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Hey, everyone! I’m excited to explain how high-water marks work in hedge funds—a crucial concept that every aspiring fund manager needs to understand. If you prefer a visual explanation, don’t forget to click here to watch my YouTube video!
Hedge Funds and the 2/20 Fee Structure
Hedge funds typically operate using a fee structure known as the 2/20 model. This means:
- Management Fees: Typically 2% of the assets under management (AUM), paid to the fund manager regardless of performance.
- Performance Fees: Typically 20% of the fund's profits, paid to the manager only if the fund performs well. The remaining 80% of profits go to the investors.
This structure incentivizes fund managers to achieve high returns since a significant portion of their compensation depends on the fund’s success.
What is a High-Water Mark?
A high-water mark is a mechanism within the 2/20 fee structure that ensures fairness in how performance fees are calculated. It protects investors by preventing fund managers from charging performance fees on the same profits more than once, especially in scenarios where the fund's value fluctuates.
Crunching the Numbers: How High-Water Marks Work
Let's break it down with an example:
- Term 1: The fund starts with $50,000.
- Term 2: The fund performs exceptionally well and grows to $150,000.
- Term 3: The fund then declines to $100,000.
- Term 4: The fund recovers and rises to $200,000.
Here’s how the fees would be calculated:
- Term 1 to Term 2: The fund grows from $50,000 to $150,000. The fund manager would earn a performance fee on the $100,000 profit. Using the 2/20 model, $80,000 goes to the investor (80%), and $20,000 goes to the manager (20%).
- Term 2 to Term 3: The fund decreases in value from $150,000 to $100,000. No performance fee is charged because the fund lost value.
- Term 3 to Term 4: The fund rebounds from $100,000 to $200,000. The high-water mark comes into play here—no performance fees are charged on the first $50,000 gain because that amount had already been subject to fees when the fund initially grew from $50,000 to $150,000. The fund manager only earns a performance fee on the new gains above the previous high-water mark, which was $150,000. Therefore, performance fees are only charged on the additional $50,000 profit.
This high-water mark mechanism ensures that fund managers do not collect performance fees multiple times on the same gains, even if the fund’s value fluctuates over time.
The Importance of High-Water Marks
High-water marks are essential for maintaining investor trust and fairness in fee distribution. They ensure that investors are not double-charged for performance fees when the fund’s value rises and falls. This protection is especially critical in volatile markets, where fund values can swing dramatically.
Do High-Water Marks Reset?
A common question I get is, “How long does the high-water mark last? Does it ever reset?”
As I mentioned in my video…
“You’re the fund manager, you decide. However, typically you don’t reset your high-water mark—it stays for the length of the hedge fund. It’s there to protect your investors from being double-charged.”
In most cases, high-water marks remain in place for the life of the fund. They are a continuous feature designed to align the interests of the fund manager with those of the investors.
Conclusion
Understanding high-water marks is crucial for anyone involved in or considering hedge fund management. They ensure that performance fees are only charged on new profits, protecting investors from being overcharged during market fluctuations.
If you're interested in learning more about hedge funds and how to start your own, click here to explore more!
That’s it for today! Thanks for stopping by, and I’ll see you soon.
Want to get direct guidance for your fund? Schedule a time with my Fund Advisors!
DISCLAIMER: This content is for educational and informational purposes only. It is not to be taken as tax, financial, or legal advice. You should always consult a legal professional before taking action. Furthermore, this is not a recommendation to buy or sell any security. The content is solely just the opinion of the authors.
