High-Water Mark
A high-water mark is the highest net asset value a fund has previously reached, establishing the baseline above which performance fees can be charged so that managers are not paid twice for recovering prior losses.
The high-water mark is one of the most important investor protections in alternative fund structures. Without it, a fund that loses 20% in one year and then recovers 25% the next would charge a performance fee on that 25% gain, even though investors who held through both periods are still in the red. The high-water mark ensures that performance fees only accrue on gains that represent genuine new wealth creation for the investor.
In practice, the high-water mark is tracked at the share class or individual account level in some fund structures, and at the overall fund level in others. Share class-level tracking is more precise because it accounts for the timing of each investor's entry into the fund. Fund-level tracking is simpler operationally but can result in some investors being charged performance fees before they have recovered their own losses if they invested at a higher NAV than others.
High-water marks create what practitioners call the option value of the performance fee. When a fund's NAV is well below its high-water mark, the performance fee is effectively out of the money. The fund must generate substantial returns just to get back in a position to charge fees, which some argue creates perverse incentives — either to take excessive risk to recover quickly or, if recovery seems unlikely, to close the fund and start fresh with a new vehicle above the watermark.
This fund closure dynamic is a known feature of the hedge fund industry. When a fund suffers large drawdowns, some managers will return capital to investors and launch a new fund, resetting the high-water mark. Investors evaluating a manager's track record should scrutinize whether continuity of strategy exists even across legally distinct fund entities.