Chris MihosA high-water mark is one of the simplest promises a manager makes, and one of the easiest to get wrong once real holders start coming and going.
A high-water mark is the rule that a manager only earns a performance fee on new gains, meaning gains above the highest value a holder’s capital has previously reached, so that nobody pays twice for the same performance. The idea is simple, but applying it correctly is not, because holders join and leave at different times and at different NAVs, which means each of them can have a different high-water mark at any moment. Getting this wrong, even unintentionally, can mean overcharging some holders and undercharging others, and it can amount to a breach of the manager’s obligations regardless of intent. The most reliable approach is to track the high-water mark for each holder and to enforce it with logic that applies the same rules to everyone, every time.
Why one fund can have many high-water marks
Imagine a fund that rises from 100 to 120 in its first year, falls to 105, and then recovers to 125. A holder who joined at the start has a high-water mark of 120 and should pay a performance fee only on the move from 120 to 125. A holder who joined when the fund was at 105 has never paid a fee at all, so they should pay on the whole move from 105 to 125. If the fund applies a single high-water mark to everyone, one of those holders is charged the wrong amount.
This is why funds use methods such as series accounting, which issues a separate series of shares for each subscription period so that each one carries its own high-water mark, or equalisation, which adjusts each holder’s position so that fees reflect their own entry point. Both methods work, but both add complexity, and they become harder to manage by hand as the number of holders, share classes and dealing dates grows.
Crystallisation adds another layer. A fund might calculate performance fees monthly, quarterly or annually, and the high-water mark only resets when a fee crystallises. Partial redemptions, losses carried forward and changes to share classes all have to be handled consistently, and each one is another place where a spreadsheet can quietly go wrong.
The cost of getting it wrong
The regulatory position is uncomfortable for managers who rely on manual calculations. US commentators have pointed out that inadvertently using the wrong formula, or the wrong inputs, when calculating fees can still violate the Investment Advisers Act, because the relevant provisions don’t require any intent to overcharge. The SEC has also pursued cases where high-water marks were deliberately sidestepped. In 2016 it brought an action against Hope Advisers, alleging that the firm arranged trades to lock in gains at the end of one month and losses at the start of the next, so that it could collect performance fees without first making up previous losses.
Beyond the regulatory risk, there’s the relationship risk. A holder who discovers they’ve been charged a performance fee on gains they’d already paid for, or who simply can’t reconcile their own statement, is unlikely to remain a holder for long, and operational due diligence teams ask detailed questions about fee methodology precisely because these errors are so common.
Enforcing the rule in code
The strongest answer is to make the high-water mark something that’s enforced rather than calculated after the fact. When each holder’s high-water mark is recorded from the moment they allocate, and the fee logic that applies it is written into the infrastructure, the same rules apply to every holder automatically, and nobody has to remember which series or which equalisation adjustment applies to whom. It also gives allocators something they can check, because the logic is consistent and the history of each holder’s high-water mark is visible.
This doesn’t change who decides the fee terms. The high-water mark, the performance fee rate and the crystallisation period remain the manager’s choices, set out in the strategy’s terms. What changes is that, once set, they’re applied exactly as written.
How MakeBanc handles high-water marks
On MakeBanc, high-water marks and performance fees are attributes of each manager’s strategy, set by the manager and enforced by smart contract logic for every holder individually. Each holder’s position is tracked from the point they allocate, so fees reflect their own entry and their own history. The fee terms belong to the manager rather than to MakeBanc, and allocators can see exactly how they’re applied before they commit.
Frequently asked questions
What is a high-water mark? A high-water mark is the highest value a holder’s capital has reached on which a performance fee has been charged. Under a high-water mark, the manager only earns a performance fee on gains above that level, so holders don’t pay twice for the same performance.
How does a high-water mark work when holders join at different times? Each holder can have a different high-water mark depending on when they joined and what fees they’ve already paid. Funds handle this through methods such as series accounting or equalisation, or by tracking each holder’s high-water mark individually and applying fee logic to each one.
Can incorrect fee calculations breach regulations? Yes. In the US, using the wrong formula or inputs to calculate fees can violate the Investment Advisers Act even without any intent to overcharge, and the SEC has brought cases where high-water marks were circumvented to collect fees.
Sources
- Hedge Fund Law Report, Fund managers may be liable for incorrect fee calculations, regardless of intent
- US SEC, Press release 2016-98: SEC charges hedge fund adviser with circumventing fee structure, 2016
- US SEC, Litigation release: Hope Advisers, LLC and Karen Bruton, 2016
MakeBanc is a technology platform that provides infrastructure to independent asset managers and connects them with investors. MakeBanc does not provide investment advice, custody services or banking services. Fee terms, including high-water marks, are set by each strategy operator and are not MakeBanc’s fees. The example above is illustrative.