How does a high-water mark work and why does it matter for investors?

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AcadiFi · Accepted Answer

A high-water mark (HWM) is the highest NAV-per-share the fund has ever achieved for a particular investor. The manager cannot earn performance fees until the NAV climbs back above that mark. This protects investors from paying incentive fees twice on the same gain after a drawdown.

The key nuance: the HWM is investor-specific (based on when they invested), not fund-wide. Two investors in the same fund can have different HWMs.

Walk through Talonridge Long/Short, 20% incentive fee, no hurdle, HWM protection. Investor Marisol invests $1M at Year 0 (NAV per share = $100; 10,000 shares).

Year 1: Fund gains 15%. NAV per share = $115. Marisol's HWM resets to $115. Incentive fee charged on all $15/share gain: $1.50/share × 10,000 shares = $15,000. (Slight simplification; actually deducted from NAV.)

Year 2: Fund loses 10%. NAV per share = $103.50. No incentive fee this year (losses). HWM stays at $115.

Year 3: Fund gains 12%. NAV per share = $115.92. Incentive fee only applies to the amount ABOVE $115 — that's $0.92/share, not the full $12.42/share of year-3 gains. Marisol owes 20% × $0.92 × 10,000 = $1,840.

Now consider Devaughn, who invests at the start of Year 2 when NAV = $115. His HWM is $115. In Year 2 he loses to $103.50; in Year 3 he gains to $115.92. He has the same HWM as Marisol but only because he happened to buy in at her peak.

Without a HWM, managers could reap incentive fees after every drawdown-then-recovery — a structural investor ripoff. HWMs are standard in hedge funds but not universal in mutual funds or SMAs.

How does a high-water mark work and why does it matter for investors?

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