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Investment Basics: High-Water Mark

The theory says that the High-Water Mark is the highest peak in value that an investment fund or account has reached. This term is often used in the context of fund manager compensation, which is performance-based. Theory also says that it is a mechanism that protects investors by ensuring that the fund manager doesn’t receive the performance fee if the performance is poor. But how does it really work, why is it important for investment funds, and how is it different from other tools and mechanisms? In this article, we will explore the High-Water Mark and how you can benefit from it if you are an investor and, more importantly, if you are a fund manager or promoter.

Working with emerging fund managers, I have always found it useful to explain the High-Water Mark by imagining that you have a big jar where you keep your favorite cookies, and someone (let’s call them your “Cookie Manager”) is helping you collect more cookies. You agree that if they do a really good job and add lots of cookies to your jar, they can take a small share of the extra cookies they helped you earn as a reward.

Now, here’s the important part: you don’t want your Cookie Manager to take rewards if your jar has fewer cookies than it did before. That’s where the “high-water mark” comes in.

The High-Water Mark is like drawing a line on your jar at the highest number of cookies you’ve ever had. The Cookie Manager can only take their reward when they add more cookies and the number goes higher than that line.

The High-Water Mark is a cornerstone for an investment fund as it protects its investors and ensures fairness in performance-based fees or interest. Every investment fund is like a cookie jar, a platform that pools investors’ cookies in order to receive potential profits or gains (more cookies) from the performance of its investment strategy. As such, it requires investors to commit a determined amount of cookies to the jar.

Investors will normally feel more comfortable investing in funds that have a well-structured High-Water Mark. This gives them the guarantee that the Cookie Manager will not take their cookies unless they have beaten the High-Water Mark and brought more cookies into the jar.

In most cases, both the Cookie Manager and the investment fund benefit from a well-structured High-Water Mark. Happy investors normally commit more cookies to the jar, which can improve the fund’s health. In turn, the Cookie Manager may earn substantially higher fees. But that’s a story for another article.


How Does the High-Water Mark Work?

To understand how the High-Water Mark works, we should first break down how a performance-based fee or interest works in standard investment funds.

Performance fees are a way fund managers are rewarded for their efforts in growing the value of an investment fund. These fees are typically calculated as a percentage of the profits generated above a certain threshold.

For example, if the Cookie Manager agrees to a performance fee of 20% of the profits and your cookie jar grows from 10 cookies to 20 cookies, the manager would get 20% of the 10-cookie gain (that’s 2 cookies).

However, without safeguards like the High-Water Mark, a manager could still receive performance fees even if the fund’s overall performance was poor over time. That’s why the High-Water Mark is critical, it ensures managers only earn fees for generating real value by exceeding the fund’s previous highest value.

The High-Water Mark normally works in three phases:

  1. At first, you invest 10 cookies in the cookie jar (the investment fund). The Cookie Manager works hard, and now you have 20 cookies. The High-Water Mark is 20, and the Cookie Manager gets its reward.
  2. But then, something happens, and you lose some cookies. Maybe the investment manager of the fund ate some (costs and expenses) or dropped them (the market didn’t perform as forecasted), and now you have 15 cookies. The High-Water Mark stays at 20.
  3. Later, the Cookie Manager brings more cookies, and you go up to 25 cookies. Now, the High-Water Mark moves up to 25, and the Cookie Manager can get another reward.

In short, the High-Water Mark makes sure the Cookie Manager only gets rewarded for making your cookie jar grow bigger than it’s ever been before!


What Happens When Investors Join at Different Times?

Imagine your investment fund or cookie jar has already been through some ups and downs. The jar once had 20 cookies but now holds 15. A new investor decides to join the fund at this point. To make sure things are fair, adjustments are made so the new investor doesn’t unfairly benefit from simply bringing the jar back up to its old High-Water Mark of 20 cookies, which existing investors already experienced.

These adjustments might involve giving the new investor an Equalization Credit, a way of accounting for the fact that they’re starting with fewer cookies in the jar. This ensures that if the Cookie Manager earns a reward for adding cookies, it’s only for real growth beyond the High-Water Mark, and everyone gets their fair share of cookies (and rewards).

While this topic can get a bit technical, the takeaway is simple: it ensures that everyone who invests their cookies into the jar is treated fairly, whether they’ve been there from the start or just joined.


Common Misunderstandings

The High-Water Mark is often confused with other fee structures, like hurdle rates or flat management fees, but they serve very different purposes. A hurdle rate, for example, sets a minimum performance threshold that the fund must achieve before the manager earns any performance fees. A hurdle rate might say, ‘The Cookie Manager must add at least 5 cookies before they can claim their share,’ even if the jar hasn’t reached the High-Water Mark.

Another common mix-up is assuming the High-Water Mark is a substitute for the fund’s overall fee structure. In reality, the High-Water Mark works alongside other fees, such as annual management fees, which are typically charged as a percentage of the fund’s assets, regardless of performance. These fees are more like a “flat rate” for the Cookie Manager’s general services, whether or not your jar is overflowing with cookies.

Lastly, some people might think the High-Water Mark is just about deciding when the Cookie Manager gets their share of cookies. While that’s its main job, it’s also a great way to make sure the Cookie Manager stays focused on bringing in more cookies for everyone. It keeps things fair, helps build trust, and makes sure everyone’s working together to fill the jar to the brim!


Conclusion

Whether you’re an investor adding cookies to the jar or a Cookie Manager working hard to grow it, understanding the High-Water Mark is essential. For investors, it’s a safeguard that ensures you’re only sharing cookies when there are more in the jar than ever before, protecting your investment and rewarding real performance. For fund managers, it’s a tool that builds trust, keeps investors happy, and aligns everyone’s goals toward filling the jar as much as possible.

Understanding the High-Water Mark fosters better communication and trust between investors and fund managers, ensuring that both parties are aligned in their expectations and incentives.

By taking the time to grasp this concept, both sides can work together more effectively, creating a partnership built on fairness and shared success. After all, a well-understood High-Water Mark means more cookies for everyone!

If you’re a promoter, director, investment manager, or general partner of a Cayman fund wondering how you can structure your fund, don’t hesitate to reach out to your legal counsel at Vale Law. At Vale Law, we’re here to help you make sure your cookie jar is airtight, fair, and brimming with potential!

Shelley Do Valeshelley.vale@valelaw.ky

Santiago Mtnez-Carvajalsc@valelaw.ky