High-Water Mark vs Hurdle Rate Performance Fees

Specific advantage: Fees are only charged on new profits above the fund's previous peak value. This ensures managers are not paid for recovering losses. This matters for long-term investors in volatile markets (e.g., crypto hedge funds) who want to ensure performance fees are truly earned.

Specific advantage: Creates a powerful incentive for the manager to exceed the previous peak. This matters for funds recovering from drawdowns, as the manager must generate a full recovery plus additional gains before earning fees, aligning effort with investor returns.

Specific advantage: Fees are charged only on returns exceeding a predefined benchmark (e.g., 8% annual return or SOFR + 5%). This matters for institutional LPs and pension funds that have specific minimum return hurdles to meet their liabilities, ensuring the manager outperforms a passive alternative.

Specific advantage: Provides a clear, time-based performance target independent of historical peaks. This matters for funds in stable or low-volatility asset classes where a High-Water Mark may not reset for long periods, as it rewards managers for generating returns above a fair cost of capital.

Superior investor protection: Fees are only charged on new profits above the fund's previous peak NAV. This prevents managers from collecting fees for simply recovering past losses, a practice known as "clawback." This matters for risk-averse LPs in volatile strategies (e.g., crypto hedge funds) where drawdowns are common.

Manager incentive misalignment after losses: If a fund suffers a significant drawdown (e.g., -50%), the manager must recover all losses before earning fees again. This can create a "option value" problem where the manager may take excessive risk to get back to the high-water mark or lose motivation, potentially leading to fund closure. This is critical for long-term strategy viability.

Clear, performance-based incentive alignment: Managers earn fees only after exceeding a predefined benchmark (e.g., 8% annual return or SOFR + 5%). This directly ties compensation to outperforming a passive alternative, which matters for institutional allocators (e.g., pensions, endowments) who measure success against specific benchmarks.

Potential for fee collection without real alpha: A manager can collect performance fees for returns that merely match a bull market, not from genuine skill. For example, in a year where the S&P 500 returns 20%, a fund with a 5% hurdle that returns 21% collects fees on the 1% excess. This matters for investors seeking true active management and not beta-driven returns.

Investor Protection: Fees are only charged on net new profits, preventing managers from collecting fees on recovered losses. This is the industry standard for funds like Bridgewater Associates and is critical for institutional LPs who prioritize capital preservation.

Manager Disincentive After Drawdowns: If a fund falls below its high-water mark, the manager must recoup all losses before earning performance fees again. This can lead to excessive risk-taking to 'get back to even' or demotivation, potentially harming long-term strategy.

Performance Benchmark Alignment: Managers only earn fees on returns exceeding a predefined benchmark (e.g., 8% annual). This aligns incentives with absolute return strategies and is favored by endowments and pensions comparing managers to a risk-free rate or index.

Complexity and Potential for Gaming: Requires precise calculation of the hurdle (soft vs. hard) and compounding method. A soft hurdle can be gamed by making small gains just above the rate each period. Adds administrative overhead for funds like smaller crypto hedge funds.

Long-Only Equity or Discretionary Macro Funds where capital preservation is paramount and drawdowns are expected to be recovered. Choose this for institutional investor comfort and alignment with traditional finance standards.

Absolute Return or Quant Funds targeting specific alpha above a benchmark. Ideal for strategies comparing themselves to US Treasury yields or a market index. Often paired with a high-water mark in a 'hybrid model' for top-tier funds.