Hurdle rates and high-water marks are benchmarks that hedge funds can set as requirements for charging incentives or performance fees from investors. A high-water mark is the highest value an investment fund or account has ever reached. A hurdle rate is the minimum profit or returns a hedge fund must earn before charging an incentive fee.
Key Takeaways
- Hurdle rates and high-water marks are measures hedge funds use to collect performance fees.
- A high-water mark is the highest value an investment fund or account has reached.
- Putting in a high-water mark ensures that hedge fund managers aren't compensated as much for a mediocre performance as when a fund is successful.
- A hurdle rate is the minimum profit or returns a hedge fund must earn before charging an incentive fee.
High-Water Mark
Setting a high-water mark ensures that hedge fund managers aren't paid as much as they would for a high-performing fund when the fund's performance is poor. If the fund is losing money, the manager must get it above its high-water mark before receiving a performance bonus.
Hurdle Rate
A hurdle rate has a similar function. For example, if a hedge fund sets a 5% hurdle rate, it will only collect incentive fees when returns are higher than that. If the same fund also has a high-water mark, it cannot collect an incentive fee unless its value is above the high-water mark and returns are above the hurdle rate.
The hurdle rate is usually a premium above the firm's weighted average cost of capital (WACC). For instance, if the fund's WACC is 5%, it may add two percentage points for a hurdle rate of 7%.
Hurdle Rate
Hedge Fund Management Fees
A hedge fund is a business partnership or other structure that pools and actively manages investments. Under a formula known as 2/20, hedge funds commonly charge management fees of 1% to 2% of a fund's net asset value (NAV) and incentive fees of 20% of the fund's profits.
The management fee is always paid by the investor, regardless of profits. However, several methods can be used to calculate profits when charging incentive fees. Under one method, the profit can be defined as the increase in NAV. Alternatively, the profit can be counted by the increase in NAV after being adjusted for management fees.
High-Water Mark vs. Hurdle Rate Example
When used in capital budgeting, a hurdle rate has a slightly different meaning: it is the minimum the company or manager expects to earn when investing in a project. Hurdle rate can also refer to the lowest rate of return for an investment to be an acceptable risk for an investor.
In general, an investment is considered sound if an expected rate of return is above the hurdle rate. The corollary is that investors typically avoid moving forward if the rate of return falls below the hurdle rate.
What Is the Hurdle Rate in a 2-and-20 Fee Structure?
A two-and-20 arrangement is a common fee structure for hedge funds, private equity, and venture capital firms. The fund charges investors 2% of assets under management plus 20% of profits over a hurdle rate annually. Typically, the hurdle rate is 7% to 10%. If the hurdle rate is not exceeded in a given year, the "20" part of the fee wouldn't apply.
How Do Hedge Funds Use High-Water Marks?
A high-water mark reflects the highest-ever level for a hedge fund's portfolio. This level is important for investors since fees may be based on achieving returns that surpass a previous high-water mark.
Why Is it Called a High-Water Mark?
Historically, populations living along waterways, such as the ancient Egyptians along the Nile River, would record how high the river's flow or tide could reach. This was done to establish where to develop residential areas so that they were above flood plains and to plan irrigation channels for agriculture.
The Bottom Line
High-water marks and hurdle rates are tools used to determine when investment fund managers receive incentives or performance fees. To receive them, managers must ensure the fund's value is higher than its previous highs or that its returns meet a minimum standard, respectively. For some funds, managers must meet both high-water marks and hurdle rates to receive incentives.
Before investing in any fund, it's important to understand the fee structure and how much you'll pay for your investment. This includes looking into a fund's rules on incentives and whether it uses a high-water mark or hurdle rate.
FAQs
A high-water mark is the highest value an investment fund or account has ever reached. A hurdle rate is the minimum profit or returns a hedge fund must earn before charging an incentive fee.
What is the concept of high-water mark? ›
High-water mark is the highest level of value that an investment account or portfolio has reached. The high-water mark clause helps investors avoid paying the performance fee for the same part of return twice after a previous loss.
What does a high-water mark mean in finance? ›
A high-water mark is the highest level in value an investment account or fund has reached. A high-water mark is often used as a demarcation point in determining performance fees that an investor must pay.
What is the difference between preferred return and high-water mark? ›
High water marks operate differently from preferred returns, but are based on similar investor concerns. They protect investors from having to pay performance fees twice where there has been a decline in the value of a hedge fund, followed by a further rise.
What is the difference between hurdle rate and performance fee? ›
Hurdles and Performance Fees
A hurdle would be a predetermined level of return a fund must meet to earn a performance fee. Hurdles can take the form of an index or a set, predetermined percentage. For example, if NAV growth of 10% is subject to a 3% hurdle, a performance fee would be charged only on the 7% difference.
Why is it called high-water mark? ›
Such a mark is often the result of a flood, but high water marks may reflect an all-time high, an annual high (highest level to which water rose that year) or the high point for some other division of time.
How is high-water mark measured? ›
Hydrologists often visit streams after a large storm to check for high-water marks. If, for example, records show that stream stage reached 17 feet during a storm, a high-water mark will show the hydrologist what a stage of 17 feet means in terms of how high the water was on the riverbanks and surrounding land.
What is the hurdle rate in finance? ›
A hurdle rate is the minimum rate of return required on a project or investment. Hurdle rates give companies clarity about whether they should pursue a specific project. Generally, the higher the risk, the higher the hurdle rate.
What is an example of a hurdle rate? ›
One of the managers responsible for the project estimated the risk premium associated with the project to be 4%. Based on the provided data, what is the minimum acceptable return, or hurdle rate, that the company should accept? Using the hurdle rate formula, the hurdle rate equals 5% + 4% = 9%.
What is hurdle rate in PMS? ›
The hurdle rate is the minimum rate of return that your portfolio must achieve before you start paying performance fees. So, if the hurdle rate is 8% and your portfolio generates a 10% return, you will pay a performance fee on the 2% profit (as it exceeds the hurdle rate).
This benchmark hurdle is applied to the high water mark to calculate an adjusted high water mark, which must be exceeded before a performance fee is accrued. This is designed to ensure that a performance fee is not charged until the net excess return of the share class exceeds the reference benchmark return.
What is the difference between loss carry forward and high water mark? ›
A high-water mark, also known as a loss carryforward position, measures the highest net asset value that an investment fund or account has reached.
What is the preferred rate of return? ›
The minimum return to investors to be achieved before a carry is permitted. A hurdle rate of 10% means that the private equity fund needs to achieve a return of at least 10% per annum before the profits are shared according to the carried interest arrangement.
What two main factors impact the hurdle rate? ›
Key considerations include: Risk premium – Assigning a risk value for the anticipated risk involved with the project. Riskier investments generally have greater hurdle rates than less risky ones. Inflation rate – If the economy is experiencing mild inflation, that may influence the final rate by 1%-2%.
How is hurdle rate determined? ›
Calculating Hurdle Rate
Here is the formula: Cost of capital + risk premium = hurdle rate. For example, if an investor's cost of capital is 5%, and the risk premium for a specific investment is 3%, the hurdle rate would be 5% plus 3% or 8%.
Is preferred return the same as hurdle rate? ›
A hurdle rate in private equity (also referred to as a “preferred return” or “required rate of return”) is the minimum return that the fund must achieve for investors before the general partner (“GP”) or manager can share in the profits.
What does high water line mean? ›
: the line of the shore of the sea or of a lake or river to which the waters usually reach at high water: (1) : the line that marks the limit of the rise of the medium tides of the sea between the spring and neap tides. (2)
What is high and low water mark? ›
From Longman Dictionary of Contemporary English high/low watermarkAmerican English a line showing the highest or lowest levels of the sea SYN tide-mark British English → watermarkExamples from the Corpushigh/low watermark• Penal Policy in a Changing Society stands as the high watermark of what later became known as the ...
