High Water Mark Provisions

Definition

A High-Water Mark Provision is a clause establishing a peak value or threshold, primarily used within Investment Management fee structures and Syndicated Loan agreements. It sets a benchmark (the “high-water mark”) that must be surpassed before certain consequences are triggered, such as the payment of Performance Fees to fund managers or adjustments to loan terms like Interest Rates or Covenants.

In Investment Management (Performance Fees)

Definition & Purpose

• In the context of Investment Management (e.g., Hedge Funds, Private Equity), this provision ensures managers only earn Performance Fees on new profits that increase the fund’s Net Asset Value (NAV) above its highest previous value for which fees were paid.
• Purpose:
  • Aligns Interests: Connects manager compensation directly to generating net new gains for investors.
  • Prevents Double Dipping: Avoids charging fees on gains that merely recover prior losses.

How it Works

1. Initial High-Water Mark: Set at the initial investment NAV or the NAV after the last performance fee payment.
2. Performance Fee Trigger: Fees are only earned on profits that push the NAV above the current high-water mark.
3. Loss Periods: If the NAV drops below the high-water mark, no performance fees are earned until the NAV recovers and surpasses that previous peak.
4. New High-Water Mark: Once fees are paid on new profits, the high-water mark is reset to the new, higher NAV level.

Key Aspects & Benefits for Investors

• Investor Protection: Investors don’t pay performance fees while the fund is recovering losses.
• Long-Term Focus: Motivates managers towards sustainable growth rather than volatile short-term gains.
• Considerations:
  • Can potentially incentivize excessive risk-taking if a manager is far below the mark.
  • Terms may include reset periods or variations (“soft” high-water marks).

Example

• Year 1: Invest $1M->NAV$1.1M. Profit $100k.Feepaid.HWMsetat$1.1M.
• Year 2: NAV drops to $1.05M.Loss.Nofee.HWMremains$1.1M.
• Year 3: NAV rises to $1.08M.Gain,butstillbelowHWM.Nofee.HWMremains$1.1M.
• Year 4: NAV rises to $1.15M.GainaboveHWM=$50k ($1.15M-$1.1M). Fee paid on $50k.NewHWMsetat$1.15M.

In Syndicated Loans (Loan Terms)

Definition & Purpose

• In a Syndicated Loan context, this provision sets specific thresholds (high-water marks) for financial metrics (like Leverage Ratio), loan utilization, or borrower actions.
• Purpose:
  • Risk Management: Protects lenders by adjusting terms if borrower risk increases (e.g., higher leverage).
  • Incentivizes Performance: Encourages borrowers to maintain strong financials to secure better loan terms (e.g., lower Interest Rates).
  • Aligns Interests: Links loan conditions dynamically to the borrower’s financial health, aligning lender and borrower goals.

Common Applications

• Performance-Based Pricing: Interest Rate margins adjust based on metrics like the Debt-to-EBITDA Leverage Ratio. Exceeding a high-water mark ratio triggers a higher margin.
• Utilization Fees: Additional fees may apply if the drawn amount on a credit facility exceeds a certain percentage (the high-water mark) of the total commitment.
• Financial Covenants: High-water marks define maximum allowable levels for key ratios. Breaching these can trigger default clauses or require corrective action.
• Debt Incurrence Limits: Caps the total amount of debt a borrower can take on.

Example

• Loan Term: Interest Rate = Base + 2.0% if Leverage Ratio ≤ 2.5x (HWM 1); Base + 2.5% if Ratio > 2.5x and ≤ 3.5x (HWM 2); Base + 3.0% if Ratio > 3.5x.
• Scenario: Borrower’s leverage ratio increases from 2.0x to 3.0x.
• Consequence: The interest rate margin increases from 2.0% to 2.5% because the 2.5x high-water mark was exceeded.

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See also: Investment Management, Performance Fees, Net Asset Value (NAV), Hedge Funds, Private Equity, Syndicated Loan, Loan Agreement, Interest Rate, Covenants, Leverage Ratio, EBITDA, Risk Management, Financial Covenants, Fund Accounting