High water mark reassessed

Managers need to reassess the applicability of the high water mark for hedge fund fees if markets enter a lengthy period of flat returns.

Dan Shapiro, head of the London office of hedge fund lawyers Schulte Roth & Zabel, said smaller equity portfolios may struggle to meet the costs of running a hedge fund business if stock markets remain flat and high water mark for fees are applied.

'The question becomes whether managers can stay in business and keep people on board if the high water mark applies to them,' said Shapiro.

A high water mark usually stipulates new investors can only have a performance fee levied on their holdings in the fund once the fund has achieved a certain level of performance following their initial investment. While the performance fee on single strategy funds is normally 20%, the annual management fee is around 1% to 2%.

'At the moment, there are only a handful of people going out of business because of the high water mark,' Shapiro said. 'But the best managers have started saying they will have a one or two-year high water mark.'

Michael Tannenbaum, senior partner at lawyers Tannenbaum Helpern Syracuse & Hirschtritt, said the high costs particularly of recruiting top staff and IT systems, will also add to the difficulties of smaller managers caused by the flat market.

'A manager coming to market with a $20m start-up and 1% management fee will find the revenue this generates will not be sufficient to meet the sorts of infrastructure they need,' he said.

Joe Press, a partner at Ernst & Young, said the burden of low fees and high costs was already hurting providers of some funds and structured products.

'The costs of building a back office, especially for a big operator, is phenomenal. For example, Long Term Capital Management was spending $40m pa on its technology alone at its peak. With these costs, and an extra 1.5% charge for putting out structured products, your end clients are doomed to a zero return.'

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