A hedge fund’s limited partnership agreement (LPA) with its investors may contain a loss-recovery provision (i.e., high-water marks). The high-water mark provision is designed to protect the investors form unnecessarily paying performance fees to the hedge fund manager.
Background on Hedge Fund Compensation
Typically, a hedge fund manager receives two forms of compensation.
First, the management company receives a fixed annual management fee, which is a percentage of the fund’s total net assets under management (AUM). Second, the manager receives a performance fee based on the fund’s investment profits.
For example, a hedge fund may abbreviate its fee arrangement as “2 and 20”. The 2-and-20 structure means a 2% fixed fee on AUM and a 20% performance fee on the fund’s profits. Because of increased competition in the sector, many fund managers have significantly lowered their fees. As of 2020, according to the Hedge Fund Research (HFR) group, the average fee arrangement was a 1.4% management fee and 16.4% performance fee.
Loss Recovery Provisions (High-Water Marks)
The high-water mark provision in a hedge fund manager’s compensation agreement states that the manager will not receive their performance fee unless the fund recovers any previously incurred losses. This provision effectively protects the investors from paying the same performance fee twice.
The high-water mark is a different provision from a hurdle rate. The hurdle rate is the minimum return on investment (ROI) a fund must achieve before the hedge fund manager receives their performance bonus.