High Water Mark & Hedge Fund Bonuses

Posted by jeff

Mon Sep 22nd, 2008 09:26 AM

high%20water%20mark.jpg The hedge fund format is a great business model. You collect a 1-2% fee on the money under management ostensibly to pay for office expenses. Although when you're running a billion dollars or more.....you can do the math. Then you collect 20% of the profits generated each year, your so-called performance fee or carried interest (in venture and private equity parlance). Most funds require that partners keep the bulk of their net worth in the fund at start-up (although, like anything else, exceptions are made) and a substantial amount of the annual performance fee is also required to be re-invested in the fund. This is to make sure partners have skin in the game and maintain it there. Believe me, when things go wrong it hurts. A neighbor of mine was partner of Amaranth and when their natural gas trading position took down the whole firm a couple of years ago, he lost the majority of his net worth. From what I know he had nothing to do with the energy team.

But there is a wrinkle that most hedge funds have in their charters that those who are not close to the business may not be aware of. It's called the high water mark. If a hedge fund loses money in any year, a fund that has a high water mark policy (and I would say that the majority do) must earn back the money they lost....or get back to their high water valuation mark....before they can start earning their performance fee. In the vast majority of cases this performance would be measured after the 1-2% management fee. Interestingly, the math is against the losing hedge fund manager. If you are running a $200 million fund and it falls 12.5%, your assets go down to $175 million, but to get back to your high water mark of $200 million you have to make 14.3%. Oh, and that's before adding back your 1 - 2% management fee....OUCH! In the past, many hedge funds that lost over 15% would close their doors, because the managers would potentially have to work sans performance fees for a couple of years to get back to the high water mark. I know the world's smallest violin is playing, but check out these statistics. Apparently it's a symphony.

According to the Wall Street Journal this morning, as of July 31, just 10% of hedge funds were receiving performance fees from their funds. Translated, this means the funds are under water and in fact according to the survey of 4,000 funds by Eurekahedge quoted in the article, 82% to 90% of funds were below their high water mark, depending on strategy. Frankly, with markets being insanely volatile and prior winning strategies like being long commodities and short financials being turned on their heads, it is unlikely that performance has gotten much better since.

The money that hedge fund workers take home as bonuses does matter to the New York City economy and frankly it's hard to say how many live within their generous salaries, or depend on bonus payments to pay for "essentials." Like anywhere else, people grow into their incomes, whether they are totally predictable or not. Hedge fund bonuses have undoubtedly had a big impact on the high-end New York City real estate market. That positive impact is sure to be on the wane until those high water marks are made back.

From the Blogosphere

Exposing the Hedge Fund Industry's Soft White Underbelly

Hedge Fund Performance Poor in August

Not All Hedge Funds Will Suffer

Add a comment

12 comments

CAPTCHA Image