In yesterday's entry here, I made what may have seemed to some a quite cryptic observation about "high water marks."
To review, I said that the use of a 20%-of-gain element in the fee structure of hedge funds makes an issue out of the high-water mark, but that I would discuss this at another day.
The underlying idea is this. A hedge fund manager takes as his compensation 20% of the increase in fund value over the last recorded maximum.
Suppose a fund was worth $3 million at the end of year 1. Then it had a bad second year, and ended that annum worth only $2.5 million. No performance fee for them, of course (they have to content themselves with their share of the AUM.) In the third year, they do somewhat better, and get the value of the whole back to $3 million.
In their heart of hearts, the managers would surely like to say that they grew their fund by $500,000 in year 3, so they are entitled to 20% of that, or $100,000. But they can't. By standard contract terms, the profit is measured against the previous high water mark. so here it is ... zero ... at the end of year three.
Good luck with a better year four guys.
Here is an academic discussion from 2007.