High-water mark

The Securities and Exchange Commission (SEC) has specific rules about when investment managers can charge performance-based fees. Under Rule 205-3SEC rule that allows registered investment advisers to charge performance-based fees to qualified clients meeting specific asset thresholds. of the Investment Advisers Act, only registered investment advisers can charge these fees, and only to "qualified clients Qualified client A qualified client is a wealthy investor who can participate in performance fee arrangements. To qualify, an investor must have either $1.1 million in assets under management with the adviser or $2.2 million in net worth. These dollar amounts are adjusted roughly every five years to account for inflation. "—typically wealthy investors who meet certain asset thresholds.

Most hedge funds operating under this regulatory framework require their investment managers to recover all previous investor losses before earning any performance-based compensation Performance fee A performance fee is compensation paid to a hedge fund manager based on the fund's investment profits, typically calculated as a percentage (commonly 20%) of returns above a specified threshold, subject to high-water marks and potentially hurdle rates. . The system also accounts for any money that investors withdraw from the fund. This means fund managers can only receive performance fees when investor account values rise above the highest level previously achieved. For existing investments, this means exceeding the level after the last performance fee was paid. For new investments, this means exceeding the original investment amount.

High-water marks provide essential protection for investors by preventing fund managers from collecting performance fees on the same gains multiple times. Here's how this works in practice: suppose an investor contributes $1,000,000 to a hedge fund. If the investment drops to $900,000 in the first year, then recovers to $980,000 in the second year, the fund manager would receive no performance fee. The manager must first help the investor recover the remaining $20,000 loss before earning any performance-based compensation.

This protection becomes even more important when fund performance fluctuates significantly. Without high-water marks, consider an investor whose account value alternates between $1,000,000 and $1,250,000 in different years. The manager would collect performance fees every time the account reached $1,250,000, even though the investor never experienced lasting gains. The high-water mark prevents this scenario by ensuring managers only profit when they deliver sustained returns to investors.

Funds can structure high-water marks in different ways depending on how they track investor losses. Some funds track losses separately for each individual investment an investor makes. Others consider all of an investor's contributions together when determining whether prior losses have been recovered.

Under the combined approach, investors can make multiple contributions to a fund at different times, when the fund's share price varies. Each contribution creates a different "seriesAccounting method that segregates different groups of investors into separate series or classes with distinct NAV calculations." of shares with its own net asset value per share. In this structure, it becomes possible for managers to collect performance fees on one series of shares even if another series remains below its high-water mark.

Funds structured as partnerships or limited liability companies use capital accounts to track each investor's contributions and share of profits or losses. These funds typically maintain separate tracking accounts for prior losses, commonly called "loss carryforward Loss carryforward Loss carryforward is a provision in hedge fund fee structures that ensures managers must recoup previous losses before earning new performance fees, typically implemented through memorandum accounts that track losses that must be recovered before incentive compensation resumes. accounts."

These loss carryforward accounts start with zero balances when investors first join the fund. When investors experience net losses, those amounts are added to the loss carryforward account as credits. Conversely, when investors experience net gains, those amounts reduce the loss carryforward account balance, but the account balance never goes below zero.

Under this system, investment managers cannot collect any performance fees until all prior losses have been recovered and the loss carryforward account balance reaches zero.

The loss carryforward account balance adjusts proportionally when investors withdraw capital. For example, imagine an investor has a $800,000 capital account balance and a $200,000 loss carryforward account balance. If the investor withdraws $100,000 (which represents one-eighth of their capital account), the loss carryforward account would be reduced by the same proportion to $175,000.

Offshore hedge funds organized as corporations have historically created different series of shares for each subscription date. Each series maintains its own separate high-water mark. Since funds typically create new series every time someone makes an investment, they must calculate high-water marks separately for each series.

Some offshore funds simplify this process by creating separate series for each individual investor rather than each investment date. Under this approach, the fund uses the same series for both the investor's original contribution and any additional contributions.

When a series reaches a performance measurement date and its value exceeds the high-water mark, the fund may convert it back into the main series through a process called "series roll-upA process where offshore funds convert series shares that have exceeded their high-water mark back into the main series to simplify record-keeping.." Funds use this process to simplify their record-keeping and reduce the number of separate series they must track.

Some hedge funds structured as corporations take a different approach. Instead of issuing different series shares for each subscription date, they issue standard shares on each subscription date at the current market value (net asset value). This creates a potential fairness problem for investors.

Under this system, investors might purchase shares during the year that have already gained value, meaning performance fees will be charged at year-end on gains they never actually experienced. Alternatively, investors might purchase shares that have declined in value, requiring the manager to recover those losses before earning performance fees on their investment.

Since this would create unfair treatment among shareholders, these funds use "share equalizationAccounting methods used by corporate hedge funds to ensure performance fees are only charged based on gains that occurred after each investor's purchase date." methods. These methods ensure that performance fees are only charged to shareholders based on gains that occurred after they purchased their shares. The system uses "equalization factors" and "depreciation deposits" to ensure performance fees are not paid until each investor's individual high-water mark is exceeded.

The equalization factor applies when investors purchase shares at a price higher than the previous high net asset value for those shares. In this situation, part of the purchase price represents an "equalization amount." This amount equals the performance fee percentage multiplied by the difference between the current purchase price and the previous high net asset value.

This equalization amount serves as a credit against any future performance fees. Essentially, it ensures that new investors don't pay performance fees on gains that occurred before they invested.

Depreciation deposits work in the opposite direction. They apply when investors purchase shares at a price below the previous high net asset value. In this case, these shareholders will owe additional performance fees if their shares appreciate back to the previous high net asset value level.

When the losses that created the need for depreciation deposits are recovered through fund performance, the deposit is paid to the investment manager as performance compensation.

The systems described above assume that funds calculate performance fees on a cumulative basis. In cumulative structures, managers must help investors recover all previous losses before collecting any performance fees, with adjustments made for any capital withdrawals.

However, some funds use modified approaches that limit how long managers must wait to earn back investors' prior losses before receiving performance compensation. For example, some funds reset their high-water marks every two years, effectively limiting the loss recovery period and allowing managers to earn performance fees sooner after periods of poor performance.