What Happens to High Water Marks When Managers Restructure Hedge Funds?

In July 2009, in response to requests for $4.7 billion in redemptions in Cerberus Partners, L.P. and Cerberus International, Ltd., hedge and private equity fund manager Cerberus Capital Management, L.P. established a restructuring plan.  The plan offered investors the opportunity to move their assets into one of two new funds: Cerberus Partners II LP and Cerberus International II Ltd.  Both are expected to have lower fees than the older funds, but a longer, three-year lock-up.  Cerberus also indicated that it would create special purpose vehicles (SPVs) for investors in each of the older funds who do not elect to participate in the new funds; interests in the SPVs are not expected to be transferable.  Cerberus expects to charge investors who stay in the SPV a 0.5 percent annual management fee, and it has not yet announced a specific timeline for the liquidation of the SPVs.  Rather, Cerberus has indicated that it intends to sell the assets in the SPVs as expeditiously as practicable and that it will distribute liquidation proceeds when such proceeds become available.  This article focuses on a provision of the Cerberus restructuring plan that would allow investors in the old funds to carry their high water marks (HWMs) over into the new funds.  Specifically, for two years after the HWM is reached, Cerberus plans to waive 60 percent of its usual performance fee.  Cerberus has not stated what the “usual performance fee” is, except to indicate that it is less than the typical – or formerly typical – 20 percent.  More generally, in light of a significant volume of fund restructurings currently occurring and anticipated in the coming months, this article examines the rationale for and incentive effects of HWMs; the barriers preventing managers below high water marks from simply closing up shop and reopening in a different corporate form and potentially under a different brand; how managers under HWMs have been renegotiating performance fees; and the clout of institutional investors in negotiations with respect to carrying over old HWMs to new or restructured funds.

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