# Fund Calculation - NAV - High WaterMark

Hey Guys,

I have a scenario here, would be great if anyone could explain me this.

Fund Investment [Jan’16] - \$100,000

Management Fee / Perf. Fee - 2 / 20

Hurdle Rate - 5% i.e [100,000 * 0.05 = \$5,000]

So, say at the end of the year, Fund NAV is \$104,000 after Management Fee and Admin Fee but before Performance Fee. Since the Investment Manager was not able to beat the hurdle, he cannot charge any Performance Fee. Now, in the new year, Jan’18, will the fund NAV will be locked at the new watermark of \$104,000 or the NAV will remain at past lock of \$100,000?

My Thought is the manager didn’t charge any performance fee for 2016 as the returns didnt beat the hurdle, however, he made a gain of 4% on the portfolio, hence that should be the new point of calculating the management fee and performance return and hurdle. What’s the correct way?

Not sure if this is covered in the curriculum bu the real world hurdle rates are usually calculated based on each year’s return (in excess of the high water mark). So in your example, for the fund to get an incentive allocation in year 2, NAV would have to end the year >\$104,000*1.05

Thanks Arbguy,

But think of this, actually, the manager didn’t earn any performance on this. So, in this case, since no performance fee was charged, the manager can keep the fund running with \$100,000 Base Net Asset Value and once he actually charges, say if in Year 2, end of year, the fund is at \$107,000, so the manager charges on the excess \$2,000 and now the new watermark becomes \$107,000 as the fund should not allow the manager to charge the performance twice on the same return, hence the new watermarking at 107,000. right?

107 end of year two is less than 5% annually (assuming year 1 and 2 are both below 5%), so HWM is at 107 and no performance fees paid. Whether NAV is before or after management fees depends on the investment management agreement.

Thanks MoonBorne. Just a thought, if the manager was not able to charge the performance fee in year 1, so the NAV was assumed to be rolling to year 2 at 100K HWM and in Year 2, the investment manager was able to beat the benchmark by 2,000 [return is 107,000 - 105,000(Min. Hurdle)]. Usually, fund admins, calculate the performance fee and min. hurdle as a cumulative month on month and end of year, they see if Return > Hurdle, Pf paid on difference and then the new HWM is set to the ending NAV.

I editted my previous reply from cumulatively to annually. The hurdle rate is effectively an IRR, which means at termination of the fund if annualized return is less than hurdle, no fees should’ve been paid (clawback provision). Fees only start when annualized return exceeds the 5%, for example returns are 3%, 5%, 8%, which triggers more than 5% on an annualized basis end of year 3 (5,3% annualized). A catch-up mechanism will typically start where you pay the 0.3% excess for the 3 years at once.

The HWM should be NAV prior to performance fees paid since the fees will reduce NAV and the manager should not be paid for two times the same performance.

What I’m describing here is more related to private equity than to hedge funds though.

To be honest these structures are also much more common in for private equity and real estate where you wouldn’t be calculating performance fees until the end of the investment (and hurdle rate would be an IRR calculation, the nuances of which (pre or post mgmt fees and expenses etc) would be explicitly laid on in the offering document).

Exactly, found alot in private equity, closed-ended RE and Infrastructure funds.

So lets this scenario,

Year 1 end:

Ending NAV - \$104,000

HWM - \$100,000 Since the manager was not to charge any performance fee.

Year 2 end:

Ending NAV - \$104,200 [The funds only was able to earn the \$200 profit for the whole year ignoring Admin and Management Fee]

HWM still on \$100,000. The return was not able to beat the watermark of \$5,000 and hence HWM sticks to \$100,000 for Year 3 as The HWM should be NAV prior to performance fees paid since the fees.

Year 3 end:

Ending NAV - \$105,200 [The funds was able to earn \$1,000 for the year ignoring Admin and Management Fee]

Return > Hurdle of 5%

Performance Fee Calculated on excess \$200. New HWM is \$105,200. This is what you meant that the HWM should be NAV prior to performance fees paid since the fees. Now here, the performance fee was paid before \$105,200, and hence the new HWM

Honestly there’s no right or wrong answer. In a HF format, where incentive fees are charged each year, all of these nuances would be addressed in the offering document and would be subject to negotiation.