High-Water Mark vs. Hurdle Rate: An Overview
Hurdle rate and high-water mark are two types of benchmarks that hedge funds can set as requirements for collecting incentive or performance fees from investors.
A high-water mark is the highest value that an investment fund or account has ever reached. A hurdle rate is the minimum amount of profit or returns a hedge fund must earn before it can charge an incentive fee.
- Hurdle rates and high-water marks are two benchmarks hedge funds use to set requirements for collecting performance fees.
- A high-water mark is the highest value that an investment fund or account has ever reached.
- If the fund is losing money, then the manager has to get it above its high-water mark before receiving a performance bonus.
- A hurdle rate is the minimum amount of profit or returns a hedge fund must earn before it can charge an incentive fee.
Setting a high-water mark is a way to make sure that a hedge fund manager isn't getting paid as much as they would for a high-performing fund if the fund's performance is poor. If the fund is losing money, then the manager has to get it above its high-water mark before receiving a performance bonus.
A hurdle rate has a similar function. If a hedge fund sets a 5% hurdle rate, for example, it will only collect incentive fees during periods when returns are higher than this amount. If the same fund also has a high-water mark, it cannot collect an incentive fee unless the fund's value is above the high-water mark, and returns are above the hurdle rate.
The hurdle rate is usually a premium above the firm's weighted-average cost of capital (WACC). For instance if the fund's WACC is 5% it may add 2 more percentage points to come to a hurdle rate of 7%.
A hedge fund is a business partnership or some other structure that pools and actively manage investments. Under a formula known as 2/20, hedge funds commonly charge management fees of 1% to 2% of a fund's net asset value (NAV) and incentive fees of 20% of the fund's profits.
The management fee is always paid by the investor, regardless of profits. However, a variety of structures can be used in calculating profits for the purpose of charging incentive fees. Under one type of structure, the profit can simply be defined as the increase in net asset value. Alternatively, the profit can be the increase in NAV with an adjustment for management fees.
High-Water Mark vs. Hurdle Rate Example
When used in capital budgeting, a hurdle rate has a slightly different meaning—it is the minimum that the company or manager expects to earn when investing in a project. Hurdle rate can also refer to the lowest rate of return on an investment that would make it an acceptable risk for the investor.
In general, an investment is considered sound if an expected rate of return is above the hurdle rate. That also means that an investor may not want to move forward if the rate of return falls below the hurdle rate.
What Is the Hurdle Rate in a Two-and-Twenty Fee Structure?
A two-and-twenty arrangement is a common fee structure for hedge funds, private equity, and venture capital funds whereby the fund charges investors 2% of assets under management (AUM) plus 20% of profits over a hurdle rate, annually. Typically this hurdle rate is around 7%-10%. If the hurdle rate is not surpassed in a given year, the "twenty" part of the fee would not apply.
How Do Hedge Funds Use High-Water Marks?
A high-water mark reflects the highest-ever level for a hedge fund's portfolio. This level is important for investors as fees may be based on achieving returns that surpass a previous high-water mark.
Why Is it Called a High-Water Mark?
Historically, civilizations living along waterways, such as the ancient Egyptians along the Nile River, would record how high the river's flow or tide would be. This was done to establish where to develop residential areas above flood plains and plan irrigation channels for agriculture.