CFA Level IAlternative InvestmentsMedium
A hedge fund uses a high-water mark provision with a 20% incentive fee and no hurdle rate. The fund's NAV per share fell to $90 last year after previously peaking at $100 (the high-water mark). This year, before fees, NAV per share rises to $105. What is the incentive fee per share charged this year?
- A$2.00
- B$0.00
- C$3.00
- D$1.00
Show answer & explanationAnswer & explanation
Correct answer: D. $1.00
The high-water mark provision requires that incentive fees only be charged on gains above the previous peak NAV of $100. The gain above the high-water mark is $105 − $100 = $5. The incentive fee = 20% × $5 = $1.00 per share, even though the total gain from $90 to $105 was $15.
Why the other options are wrong
- A. Uses an incorrect base gain (e.g., $10) rather than the $5 gain above the true high-water mark.
- B. Incorrectly assumes no fee is due since NAV started the year below the high-water mark, ignoring that NAV exceeded it by year-end.
- C. Incorrectly calculates 20% fee based on the full $15 gain from $90 to $105.
High-Water Mark Provision
A high-water mark ensures a hedge fund manager only earns incentive fees on new profits that exceed the fund's previous highest NAV, preventing fees on recovered losses.
- Protects investors from paying twice for the same gains
- Fee only applies to NAV growth above the prior peak
- Common alongside incentive fees in hedge fund structures
Memory trick: No fee for climbing back to where you already were — only for new heights.