The management fee keeps running on the way back, so the recovery takes longer than the loss suggests, and the fee-free years are worth real money to the investors who stayed.
Longer than the loss suggests, because the management fee keeps running while the fund climbs back. After an illustrative 20 per cent loss, a fund charging 2 and 20 sits at 78.00 and needs a 28.21 per cent net gain to regain its mark; at a steady 10 per cent gross return that takes four full years, and only in year five does a performance fee become payable again. For an investor with 10,000,000 in the fund, the high-water mark is worth 593,420 of end value over eight years.
Worked in full in Alternative Investments by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The high-water mark is usually described as a fairness rule: the manager is paid once for each gain, not twice for the same ground recovered. Seen from the other side, it is a free ride the investor has already paid for with the loss. The question an allocator faces after a bad year is how long that free ride lasts, what it is worth, and why the manager may be tempted to end it early.
| Input | Value |
|---|---|
| Starting NAV and high-water mark | 100.00 |
| Management fee, on opening NAV | 2.0% |
| Performance fee, above the mark, crystallised annually | 20.0% |
| Gross return, year 1 | −20.0% |
| Gross return, years 2 to 8 | 10.0% |
| Investor's holding | 10,000,000 |
Pre-fee NAVt = opening NAV × (1 + gross return) − 2.0% × opening NAV
Performance feet = 20.0% × max(0, pre-fee NAV − high-water mark)
New mark = max(old mark, closing NAV)
In Excel, with opening NAV in B5, gross return in C5 and the mark in F5: =0.2*MAX(0,B5*(1+C5)-0.02*B5-F5). The mark in the next row is =MAX(F5,H5), where H5 is the closing NAV.
Year 1 takes the fund from 100.00 to 80.00 gross, and the management fee of 2.00 leaves 78.00. Recovering 100.00 from 78.00 is a 28.21 per cent net gain, not the 25.0 per cent that the textbook recovery arithmetic for a 20 per cent loss gives, because the management fee was charged on the way down too. Done in a single year, it would need a gross return of 30.21 per cent.
| Year | Opening | Gross | Mgmt fee | Pre-fee NAV | Mark | Perf fee | Closing |
|---|---|---|---|---|---|---|---|
| 1 | 100.00 | −20.0% | 2.00 | 78.00 | 100.00 | 0.00 | 78.00 |
| 2 | 78.00 | 10.0% | 1.56 | 84.24 | 100.00 | 0.00 | 84.24 |
| 3 | 84.24 | 10.0% | 1.68 | 90.98 | 100.00 | 0.00 | 90.98 |
| 4 | 90.98 | 10.0% | 1.82 | 98.26 | 100.00 | 0.00 | 98.26 |
| 5 | 98.26 | 10.0% | 1.97 | 106.12 | 100.00 | 1.22 | 104.89 |
| 6 | 104.89 | 10.0% | 2.10 | 113.29 | 104.89 | 1.68 | 111.61 |
| 7 | 111.61 | 10.0% | 2.23 | 120.54 | 111.61 | 1.79 | 118.75 |
| 8 | 118.75 | 10.0% | 2.38 | 128.25 | 118.75 | 1.90 | 126.35 |
| Total | 15.73 | 6.59 | 126.35 |
Net of the management fee the fund compounds at 8.0 per cent a year, so 78.00 grows to 98.26 by the end of year 4 and still falls short of the mark. Year 5 crosses it, and only the 6.12 above 100.00 is charged: a fee of 1.22 rather than the 1.57 a full year of gains would carry. From year 6 the fund is back on the ordinary treadmill, paying a fifth of every net gain.
Run the same returns with the mark reset to the opening NAV every year, which is what an investor gets with no high-water mark, and the performance fee bites from year 2. It charges 1.25, 1.33, 1.41 and 1.50 in years 2 to 5, 5.49 in all, during the years the high-water mark fund charges nothing.
| Per unit | With mark | Without | Difference |
|---|---|---|---|
| Performance fees paid | 6.59 | 10.60 | 4.02 |
| Closing NAV, year 8 | 126.35 | 120.42 | 5.93 |
| Closing value of 10,000,000 | 12,635,070 | 12,041,650 | 593,420 |
The end-value gap, 5.93, is larger than the fees saved, 4.02, because the fees not paid in years 2 to 5 stay invested and compound. Discounted at an illustrative 8.0 per cent, the fee saving is worth 3.21 per unit today, or 320,606 on the holding: a real asset that appears on no statement.
| Loss in year 1 | 6% gross | 8% gross | 10% gross | 15% gross |
|---|---|---|---|---|
| −10% | 4 | 3 | 2 | 2 |
| −20% | 7 | 5 | 4 | 3 |
| −30% | 10 | 7 | 6 | 4 |
The management fee does most of the damage at low returns: at 6 per cent gross the fund only nets 4 per cent, and a 30 per cent loss leaves the manager without a performance fee for a decade. That is the economics behind the familiar pattern of funds closing after a deep drawdown. On an illustrative 500,000,000 fund, the manager still collects 7,800,000 a year of management fee at a NAV of 78, but the 8,000,000 a year of performance fee a 10 per cent gross year would earn from a fund at its mark is gone for four years.
If the manager winds the fund down and launches a new one with a fresh mark at the current NAV, an investor who follows pays a performance fee from the first year of recovery. On this path the relaunched vehicle ends at 120.42, exactly the no-high-water-mark outcome, and the original fund, had it carried on, would have ended 4.93 per cent higher: 593,420 more on the holding.
Treating the shortfall to the mark as the investor's only concern and assuming a new subscription buys into the free ride. In a fund that uses series accounting or equalisation, a subscriber who enters below the mark is charged on gains from its own entry price, so the 3.21 per unit of present value belongs to investors who were already in the fund when it fell. An allocator deciding whether to stay or redeem after a loss should count that value as a reason to stay; one deciding whether to add should not count it at all. The second error is computing the recovery on gross returns: 78.00 at 10 per cent gross reaches 103.8 in three years on paper, but four once the 2.0 per cent fee is charged.
After a loss, model the ledger rather than the percentage: the mark, the management fee on the way back and the year the performance fee returns. A 20 per cent loss at 2 and 20 means four fee-free years at 10 per cent gross, worth 4.02 per unit in fees and 5.93 in end value. Alternative Investments builds the same discipline around the return that actually reaches the investor; the free workbook for this case carries the book's own cash-flow engine, and the gross return a fund needs to deliver a net target is worked in what gross return a hedge fund needs to net 8 per cent.
No performance fee is charged until the NAV, after the management fee, climbs back above the previous peak, and then only on the gain above it. In the illustrative case a fund at 78.00 compounds at 8.0 per cent net and charges nothing for four years; in year five it charges 1.22 on the 6.12 above the mark, not 1.57 on the full year's gain.
Because the performance fee, usually the larger part of the manager's income, disappears for years. After a 30 per cent loss at 6 per cent gross, a 2 and 20 fund needs 10 years to regain its mark. A fresh fund with a new mark at today's NAV would earn fees immediately, which is why relaunches happen, and investors who follow pay for them: in the illustrative case they end 4.93 per cent below what the original fund would have delivered.
Not in a fund using series accounting or equalisation. A subscriber entering below the mark is charged a performance fee on gains from its own entry price. The free ride, worth 3.21 per unit in present value in the illustrative case, belongs to investors who held the fund through the loss, which is a reason to weigh it when deciding whether to redeem.
This article is one calculation from Alternative Investments. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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