High-Water Marks and Hedge Fund Management Contracts

Abstract

Incentive or performance fees for money managers are frequently accompanied by high-water mark provisions which condition the payment of the performance fee upon exceeding the maximum achieved share value. In this paper, we show that hedge fund performance fees are valuable to money managers, and conversely represent a claim on a significant proportion of investor wealth. The high-water mark provisions in these contracts limit the value of the performance fees. We provide a closed-form solution to the high-water mark contract under certain conditions. This solution shows that managers have an incentive to take risks. Our results provide a framework for valuation of a hedge fund management company. We conjecture that the existence of high-water mark compensation is due to decreasing returns to scale in the industry. Empirical evidence on the relationship between fund return and net money flows into and out of funds suggests that successful managers, and large fund managers are less willing to take new money than small fund managers.