High water mark with hurdle rate - How to calculate?

[Herkshire]

Hi guys,
First post here, glad to join the rank and file.
Would anyone be able to provide color on the following question?
ASSUMPTIONS:
1 - a hurdle rate of 5% compounded
2 - subject to a high water mark
3 - performance fee of 20% of outperformance
YEAR 1:
The fund starts with NAV of $100.
At the end of year 1 the funds NAV is $120, i.e. 20% return.
Therefore, performance fee is equal to 20% * $15 = $3.
NAV after performance is now $117.
YEAR 2:
At the end of year 2 the funds NAV is equal to $120, i.e. Returned 2.5%.
QUESTIONS:
1 - At the end of year 1, is the high water mark $117 or $120?
2 - Can any outperformance fee be charged at the end of year 2 given that the fund has beaten the hurdle rate (on a cumulative basis)? Or is the hurdle set at 1.05 * highwater mark?
3 - And, for bonus kudos, would anyone care to explain the logic behind this?
Thanks in advance,
Herkshire

 

[chad.sandstedt]

Welcome to AF!
1 - $117 since the fee is being deducted from NAV. The manager is only managing $117 in the second year so that should be the basis for the calculation. If it was paid outside of NAV, you would use $120.
2 - There would not be a fee for year 2 since the new hurdle is $122.85.
3 - The highwater mark is designed to prevent double dipping on fees. Since you did not mention a clawback I’m assuming the manager does not have to re-pay any fees for under-performance in year 2. For example, if the manager loses 50% in year 3 they have been paid a fee even through the performance is well below the hurdle.

 

[Herkshire]

chad.sandstedt wrote:
3 - The highwater mark is designed to prevent double dipping on fees. Since you did not mention a clawback I’m assuming the manager does not have to re-pay any fees for under-performance in year 2. For example, if the manager loses 50% in year 3 they have been paid a fee even through the performance is well below the hurdle.

Thanks for the info and the welcome Chad, most appreciated!
Is a claback provision relatively standard these days?