High-Water Mark

A fund that makes 20% in year one, loses 5% in year two and makes 11% in year three has not made 26%. But if the manager is paid an incentive fee on each year in isolation, the manager is paid on year one and again on year three, and is never asked to give anything back for year two.

The high-water mark stops that. It is a ratchet: the highest net asset value the fund has ever ended a year at. Until the fund gets back above that mark, the manager earns nothing on the recovery, because the recovery is not a gain — it is the repair of a loss the investors have already borne.

The high-water mark is the highest NAV net of operating expenses, transaction expenses and management fees achieved by the AIF at the end of a year. If the NAV has only ever fallen since inception, the high-water mark is taken as the initial subscription price of the units.

It does not work alone. For Category I and Category II AIFs the incentive fee is computed on the excess of NAV (pre-incentives) over the higher of two thresholds:

• the high-water mark — have we recovered past our own best?
• the Reference Hurdle NAV — have we beaten the return the investors were promised?

If the excess is negative, no incentive fee is payable at all. In practice the high-water mark is applied at the point the manager exits a portfolio company, under a deal-by-deal distribution waterfall.

The mark is also a diagnostic. A high-water mark that keeps rising above its previous level denotes superior performance and is a good indicator for future estimated returns. A high-water mark that has not moved in years is telling you the opposite.

Applicable NAV not eligible for incentives
        = higher of ( High-water mark , Reference Hurdle NAV )

Incentive fee = Incentive rate × [ NAV (pre-incentives) − Applicable NAV ]
                if positive; otherwise nil

Reference Hurdle NAV, year n
        = Reference Hurdle NAV, year n−1 × (1 + hurdle rate)      ← compounds

Fund ABC, a Category I AIF: committed capital Rs 50 crore fully called, 5,00,000 units at Rs 1,000, tenure 5 years, management fee 1.50% of gross asset value plus 18% GST, set-up cost Rs 1.25 crore amortised over five years (Rs 25 lakh a year), yearly fund expenses Rs 30 lakh, hurdle 10%, incentive fee 15%.

Worst case — the fund drifts.

Year 1's high-water mark is the initial subscription amount, Rs 50 crore. By Year 2 it has ratcheted to Rs 53,47,65,000 — Year 1's NAV — and the Year 2 NAV of Rs 52,49,42,000 is below it. Even with no hurdle in the contract, the manager would earn nothing.

Best case — the fund performs. Gross asset value Rs 58 crore then Rs 65 crore:

• Year 1: NAV (pre-incentives) Rs 56,42,34,000; applicable NAV Rs 55 crore (the hurdle wins); excess Rs 1,42,34,000; fee at 15% = Rs 21,35,100.
• Year 2: NAV (pre-incentives) Rs 63,29,95,000; high-water mark Rs 56,42,34,000, Reference Hurdle NAV Rs 60,50,00,000; the hurdle is higher, so it is the threshold; excess Rs 2,79,95,000; fee at 15% = Rs 41,99,250.

Two years of incentive fee: Rs 63,34,350 against nil. Same fund, same manager, same fee terms — the whole difference is on which side of the thresholds the NAV landed.

Chapter 6 (Fee Structure of Alternative Investment Funds), section 6.3 — and the chapter names "Concepts of High Watermark and Catch-up" as one of its two stated learning objectives, so it is guaranteed territory. The worked illustration is Example 6.4.

Expect a table-completion question: you are handed gross asset value, the fee rates and the hurdle, and asked for the incentive fee. The step candidates get wrong is picking the threshold — it is the higher of the high-water mark and the Reference Hurdle NAV, never the lower and never just one of them.

• The high-water mark never falls. After a loss year it stays where it was; it only moves when a new high is set.
• Year 1's mark is the initial subscription price — but only because the NAV has not yet exceeded it. It is the highest-ever NAV rule, applied at the start.
• It is not an alternative to the hurdle. You take the higher of the two. A fund can clear its high-water mark comfortably and still pay no incentive fee because the compounding hurdle is above it — which is exactly what happens in Year 2 of the best case above.
• The mark is struck net of operating expenses, transaction expenses and management fees, but before incentive fees. Deduct in that order.
• High-water mark is not clawback. The high-water mark prevents a fee being paid; clawback recovers a fee already paid when later deals lose money. One is a gate, the other is a refund.
• The Reference Hurdle NAV compounds: Rs 50 crore × 1.10 then Rs 55 crore × 1.10, not Rs 50 crore plus 10% of Rs 50 crore each year.
• Be aware the workbook's own commentary on the worst-case solution says the NAV is "higher than the High-Water Mark, but lower than the Reference Hurdle", while its table and its conclusion both show the Year 2 NAV below the mark. The table is the one to trust.