In the wake of the recent financial crisis, many hedge funds are still struggling to climb back to their "high water marks"-the prior highest point of profitability, or the prior highest net asset value ("NAV"), of a hedge fund. Some hedge fund firms have lost talented investment professionals, traders and portfolio managers along the way, as the prospect of future profits and a share of the incentive allocation or carried interest becomes too remote for some to wait out the downturn. The following summarizes different approaches to the traditional high water mark mechanism, some motivated by the current economic climate, and provides an analysis of each approach.

The Traditional High Water Mark

Assuming that a hedge fund is structured as a limited partnership, in the traditional high water mark regime, the general partner of the partnership is not entitled to an incentive allocation – typically a 20% share of net profits – until the fund has recovered prior losses and generated additional profits. Because investors are periodically subscribing for new interests and withdrawing existing interests, the high water mark is measured on an investor-byinvestor basis.1 The following example illustrates how the traditional high water mark mechanism works, in its simplest form.

Assume Investor X invests $1 million in Fund A on January 1, 2008. Further assume that, as of December 31, 2008, Investor X's capital account balance has declined in value to $700,000. Under these facts, Fund A's general partner is not entitled to any incentive allocation in respect of Investor X's investment until Investor X's capital account balance exceeds $1 million – the high water mark for Investor X's capital account as of December 31, 2008. If we further assume that Investor X's capital account balance increases to $1.2 million by December 31, 2009, Fund A's general partner then is entitled to 20% of the $200,000 that exceeds the $1 million high water mark. Therefore, as of January 1, 2010, the high water mark in respect of Investor X's capital account would now be $1.16 million (typically the new high water mark is measured net of the incentive allocation taken, $40,000 in this case, so that the fund does not have to earn back the amount deducted as incentive allocation).

Variations on a Theme

As the hedge fund market has matured and evolved over the last decade, so have the approaches to implementing the high water mark. The following outlines some of these approaches.

The Benchmark High Water Mark. Under this approach, an independent benchmarksuch as the performance of the S&P 500 Index-substitutes for the high water mark. Thus, the general partner is entitled to its incentive allocation in any given year only if the profits for that year in respect of an investor's capital account exceed that predetermined benchmark. This approach may be most appropriate where a fund's performance is strongly correlated with a particular market and a published index for such market exists. The following example illustrates how a benchmark high water mark might work.

Assume that Fund B invests primarily in U.S. municipal bonds. An appropriate benchmark might be the performance of the S&P Investortools Municipal Bond Index. Further, assume that Investor X invests $1 million in Fund B on January 1, 2008, and that, as of December 31, 2008, Investor X's capital account balance has declined in value to $700,000. Assuming that the weighted average value of the S&P Investortools Municipal Bond Index over 2008 was -40%, there are two possible ways to employ a benchmark high water mark mechanism based on that index.

On the one hand, Fund B's general partner could take an incentive allocation on the amount by which the returns of the fund exceeded the benchmark return. Under the facts described above, Investor X's capital account has decreased by 30%, but had Investor X made its investment in the securities comprising the S&P Investortools Municipal Bond Index, Investor X would have lost 40%. Therefore, in relative terms, Investor X's account compares favorably to the benchmark bond index and Fund B has "outperformed" the index. Fund B's general partner, however, may have difficulty paying itself an incentive allocation on the $100,000 of "profits" ($100,000 being the difference between $700,000, the actual value of Investor X's account, and $600,000, the value the account would have had had it been invested in the securities comprising the bond index). The underlying philosophy of this approach is that if the fund sponsor has targeted a return (the performance of the bond index) the sponsor should be rewarded for having exceeded the performance of that index.

On the other hand, Fund B's general partner may not take any incentive allocation. Although Fund B has outperformed the bond index, Investor X's capital account has lost value. The underlying philosophy of this approach is that the fund sponsor should not be rewarded unless it generates profits for its investors.

If Investor X's capital account increases to $1.2 million by the end of 2009, Fund B's general partner will have several choices over how the benchmark high water mechanism might work. Assuming that over the year 2009, the weighted average value of the bond index was 1%, there are four possibilities. First, Fund B's general partner could take an incentive allocation on $500,000, because Investor X's account has increased in value by $500,000 since the last year end (the excess of $1.2 million over $700,000). Also, $500,000 clearly exceeds a 1% return on the capital account balance as of the start of the year, which was $700,000 (1% of $700,000 being only $7,000). Second, Fund B's general partner could take an incentive allocation on $493,000, or $500,000 less a 1% return on the $700,000 capital account balance as of the beginning of the year. Under this approach, Fund B's general partner is entitled to a share of only those profits that exceed the benchmark. Third, Fund B's general partner could take an incentive allocation on $200,000. This approach combines the traditional high water mark feature and the benchmark and allows the general partner to a share of profits only if two conditions are satisfied: (x) the profits exceed the previous high water mark ($1 million) and (y) the profits exceed the benchmark for the year in which the incentive allocation is calculated ($7,000). Finally, Fund B's general partner could take an incentive allocation on $193,000. This assumes that the two conditions above under the third approach above are satisfied and that the general partner shares only in profits that actually exceed the benchmark return (again, $7,000).

If the S&P Investortools Municipal Bond Index's performance had been 1% in 2008, rather than -40%, one would face the additional decision as to whether the benchmark is cumulative or is applied only for the year in which the incentive allocation is taken. Thus, by tweaking our original factual assumptions and assuming that the bond index was 1% for 2008 and 1% for 2009, under the approach outlined in the last option above, the incentive allocation would be 20% of $183,000 (the excess of $200,000 over $10,000 (for 2008) and $7,000 (for 2009)) rather than $193,000 (the excess of $200,000 over $7,000 (for 2009) only).

In determining which benchmark is the best fit, a hedge fund sponsor must weigh the need to incentivize its investment professionals, traders and portfolio managers against a need to present an equitable economic deal to its investors and a proper alignment of investor interests with the general partner's interests.

Modified High Water Mark. Unlike the occasional dips that characterize relatively stable market activity, prolonged market downturns pose unique challenges to fund sponsors and investors. When a fund experiences significant losses, as many funds did from 2000 to 2002 and more recently during the financial crisis, fund sponsors may have difficulty retaining investment professionals, traders and portfolio managers who may look to a share of the incentive allocation as a significant part of their overall compensation.2 Under these circumstances, a fund could implement a modified high water mark mechanism that enables it to take a share of profits even when the fund is below its traditional high water mark. Under this approach, the general partner would benefit from a reduced high water mark on any profits generated while the fund is below its traditional high water mark until the fund has generated an amount of profits sufficiently in excess (usually by some multiple) of its traditional high water mark.

For example, assume Investor X invests $1 million in Fund C on January 1, 2008 and that, as of December 31, 2008, Investor X's capital account balance has declined in value to $700,000 (meaning Investor X has a loss recovery account balance of $300,000). Under these facts, Fund C's general partner is not entitled to any incentive allocation as of the year end 2008 because the Fund has generated only losses. Further assume that, as of December 31, 2009, Investor X's capital account balance has increased to $800,000. Now Fund C has generated $100,000 of new profits, although Investor X's account is still below its traditional high water mark ($1 million). On December 31, 2009, Fund C's general partner could be entitled to an incentive allocation of 10%, for example, on the new profits attributable to Investor X's account, but would not be entitled to take its full 20% profit share until new profits in respect of Investor X's account equals a certain multiple (say, 2.5x) of the losses that were sustained. Thus, If Investor X's capital account balance were to equal $1.2 million on December 21, 2010, Fund C's general partner would still only be entitled to a 10% share of the $400,000 in profits (the excess of $1.2 million over $800,000), even though Investor X's account is once again above its traditional high water mark. Under this approach, Fund C's general partner actually earns slightly less in aggregate incentive compensation. Because it is able to reap some modest profits over the period during which Fund C is below its traditional high water mark, however, it is better able to incentivize and reward its investment professionals, traders and portfolio managers. Furthermore, because Investor X would bear less incentive allocation over the long run, Investor X has an incentive to remain invested during this period and wait until Fund C has generated the full 2.5x of losses that were incurred.

Private Equity Style High Water Mark. More recently, a select minority of institutional investors have succeeded in negotiating certain private equity style protections to modify the traditional high water mark. Under this approach, a general partner clawback is grafted onto the high water mark mechanism such that if an investor's capital account balance remains below its traditional high water mark at the end of each defined period (e.g., successive threeyear periods), then the fund's general partner must refund any incentive allocation taken earlier within such period. This approach ensures that the fund's general partner receives no more than 20% of the profits over any period of time that is longer than one year. This clawback protection may be appropriate for a fund seeking to impose more restrictive liquidity terms on its investors.

Conclusion

Designing a high water mark that best fits a hedge fund involves consideration of numerous factors, including fund liquidity, the nature of the investor base, the correlation between the fund's strategy and the relevant market(s) for the asset classes in which the fund invests, and the need to provide appropriate incentives to investment professionals, traders and portfolio managers while ensuring appropriate alignment of the general partner's interests with those of the fund investors. Reaching the appropriate balance may involve a moving target that changes with market conditions and investor confidence generally.