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.

Why They Exist

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.

Background on Fees

A hedge fund is a business partnership or some other structure that pools and actively manages 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.

Another Meaning of Hurdle Rate

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.