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A high water mark is the highest net asset value a fund has ever reached. Fund managers can only charge performance fees on gains that push the fund above this previous peak. If the fund loses value and then recovers, the manager earns no performance fee on the recovery until the fund surpasses the previous high.
The high water mark is a core investor protection built into most hedge fund fee structures. Without it, a manager could collect performance fees on the same gains multiple times, once when the fund rises to a peak, and again after it falls and recovers to the same level.
The clearest way to understand the high water mark is through a simple three-year example. In Year 1, a $1 million fund grows to $1.1 million. The manager earns a 20% performance fee on the $100,000 gain, collecting $20,000. The high water mark is now set at $1.1 million.
In Year 2, the fund drops to $900,000. No performance fee is charged because there are no gains. The fund finished below the high water mark.
In Year 3, the fund climbs from $900,000 to $1.2 million. The manager only earns a performance fee on the $100,000 of gains above the previous high water mark of $1.1 million, not on the entire $300,000 recovery. This protects you from paying twice for the gains between $900,000 and $1.1 million.
Hedge funds typically charge two types of fees. The management fee, usually 2% of assets under management, is charged regardless of performance. The performance fee, usually 20% of profits, is charged only when the fund generates positive returns above the high water mark.
Think of it like a sales commission structure: the commission only applies to new customers brought in, not to the same customers repeatedly.
The Securities and Exchange Commission requires that only registered investment advisers charge performance-based fees, and only to qualified clients. Under SEC rules, a qualified client is generally someone with at least $1.1 million in assets managed by the adviser or at least $2.2 million in net worth.
The high water mark and the hurdle rate both serve to protect investors from paying performance fees too easily, but they work differently.
Some funds use both. A fund with a 4% hurdle rate and a high water mark means the manager earns no performance fee unless the fund both exceeds the hurdle and surpasses the previous peak value.
When investors join a fund at different points, they have different entry prices and therefore different personal high water marks. Series accounting handles this by issuing a new series of shares on each subscription date, each carrying its own high water mark.
Databento's trading compliance documentation explains that series accounting allows managers to collect performance fees on one group of investors' gains even if another group, who entered at a higher price, is still below their individual high water mark.
A significant drawdown can leave a manager's high water mark so far above current value that reaching it seems nearly impossible. In this scenario, some managers may choose to close the fund rather than manage it without any prospect of earning performance fees.
This is one of the structural criticisms of the high water mark. It may discourage fund managers from continuing to manage a deeply underwater fund when no performance compensation is in sight. Estably, a digital asset management firm, notes this as the main practical downside of the mechanism despite its fairness to investors.
With deep roots in traditional finance and the digital asset industry, Acquire.Fi operates as a specialist M&A advisory firm. Coverage spans M&A, secondaries, OTC, and capital markets advisory across digital assets and frontier tech. Decades of combined experience across every stage of the deal lifecycle.
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