High-water mark and hurdle rate in hedge funds: worked examples in dollars

At the end of 2008, Ramius Multi-Strategy Fund Ltd had lost 26.76% net of management fees. Before its manager could earn another incentive fee from an investor who had been in for the whole loss, the fund had to gain 36.5% net of management fees. The prospectus that disclosed this figure also warned that investment staff paid on the same thresholds might leave.

The 36.5% threshold is the fund's high-water mark. A hurdle rate adds a second test: a minimum return for the period before any performance fee applies.

High-water mark

The highest value of an investor's capital, or of a share, on which the manager was last paid a performance fee. No new fee is due until the value is back above it.

Loss carryforward

The same idea kept as a running balance in a partnership's capital accounts: losses add to it, gains reduce it, and the manager is paid only once it is back to zero.

Hurdle rate

A minimum return for the period, fixed or tied to a cash rate or an index, that the fund must beat before a performance fee applies.

Crystallization

The date on which an accrued performance fee becomes final and is paid to the manager, typically the end of a quarter or a year, and the date of a redemption.

The 2 and 20 fee structure itself, and how it adds up in a single year, is covered in hedge fund fees explained.

A five-year high-water mark example in dollars

An investor puts 1 million dollars into a fund that charges a 20% performance fee, calculated and paid once a year, with a high-water mark. To keep the arithmetic readable, the management fee is left out. The fund's gross returns over five years are +20%, −25%, +25%, +15% and +5%.

In year 3 the fund gains 25%, or 217,500 dollars, and the manager earns nothing, because the whole gain rebuilds value lost in year 2. In year 4 the fee applies to the 90,625 dollars above the old peak of 1,160,000 dollars, and the fee paid then sets a new mark of 1,232,500 dollars.

Over five years the investor pays 70,450 dollars in performance fees and ends with a net gain of 281,800 dollars. The fees come to exactly 20% of the 352,250 dollars the account earned before fees.

Run the same returns with no high-water mark, where each year's gain is charged on its own. The manager collects 43,500 dollars in year 3, 31,320 dollars in year 4 and 11,692.80 dollars in year 5. Total fees reach 126,512.80 dollars, the investor's net gain falls to 216,051.20 dollars, and the fee takes 36.9% of the pre-fee profit.

The gain needed to recover a loss equals the loss divided by the capital left after it:

• a 20% loss needs a 25% gain
• the Ramius loss of 26.76% needed 36.5%
• a 50% loss needs a 100% gain

Loss carryforward accounts and partial redemptions

US hedge funds set up as limited partnerships or LLCs usually track the mark as a loss carryforward in each investor's capital account. The Graham Alternative Investment Fund, a macro fund that files with the SEC, is one example. At the end of each calendar quarter, Graham takes an incentive allocation of 20% of "New High Net Trading Profits", which are the quarter's net gains minus any carryforward loss. The carryforward grows with each quarterly loss, shrinks with each quarterly gain, and never goes below zero.

Redemptions change the balance. When an investor withdraws, the carryforward loss is reduced in the same proportion as the capital withdrawn, and an incentive allocation accrued on the redeemed units is paid on the redemption date. Take an account of 2 million dollars carrying a loss of 300,000 dollars. Redeeming 500,000 dollars, a quarter of the account, cuts the carryforward to 225,000 dollars. The manager no longer has to earn back the 75,000 dollars of loss attached to the money that left.

The fee can also be an allocation of profit to the general partner's capital account, which is how Graham structures it. Two thirds of the Cayman Islands funds launched in 2024 and the first three quarters of 2025 structured the incentive fee as an allocation.

Crystallization frequency: quarterly against annual

An accrued performance fee sits in the fund's net asset value as a liability until it crystallizes. After that it belongs to the manager, and a later loss does not bring it back. Graham crystallizes quarterly. The Pershing Square funds pay performance fees on crystallization events that include December 31 of each year and investor withdrawals, measured against a prior high-water mark.

Take a 10 million dollar fund with a 20% fee and quarterly gross returns of +10%, −10%, +12% and −2%.

• Quarterly crystallization. The first quarter's gain produces a 200,000 dollar fee that is paid and gone. After the second-quarter loss and the third-quarter gain, the fund is 86,400 dollars above the new mark and pays another 17,280 dollars. Total fees: 217,280 dollars. The investor ends the year with 10,651,738 dollars.
• Annual crystallization. The four quarters compound to +8.66% for the year, a gain of 866,240 dollars, and the single fee is 173,248 dollars. The investor ends with 10,692,992 dollars.

Same portfolio, same gross return, and the quarterly schedule costs the investor 41,254 dollars more, because the fee on the first quarter's peak was paid before the second quarter took part of that gain away.

European rules cap this effect for funds sold to retail investors. ESMA's guidelines on performance fees for UCITS and certain retail alternative funds say crystallization should not happen more than once a year, generally set the date at December 31 or the end of the fund's financial year, and require fees on redeemed shares to crystallize in proportion on the redemption date. The guidelines cover UCITS and alternative funds marketed to retail investors in the EU, which leaves out private hedge funds sold only to professional investors.

Investors who buy in at different prices: series and equalization

In a fund with a single share price, one performance fee calculation covers investors who bought at different prices. Suppose investor A buys at 100 dollars a share in January. By June the net asset value is 110 dollars, before any fee accrual, and investor B buys in. At the year end the price is 120 dollars.

Charged on the fund as a whole, the fee is 20% of the 20 dollar gain, 4 dollars a share, and it falls on every share alike. A pays 4 dollars on a 20 dollar gain. B pays 4 dollars on a 10 dollar gain, an effective rate of 40%. Reverse the story, with B buying after a fall below the mark, and B collects part of the recovery free of any fee, the "free ride" that equalization was designed to prevent. Funds fix this in one of two ways.

Series accounting. Each subscription date gets its own series of shares with its own high-water mark. B's June series pays 2 dollars on its own 10 dollar gain. At the end of the year, series that are above their marks are rolled up into the lead series, which keeps the number of series under control. Series that are still below their marks stay separate until they recover. Pershing Square International, for example, measures its performance fee on each series and class of shares.

Equalization. Everyone holds the same shares, and the adjustment is made investor by investor. A buyer who pays above the high-water mark pays an equalization credit on top of the price, equal to the fee rate times the gain since the mark. In the example, B pays 2 dollars a share, 20% of the 10 dollar gain from 100 to 110, and gets it back as extra shares if the price is still above the mark at a later crystallization date. A buyer who pays below the mark owes a depreciation deposit: the fee on the climb back up to the mark, paid to the manager once the price gets there.

Recent Cayman Islands launches mostly use series accounting. Only 5% of the Cayman funds launched in 2024 used equalization, and 3% of those launched in the first three quarters of 2025. The sample covers about a third of all Cayman open-ended funds.

Hard and soft hurdles at five return levels

A hurdle adds a return the fund must beat in the period before any fee applies, on top of recovering any loss below the mark. Take a 10 million dollar fund with a 6% annual hurdle and a 20% fee. Under a hard hurdle, the fee applies only to the return above 6%. Under a soft hurdle with a full catch-up, the manager takes all of the return between 6% and 7.5% until the fee equals 20% of the whole gain, and 20% of everything above that.

Between 6% and 7.5%, the investor under the soft hurdle keeps exactly 600,000 dollars whatever the fund earns, because every extra dollar goes to the manager. Above 7.5%, the gap between the two versions is fixed at 120,000 dollars, 20% of the 600,000 dollar hurdle amount.

Some documents write the soft hurdle without a catch-up, as a switch: once the hurdle is cleared, the fee applies to the whole gain. At a 6.5% return that fee is 130,000 dollars, and the investor keeps 520,000 dollars, a 5.2% net return, below the hurdle the fund just cleared.

A hurdle can also be cumulative or non-cumulative. A non-cumulative hurdle starts fresh each year, so a shortfall in one year is dropped the next. A cumulative hurdle carries the shortfall forward, the way a private equity preferred return keeps accruing until it is paid. Pershing Square's Tranche G interests carry a performance allocation of 30% above an annual 5% hard hurdle, non-cumulative, reduced by the investor's loss carryforward, next to Tranche A interests charged 20% with no hurdle. Setting 30% of the return above 5% equal to 20% of the whole return gives a break-even at a 15% gross return. Below 15% a year, Tranche G pays less than Tranche A. Above it, Tranche G pays more.

Hurdle rate benchmarks: fixed rates, cash rates and indexes

Hurdles are less common than high-water marks. Among Cayman Islands funds with an incentive fee, about 90% of those launched in 2024 and the first three quarters of 2025 had a high-water mark or loss carryforward. About 50% of the 2024 launches had a hurdle, and about 35% of the 2025 launches. The average hedge fund fee stood at an estimated 1.32% management fee and 15.78% incentive fee in the first quarter of 2026.

The benchmark behind a hurdle falls into one of three groups.

1. A fixed rate, such as Pershing Square's 5% or the 8% common in private equity. ESMA defines a hurdle rate as a predefined minimum fixed rate of return.
2. A cash rate, usually Treasury bill yields or SOFR, both of which move with the federal funds rate. The Federal Reserve set that rate at 0 to 0.25% in March 2020 and raised it to 5.25 to 5.50% in July 2023. At the March 2020 level, a hurdle pegged to that rate asked a manager for almost nothing. At the July 2023 level, it asked for more than 5% a year.
3. An index, where the fee is paid on performance relative to a market benchmark. For UCITS funds using this model, ESMA requires any underperformance against the benchmark to be made up before a fee is paid, over a reference period of at least five years.

US law shapes who can be charged these fees at all. The Advisers Act bars an adviser registered, or required to register, with the SEC from charging performance fees, with exceptions. One covers qualified clients under Rule 205-3, with at least 1.4 million dollars under the adviser's management or 2.7 million dollars of net worth since June 29, 2026. Funds limited to qualified purchasers under section 3(c)(7) fall outside the ban. For a mutual fund sold to the public, the route is a fulcrum fee, which under section 205(b)(2) of the Advisers Act must increase and decrease proportionately with the fund's performance against an index. A fulcrum fee falls when the fund lags its index, and a hedge fund's incentive fee only ever drops to zero.

What managers do when the fund is below its high-water mark

A manager below the mark lives on the management fee alone. That is the retention risk Ramius described in 2009, for investment professionals whose pay depended on performance above the mark. After the losses of 2008, investors were generally willing to negotiate new performance fee terms with managers whose funds were still below their marks.

Tiger Global's long/short equity fund fell more than 50% in 2022, gained 28.5% in 2023 and was up 10.7% through July 2024, and was still well short of its high-water mark. Those returns compound to at most 71% of the fund's end-2021 value, so a gain of more than 40% was still needed just to get back to that level. In June 2022 the firm cut the fund's management fee by half a point to 1% until December 2023. Across the industry, about a third of hedge funds were still below their high-water marks in mid-2024, including 45% of discretionary macro funds and 47% of systematic macro funds.

A manager below the mark has four options.

• Earn it back. Investors who stay pay no performance fee until the loss is recovered.
• Renegotiate. A modified high-water mark can amortize the loss over two or three years, so that some performance fee is earned during the recovery.
• Reset by contract. The offering documents can provide for a reset. Under ESMA's guidelines, a UCITS high-water mark that resets must look back over at least five years on a rolling basis, and fees can be charged only if the outperformance exceeds any underperformance in those five years.
• Close the fund. A new fund starts with its mark at the launch price, and investors who follow the manager across leave their carryforward behind. A record 1,471 hedge funds liquidated in 2008, more than 70% above the previous record of 848 set in 2005.

Across 5,917 hedge funds over 22 years, the aggregate effective incentive fee rate was about 50%, 2.5 times the contractual rate. Investors kept 36 cents of every dollar their capital earned above a risk-free rate, before any risk adjustment. Three things drive the gap: the one-way shape of the contract, investors moving money into funds after good years, and funds shutting down while under water, taking their unrecovered losses with them.

Valued as an option held by the manager, the performance fee is a claim on a significant share of investor wealth, and the high-water mark reduces that value. Managers raise volatility after poor results relative to their peers, and fund survival depends on absolute and relative performance, volatility and fund age, in data on hedge funds and commodity trading advisers. The tendency to add risk after losses is weaker when the incentive fee is tied to a high-water mark, when the fund faces little immediate risk of liquidation, and when the manager has substantial personal capital in the fund. With a mark that lasts indefinitely, even a risk-neutral manager has reason to hold a constant share in risky assets, because the option-like pay pushes toward extra risk mainly when the horizon is short.

Private equity hurdles: an 8% preferred return over the fund's life

In private equity the hurdle is called the preferred return, and it is measured differently. In a sample of 238 funds raised from 1992 to 2006, 93.1% of buyout funds and 47.6% of venture capital funds had a hurdle. The modal rate was 8%, used by about three quarters of the buyout funds with a hurdle, and most of those funds paired it with a 100% catch-up.

The 8% accrues on the cash investors have paid in. The ILPA Principles, the investor association's recommended terms, ask for it to run from the date capital is called, or from the date a credit line backed by uncalled commitments is drawn. Drawing on those subscription lines delays capital calls, which can lift a fund's reported IRR, and ILPA recommends keeping them outstanding for no more than 180 days and capped at about 20% of commitments. ILPA also recommends a hard hurdle, a whole-of-fund waterfall, and clawbacks repaid gross of tax within two years.

The wider comparison of the two fund types is in hedge fund vs private equity.

Fee terms to check in the offering documents

1. Is the high-water mark perpetual, or does it reset after a number of years or on a change of fund?
2. Is it tracked per investor, per series or per class, and does the fund use series accounting or equalization?
3. How often does the fee crystallize, and does a redemption crystallize it for the redeemed units?
4. Is the loss carryforward reduced in proportion on a partial redemption?
5. Is there a hurdle, is it hard or soft, is there a catch-up, and is it cumulative?
6. What is the hurdle measured against: a fixed rate, Treasury bills, SOFR or an index?
7. Is the performance fee charged before or after the management fee?

These questions sit alongside the wider checks in hedge fund due diligence. This article is general information, not investment advice.

Frequently asked questions

How does a high-water mark work in a hedge fund?

The high-water mark is the highest value on which the manager was last paid a performance fee. After a loss, the manager earns no performance fee until the investor's capital climbs back above that level, and the fee is then charged only on the gain above it. A 1 million dollar account that peaks at 1.16 million dollars, falls to 870,000 dollars and recovers to 1.0875 million dollars pays no performance fee on the 217,500 dollar recovery.

What is a hurdle rate in a hedge fund?

A hurdle rate is a minimum return the fund must earn in a period before a performance fee applies. It can be a fixed rate, such as the 5% annual hurdle on Pershing Square's Tranche G interests, a cash rate such as Treasury bill yields, or an index. About half of the Cayman Islands funds launched in 2024 that charged an incentive fee had a hurdle, against about 90% with a high-water mark.

What does an 8% hurdle rate mean?

It means investors keep the first 8% of return a year before the manager takes any share of profit. In private equity, the 8% preferred return accrues on the cash investors have paid in, from the date it is called until it is distributed, and it is usually followed by a catch-up that restores the manager's full 20% share once investors have received their 8%.

Can a hedge fund reset its high-water mark?

Only if the fund documents allow it or investors agree. Some funds use a mark that resets after a set period, and after the 2008 losses managers below their marks negotiated new fee terms with investors. For European UCITS funds, ESMA guidelines require a high-water mark with a reset to look back at least five years on a rolling basis. A manager can also close a fund and open a new one, whose mark starts at its launch price.

What happens to my high-water mark if I redeem part of my investment?

The loss still to be recovered shrinks in proportion to the capital withdrawn. In the Graham Alternative Investment Fund, for example, the carryforward loss is multiplied by the ratio of capital redeemed to capital held just before the redemption, so withdrawing a quarter of the account removes a quarter of the loss the manager must recover.