What is a High-Water Mark
A high-water mark is the highest peak in value that an investment fund or account has reached. This term is often used in the context of fund manager compensation, which is performance-based. The high-water mark ensures the manager does not get paid large sums for poor performance. If the manager loses money over a period, he must get the fund above the high-water mark before receiving a performance bonus from the assets under management (AUM).
BREAKING DOWN High-Water Mark
High-water marks ensure that investors do not have to pay performance fees for poor performance, but more importantly, guarantee that investors do not pay performance-based fees twice for the same amount of performance.
High-Water Mark in Practice
For example, assume an investor is invested in a hedge fund that charges a 20% performance fee, which is quite typical in the industry. Assume the investor places $500,000 into the fund, and during its first month, the fund earns a 15% return. Thus, the investor's original investment is worth $575,000. The investor owes a 20% fee on this $75,000 gain, which equates to $15,000.
At this point, the high-water mark for this particular investor is $575,000, and the investor is obligated to pay $15,000 to the portfolio manager.
Next, assume the fund loses 20% in the 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 fee does not have to be paid on any gains from $460,000 to $575,000, only after the high-water mark amount. Assume in the third month, the fund unexpectedly earns a profit of 50%. In this unlikely case, the value of the investor's account rises from $460,000 to $690,000. Without a high-water mark in place, the investor owes the original $15,000 fee, plus 20% on the gain from $460,000 to $690,000, which equates to 20% on a gain of $230,000, or an additional $46,000 in performance fees.
Value of a High-Water Mark
The high-water mark prevents this "double fee" from occurring. With a high-water mark in place, all gains from $460,000 to $575,000 are disregarded. But gains above the high-water mark are subject to the performance-based fee. In this example, beyond the original $15,000 performance-based fee, this investor owes 20% on the gains from $575,000 to $690,000, which is an additional $23,000.
In total, with a high-water mark in place, the investor owes $38,000 in performance fees, which is $690,000 less the original investment of $500,000 multiplied by 20%. Without a high-water mark in place, which is below industry standards, the investor owes a 20% performance fee on all gains, which equates to $61,000. The value of a high-water mark is unquestionable.
High-Water Marks and the "Free Ride"
Several things can happen when an investor enters a fund during a period of underperformance. For instance, at Goldman Sachs Asset Management, an investor who buys into the fund at a net asset value (NAV) below the high-water mark will enjoy the upside from the subscription NAV to the high-water mark without paying a fee. This situation is known as a "free ride." It allows new investors to benefit from buying into an underperforming fund without penalizing existing investors. Other funds may avoid the "free ride" by charging a performance fee for any positive performance.