High-Water Marks and Hedge Fund Management Contracts

41 Pages Posted: 8 Feb 1998  

William N. Goetzmann

Yale School of Management - International Center for Finance; National Bureau of Economic Research (NBER)

Jonathan E. Ingersoll Jr.

Yale School of Management - International Center for Finance

Stephen A. Ross

Massachusetts Institute of Technology (MIT) - Sloan School of Management; Yale University - International Center for Finance

Multiple version iconThere are 2 versions of this paper

Date Written: April 18, 2001

Abstract

Incentive or performance fees for money managers are frequently accompanied by high-water mark provisions which condition the payment of the performance fee upon exceeding the maximum achieved share value. In this paper, we show that hedge fund performance fees are valuable to money managers, and conversely represent a claim on a significant proportion of investor wealth. The high-water mark provisions in these contracts limit the value of the performance fees. We provide a closed-form solution to the high-water mark contract under certain conditions. This solution shows that managers have an incentive to take risks. Our results provide a framework for valuation of a hedge fund management company.

We conjecture that the existence of high-water mark compensation is due to decreasing returns to scale in the industry. Empirical evidence on the relationship between fund return and net money flows into and out of funds suggests that successful managers, and large fund managers are less willing to take new money than small fund managers.

JEL Classification: G2

Suggested Citation

Goetzmann, William N. and Ingersoll, Jonathan E. and Ross, Stephen A., High-Water Marks and Hedge Fund Management Contracts (April 18, 2001). Yale ICF Working Paper No. 00-34. Available at SSRN: https://ssrn.com/abstract=57933 or http://dx.doi.org/10.2139/ssrn.57933

William N. Goetzmann (Contact Author)

Yale School of Management - International Center for Finance ( email )

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National Bureau of Economic Research (NBER)

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Jonathan E. Ingersoll Jr.

Yale School of Management - International Center for Finance ( email )

135 Prospect Street
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New Haven, CT 06520-8200
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203-432-5924 (Phone)
203-432-6974 (Fax)

Stephen A. Ross

Yale University - International Center for Finance

Box 208200
New Haven, CT 06520-8200
United States

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

77 Massachusetts Ave.
E62-416
Cambridge, MA 02142
United States
203-432-6015 (Phone)
203-432-8931 (Fax)

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