High-Water Marks and Hedge Fund Compensation

Abstract

We examine the role of high-water mark provisions in hedge fund compensation contracts. In our model of competitive markets and asymmetric information on manager ability, a fee contract with a high-water mark can improve the quality of the manager pool entering the market. In addition, a high-water mark contract can reduce inefficient liquidation by raising after-fee returns following poor performance. Consistent with our model's predictions, we find that high-water marks are more commonly used by less reputable managers, funds that restrict investor redemptions, and funds with greater underlying asset illiquidity. High-water marks are also associated with greater sensitivity of investor flows to past performance, but less so following poor performance. Overall, our results suggest that compensation contracts in hedge funds help alleviate inefficiencies created by asymmetric information.

Keywords: Hedge Fund, High-Water Mark, Adverse Selection, Illiquidity, Lockup.

JEL Classification: G2, D8, G1.