Hedge Fund Compensation

• The managers of a hedge fund are typically compensated with a so-called 20 and 2 payment structure. This means that the hedge fund receives an annual fee equivalent to 2 percent of the total holdings of the fund. In addition, it receives 20 percent of the increase in the value of the fund experienced over the previous year. This helps reward good performance by managers.
  
  

High Water Mark

• But what if a hedge fund has an extremely poor year followed by a very good year? To prevent being rewarded for inconsistent performance, many hedge funds set a high water mark, meaning that the baseline figure used to calculate their 20 percent cut of the profits is set at the highest value of the fund during a previous year. This way, this figure is not based on a low-performing year.
  
  

Example

• So, for example, if a fund was worth $40 billion one year and then rose to $50 billion the next, the managers would receive $2 billion --- a 20 percent cut on the increase. Let's say the fund dropped to $30 billion the next year and then rose back to $60 billion in the third year. During the second year, managers would receive nothing, and then, during the third year, managers would receive $2 billion again --- not $6 billion. This is because the high water mark for the fund was set at $50 billion, so the increase to $60 billion was not calculated from the $30 billion of the previous year.
  
  

Considerations

• Not all hedge funds use high water marks. In addition, some will not have high water marks that extend back more than a year or two. Also, some high water marks may be modified, in that the baseline figure will be equivalent to the average between a high water mark and a low performing year, to reflect the hedge funds performance in coming back from steep losses.