Positive performance fees for managers of hedge funds are typically paid only if the market value of the investment fund managed by him or her exceeds the previous high watermark. Such an arrangement prevents the fund manager from earning a positive performance fee even if he or she has lost money in comparison to past high values of his or her investment funds.
The agreement on high watermarks is important because performance fees are generally restricted to nonnegative values so that investment managers with poor performance do not have to incur penalty payments.
Without the application of high watermarks, the investment manager’s performance fee would simply be piecewise linear with a slope of zero for negative annual fund returns and a positive slope for positive annual fund returns.
The establishment of a high watermark implies a “dynamic” kink of this incentive scheme that shifts to positive annual returns when past high watermarks are violated at the beginning of the current period for which the incentive fee is to be computed.
For example, a fund starts at the beginning of year 1 with an amount of $180,000 under management and reaches a peak of $200,000 at the end of year 1. Then its value decreases to $150,000 at the end of year 2 and eventually increases once again to $170,000 at the end of year 3. Every year, the manager gets a performance fee that amounts to 20% of the (positive) value creation during the respective year.
Without a high watermark being in effect, the manager gets fees amounting to $4,000 in year 1, $0 in year 2, and again $4,000 in year 3. The recognition of a high watermark arrangement implies payments of $4,000 in year 1 and $0 in year 2 and year 3 to the manager.
High watermark arrangements lead to option-like incentive schemes for managers of hedge funds. As hedge funds typically employ rather high-variance portfolio strategies that are based on superior knowledge, high watermarks assure the long-term attractiveness of such strategies for fund managers.
Moreover, such bets on “superior manager skills” may imply diminishing returns to scale in the hedge fund industry so that growth opportunities for hedge funds are rather limited and—as a consequence—asset-based fees (simply amounting to a fixed percentage of the total volume of assets under management) will not work as an effective reward scheme for successful investment managers.