Modified High Water Mark Provisions May Reduce Risk and Enable Hedge Fund Managers to Retain Talent (Part One of Two)

Following a market downturn or period of bad performance, traditional high water mark provisions – which prevent hedge fund managers from receiving incentive or performance fees until prior losses are recouped – can result in additional pressure on hedge fund managers, even after those managers have begun to turn fund performance around.  Managers may not be able to subsist entirely on management fees and may risk losing key investment personnel without incentive compensation.  To alleviate some of this financial pressure, certain managers may consider using modified high water mark provisions, allowing them to receive lower amounts of incentive compensation during periods when the fund remains below the high water mark.  Seward & Kissel’s 2014 New Hedge Fund Study noted that all of the funds analyzed included some type of high water mark, and 7.4% of funds in the study included a modified high water mark.  See “Seward & Kissel New Hedge Fund Study Identifies Trends in Investment Strategies, Fees, Liquidity Terms, Fund Structures and Strategic Capital Arrangements,” Hedge Fund Law Report, Vol. 8, No. 9 (Mar 5, 2015).  This article, the first in a two-part series, analyzes elements of modified high water mark provisions and explores the benefits of such modified high water marks.  The second article will discuss the industry prevalence of and investor reception to modified high water marks and examine issues that hedge fund managers should consider before implementing a modified high water mark.

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