Hurdle rates and high-water marks are benchmarks that hedge funds can set as requirements for charging incentives or performance fees from investors. A high-water mark is the highest value an investment fund or account has ever reached. A hurdle rate is the minimum profit or returns a hedge fund must earn before charging an incentive fee.
Key Takeaways
- Hurdle rates and high-water marks are measures hedge funds use to collect performance fees.
- A high-water mark is the highest value an investment fund or account has reached.
- Putting in a high-water mark ensures that hedge fund managers aren't compensated as much for a mediocre performance as when a fund is successful.
- A hurdle rate is the minimum profit or returns a hedge fund must earn before charging an incentive fee.
High-Water Mark
Setting a high-water mark ensures that hedge fund managers aren't paid as much as they would for a high-performing fund when the fund's performance is poor. If the fund is losing money, the manager must get it above its high-water mark before receiving a performance bonus.
High-Water Mark
Hurdle Rate
A hurdle rate has a similar function. For example, if a hedge fund sets a 5% hurdle rate, it will only collect incentive fees when returns are higher than that. If the same fund also has a high-water mark, it cannot collect an incentive fee unless its value is above the high-water mark and returns are above the hurdle rate.
The hurdle rate is usually a premium above the firm's weighted average cost of capital (WACC). For instance, if the fund's WACC is 5%, it may add two percentage points for a hurdle rate of 7%.
Hurdle Rate
Hedge Fund Management Fees
A hedge fund is a business partnership or 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, several methods can be used to calculate profits when charging incentive fees. Under one method, the profit can be defined as the increase in NAV. Alternatively, the profit can be counted by the increase in NAV after being adjusted for management fees.
High-Water Mark vs. Hurdle Rate Example
When used in capital budgeting, a hurdle rate has a slightly different meaning: it is the minimum the company or manager expects to earn when investing in a project. Hurdle rate can also refer to the lowest rate of return for an investment to be an acceptable risk for an investor.
In general, an investment is considered sound if an expected rate of return is above the hurdle rate. The corollary is that investors typically avoid moving forward if the rate of return falls below the hurdle rate.
What Is the Hurdle Rate in a 2-and-20 Fee Structure?
A two-and-20 arrangement is a common fee structure for hedge funds, private equity, and venture capital firms. The fund charges investors 2% of assets under management plus 20% of profits over a hurdle rate annually. Typically, the hurdle rate is 7% to 10%. If the hurdle rate is not exceeded in a given year, the "20" part of the fee wouldn't apply.
How Do Hedge Funds Use High-Water Marks?
A high-water mark reflects the highest-ever level for a hedge fund's portfolio. This level is important for investors since fees may be based on achieving returns that surpass a previous high-water mark.
Why Is it Called a High-Water Mark?
Historically, populations living along waterways, such as the ancient Egyptians along the Nile River, would record how high the river's flow or tide could reach. This was done to establish where to develop residential areas so that they were above flood plains and to plan irrigation channels for agriculture.
The Bottom Line
High-water marks and hurdle rates are tools used to determine when investment fund managers receive incentives or performance fees. To receive them, managers must ensure the fund's value is higher than its previous highs or that its returns meet a minimum standard, respectively. For some funds, managers must meet both high-water marks and hurdle rates to receive incentives.
Before investing in any fund, it's important to understand the fee structure and how much you'll pay for your investment. This includes looking into a fund's rules on incentives and whether it uses a high-water mark or hurdle rate.
FAQs
Putting in a high-water mark ensures that hedge fund managers aren't compensated as much for a mediocre performance as when a fund is successful. A hurdle rate is the minimum profit or returns a hedge fund must earn before charging an incentive fee.
What is the high watermark calculation? ›
High-water mark indexing is used in investment management to calculate the performance fees charged by hedge funds or other investment funds. It is designed to ensure that the fund manager is only rewarded for generating positive returns for investors.
What does a high water mark mean in finance? ›
A high-water mark is the highest level in value an investment account or fund has reached. A high-water mark is often used as a demarcation point in determining performance fees that an investor must pay.
What is an example of a high water mark performance fee? ›
For example, if an investor puts in $100,000 and the fund's net asset value goes up to $150,000, the high-water mark is $150,000. If the value decreases below the high-water mark, the fund manager does not receive a performance fee until the investment value surpasses the previous peak.
What is the difference between loss carry forward and high water mark? ›
A high-water mark, also known as a loss carryforward position, measures the highest net asset value that an investment fund or account has reached. For fee arrangements that include a high-water mark provision, the manager must get their fund past the mark to receive a performance bonus.
What is the difference between a hurdle rate and a high watermark? ›
A high-water mark is the highest value an investment fund or account has ever reached. A hurdle rate is the minimum profit or returns a hedge fund must earn before charging an incentive fee.
How do you determine the high-water mark? ›
“The term ordinary high water mark means that line on the shore established by the fluctuations of water and indicated by physical characteristics such as a clear, natural line impressed on the bank, shelving, changes in the character of soil, destruction of terrestrial vegetation, the presence of litter and debris, or ...
What is a hurdle rate in finance? ›
The definition of hurdle rate is the minimum required rate of return on a financial proposition for it to receive the green light. This hurdle rate concept can be applied to investments and business projects. The greater the risk involved in an investment, the higher the hurdle rate will be.
What is the meaning of high watermark? ›
noun. a mark showing the highest level reached by a body of water. the highest point of anything; acme: Her speech was the high-water mark of the conference.
What is a high-water mark classification? ›
A high-water mark is the minimum level that a fund manager needs to achieve to receive a performance bonus. The high-water mark clause protects investors by avoiding paying the performance fee for the same part of return when an investment fund or account recovers from the previous loss.
Hurdles and Performance Fees
A hurdle would be a predetermined level of return a fund must meet to earn a performance fee. Hurdles can take the form of an index or a set, predetermined percentage. For example, if NAV growth of 10% is subject to a 3% hurdle, a performance fee would be charged only on the 7% difference.
What is a hard hurdle rate? ›
A hard hurdle rate means that incentive fees are only collected on returns in excess of the benchmark. For example, if a hedge fund returned 25% with a 10% hurdle rate, incentive fees would be collected on the excess return of 15%.
What is the high-water mark principle? ›
The high-water mark principle is to ensure that the manager does not get paid performance fee for recent poor performance. If the manager loses money or makes less money over a period, he must take the fund value above the previous high – that is the high-water mark -- before receiving a performance fee.
What is the mean high-water mark? ›
A high water mark is a point that represents the maximum rise of a body of water over land. Such a mark is often the result of a flood, but high water marks may reflect an all-time high, an annual high (highest level to which water rose that year) or the high point for some other division of time.
How many years can you carry forward losses? ›
Key Takeaways
Capital losses that exceed capital gains in a year may be used to offset capital gains or as a deduction against ordinary income up to $3,000 in any one tax year. Net capital losses in excess of $3,000 can be carried forward indefinitely until the amount is exhausted.
What is low and high-water mark? ›
From Longman Dictionary of Contemporary English high/low watermarkAmerican English a line showing the highest or lowest levels of the sea SYN tide-mark British English → watermarkExamples from the Corpushigh/low watermark• Penal Policy in a Changing Society stands as the high watermark of what later became known as the ...
What is the high-water mark method? ›
A high-water mark is the minimum level that a fund manager needs to achieve to receive a performance bonus. The high-water mark clause protects investors by avoiding paying the performance fee for the same part of return when an investment fund or account recovers from the previous loss.
What is the high water mark of the Confederacy? ›
What is the High-Water Mark? The High-Water Mark of the Confederacy or “high tide of the Confederacy” refers to an area on Cemetery Ridge near Gettysburg, Pennsylvania, marking the farthest point reached by Confederate forces during the action known as Pickett's Charge on July 3, 1863.
What is the high-water mark in Kafka? ›
Solution. The high-water mark is an index into the log file that records the last log entry known to have successfully replicated to a Majority Quorum of followers. The leader also passes on the high-water mark to its followers during its replication.
What is the high-water mark of a table? ›
The high water mark refers to the page number of the first page in the extent following the last allocated extent. For example, if a table space has 1000 pages and an extent size of 10, there are 100 extents.
