.
Then suppose the fund loses 20% next month. The investor’s account drops to a value of $ 460,000. This is where the importance of the high water mark is noted. A performance commission should not be paid on winnings of $ 460,000 to $ 575,000, only after the amount of the high-high mark. Suppose that in the third month, the fund makes an unexpected profit of 50%. In this unlikely event, the investor’s account value drops from $ 460,000 to $ 690,000. Without a high-high mark in place, the investor owes upfront costs of $ 15,000, plus 20% on the gain of $ 460,000 to $ 690,000, which equals 20% on a gain of $ 230,000, or $ 46,000 in additional performance fees.
Value of a high water line
The high water line prevents this “double tariff” from occurring. With a high threshold in place, all winnings from $ 460,000 to $ 575,000 are not taken into account, but gains above the high threshold are subject to performance-based fees. In this example, in addition to the performance fees of $ 15,000, this investor owes 20% on the gains from $ 575,000 to $ 690,000, which represents an additional $ 23,000.
In total, with a climax in place, the investor owes $ 38,000 in performance fees, or $ 690,000 less the initial investment of $ 500,000 multiplied by 20%. Without setting up a high water line, which is below industry standards, the investor owes a performance commission of 20% on all earnings, which equates to $ 61,000. The value of a high water line is indisputable.
A high water line and the “Free Ride”
Several things can happen when an investor enters a fund during a period of underperformance. For example, at Goldman Sachs Asset Management, an investor who buys in the fund at a net asset value (NAV) below the high-high mark will benefit from the rise in the subscription NAV to the high-high mark without paying any fees. This situation is known as “free ride”. It allows new investors to benefit from an investment in an underperforming fund without penalizing existing investors. Other funds can avoid the “free ride” by charging a performance commission for any positive performance.