What does the term 'High Watermark' refer to in investment funds?

The term 'High Watermark' refers to the highest Net Asset Value (NAV) level that a fund has achieved during a previous performance period. This concept is significant in the context of performance fees, particularly in hedge funds and other investment vehicles that charge fees based on performance. A high watermark ensures that the fund manager only earns performance fees on gains above this threshold, which aligns the interests of the manager with those of the investors.

This mechanism serves to protect investors from paying performance fees on gains that merely recover losses from prior periods. For example, if a fund's NAV reaches its peak one year, then declines in the following year, the fund manager must exceed that peak NAV before they can charge any performance fees again. Thus, the focus on past high performance provides an incentive for the fund manager to deliver consistent, positive returns over time.