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.
High-Water Mark
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.
