A:

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.

For instance, a fund might set up a 5% hurdle rate, allowing it to collect incentive fees only 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.

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 (see How can I calculate the hurdle rate in Excel?).

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.

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