Bridger Pennington explains how hedge funds use high watermarks to prevent managers from charging performance fees twice on the same gains. With a 2% management fee and 20% performance fee, a high watermark locks in the peak value a fund reaches, so managers only earn carried interest on new profits above that mark.
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Hey, hey, welcome back to the show where we talk all things funds and finance. Today we're gonna talk about what is a high watermark, how to use them in a hedge fund, and why you want to have them as an investor. So let's go down to the iPad of truth and justice to see what we got here. So now this traditionally is for hedge funds. This doesn't happen as often in closed-ended real estate funds or closed-ended venture capital funds, but in hedge funds specifically, this happens quite a bit. Now most hedge funds typically charge 2 different types of fees. Number one is you have management fees, Typically around 2%. This is typically 2% of the capital in the fund, not total AUM and debt, just the capital raised from you in the fund. Typically charged at a quarterly rate. So 0.5% every quarter gets taken out and given to managers to keep the lights on, to keep the whole fund afloat. The next type of fee charged to a fund manager is a performance fee. Now this is what us as fund managers are all going after. And some of you guys know I've ran 3 funds now. We've trained and coached students that have run hundreds of funds in the hundreds of millions, even billion-dollar realm. It's pretty cool what we do here at Invest Fund Secrets. Pretty fun. And Everybody in all of our communities, everybody, we all are trying to go after this, right? Big performance fees. Now in a typical fund, you can have a hurdle rate or a pref or a catch-up, all that kind of stuff. We're gonna keep it simple for today. Typically you see an 80/20 split. 80% to the investor and my 20% cutoff there, 20% to the manager, okay? So if you ever heard the term 2 and 20, that means 2% management fee and 20%, this is called carried interest or a performance fee based on how well the fund performs. Now let's go down to this beautiful graph that I drew with my own two hands here. So let's say we started our investment at $50,000 with a particular fund, okay? And they're gonna do a 2 and 20 model. Now let's say this investment year 1 or term 1 did very, very well. We had an awesome time. We got all the way up to $150,000. Let's say the next year we went down to $100 grand and then we went back up to $200,000, okay? And my graph is way off, but you guys get the point, okay? You get what I'm going for here. This is kind of what we got. Purpose for again a high watermark is so that fund managers don't collect fees two or three times based on different time periods. So for example, this first growth right here—an investor. Let's just keep the numbers simple. We're going to split eighty twenty on this growth for performance fees. Okay, man, we did really well. And hey, oh shoot, crap! We had a bad little time. We're down. So we're going to take just zero. Zero fees are charged because there was no performance to. There was no performance. Okay, we only collected our management fees. What we've done is set a high watermark. Right here. We don't want investors, because this next year it starts to grow, we don't want investors to be charged again for that amount of money. Does that make sense? Because they already were charged that money here. From here to here, they were already billed an 80/20 split for that performance. Now by this term, they hit that performance again. The fund manager, because of a high watermark, don't make any performance fees until again they get above that high watermark. And at this point they do. They can get above that high watermark. Everything from here to here would then again Split from 80/20. So if you look at it from a long-term perspective, let me zoom out a little bit. From term 1 here all the way to here, the split ended up being a fair 80/20 like we all agreed upon. It wasn't 80/20, then down, then 80/20 again. Double— it's like getting double taxed. No one likes that. Now a good question to ask is, Bridger, how long does this happen for? Does this ever reset? Again, you're the fund manager. You can determine what you'd like to do, but typically what we've seen is that this does not reset. You don't reset your high watermark. It is for the length of your hedge fund. And again, these are measures put in place to protect investors from being double taxed or double feed, any way you like to put it. If you want to learn more on how to start a hedge fund, you can click some of the videos above. We have videos on how to start a hedge fund, how to start a private equity fund, and we're throwing a bunch of live events. So if you guys want to come to one of our live events called Fund Launch Live, click link below. Tickets are still available. We'll see you guys there. Bye.
