High Water Mark Definition: How Do Hedge Funds Protect Against Low-Performing Managers?

High water mark definition: Despite the fact that the term is often used in reference with a body of water, it also is frequently applied in reference with hedge funds. That is why if you are really interested in how hedge funds work, it is very important to internalize the meaning of what a high water mark is, and how it works. However, in order to provide you with more insightful information, and to help you better understand the term, we suggest you also take a look at our hedge fund definition.

Warren Buffett portrait

Firstly, the term high water mark is used in reference with the fees that are paid for the manager of a hedge fund. It represents the biggest value reached by a hedge fund, or basically every investment fund. Since it describes the performance of the hedge fund, it helps to calculate the amount of fees that a fund manager receives.

So, let’s say a hedge fund with $1.0 billion, which is the highest value of its assets, losses 5% in one year, which decreases it’s value to $950 million. If the next year, the hedge fund earns $75 million, than the manager exceeded the “peak” by only $25 million, which is the amount on which the manager will get a bonus calculated as a percentage from the high water mark-exceeded value. In other words, the high water mark makes sure that low-returning managers don’t get paid for poor performance; to make a paycheck, they have to be above this mark.

For example, David Tepper, the manager of Appaloosa Management, is the hedgie with the highest paycheck, worth $2.2 billion in 2012, according to Forbes. With assets worth around $15 billion, Appaloosa succeeded to return 30% during the last year. And Tepper’s case is not the only one out there. Among hedge fund managers with highest pay rates we can also include Carl Icahn, the manager of Icahn Capital with earnings of almost $2 billion, and Steven Cohen from Sac Capital Advisors, who earned $1.3 billion.

Basically, there are many different fees applied by hedge funds in order to calculate the amount that has to be paid to the manager. To put things more simply, these fees can be divided into management fees and fees based on hedge funds’ performance.

The management fee usually represents a small amount of the fund’s assets. Performance fees could represent a much bigger value for the manager, since they represent a significant amount, usually at least 20% of the profits earned by the hedge fund. So, the high water mark could be included in the “performance fees” section, but it represents more of an bonus or incentive.

One of the dangers of the high water mark is that it might increase the risk implied by the manager. In order to cover for losses, a hedge fund manager might consider more risky investments, which is in exchange of a higher risk of losing money given a probability of larger returns among its peers.

Recommended Reading:

Hedge Fund Strategies

Top Hedge Funds

How To Be A Hedge Fund Manager

Disclosure: none