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High-Water Marks and Hedge Fund Management Contracts: Understanding the Basics

Hedge fund management contracts can be complex, with multiple clauses and provisions to protect both the investor and the fund manager. One such provision is the high-water mark, which is a critical aspect of hedge funds and helps investors evaluate the performance of their investment over a specified period.

What is a High-Water Mark?

A high-water mark refers to the highest point of a fund`s net asset value (NAV) at any given time. This point sets the benchmark for any future performance fees that the fund manager may receive. If the fund`s NAV drops below the high-water mark, the fund manager cannot take a performance fee until the NAV surpasses the previous high-water mark.

For example, suppose a hedge fund has a high-water mark of $10 million. In the first year, the fund generates a positive return, and the NAV increases to $11 million. The fund manager may take a performance fee based on the difference between the new NAV and the previous high-water mark. However, if the fund`s NAV drops to $9.5 million, the manager cannot take a performance fee until the NAV surpasses the previous high-water mark of $10 million.

The Purpose of the High-Water Mark

The high-water mark ensures that fund managers are only compensated for creating value for their investors. It incentivizes them to make investments that will generate attractive returns and reduce the risk of suffering significant losses. As a result, hedge fund managers must continually seek to outperform their previous high-water mark before receiving a performance fee. This mechanism helps align the interests of the investor and the fund manager.

Implications for Hedge Fund Investors

The high-water mark is an essential consideration for hedge fund investors when evaluating the performance of their investment. Before investing in a hedge fund, investors should review the terms of the management contract to understand the high-water mark provision`s details.

Investors should also consider the time horizon of the investment, as the high-water mark provision may not be applicable over the short term. Additionally, investors should be aware of any other fees, such as management fees, to have a complete understanding of the total costs associated with investing in the hedge fund.

Conclusion

The high-water mark is a vital aspect of hedge funds and helps ensure that fund managers are only compensated for creating value for their investors. It is essential for investors to understand the high-water mark provision`s details before investing in a hedge fund, as this provision will impact the total return earned on their investment. By understanding the high-water mark provision, investors can make informed decisions about whether to invest in a specific hedge fund and better evaluate the fund`s performance over time.

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