Melvin's High-Water Mark

The discussion on Melvin Capital’s plan to reset its high-water mark seems to be fairly one-sided and missing the nuance on a tricky subject. High-water marks there for the protection of hedge fund LPs, so it’s not surprising that any hint of loosening them is uncomfortable; but shutting down that negotiation completely is a good way to encourage worse outcomes.

High-water marks are there to prevent a hedge fund from earning performance fees twice on the same increase in fund value. A simplified example would be a fund which charges 0 and 20, a 0% management fee and a 20% carry, or performance fee. In a given period, if the fund increases its NAV1 from $100 to $200, a $100 increase; it is entitled to 20% of that performance, or ‘$20’. Should the NAV drop back to $100, the fund can not charge performance fees again until it reaches its highest ever value from before, $2002 also known as its high-water mark.

The traditional hedge fund fee structure is 2 and 20, a 2% management fee it always earns, and a 20% management fee it only earns when it is above its high-water mark. This may seem obvious, but 20 is a lot more than 2! That 20% is a hell of an incentive, while most of that 2% probably goes to keeping the lights on3. Melvin Capital was discussing resetting its high-water mark lower such that it could earn performance fees again despite being below its high-water mark; effectively double-dipping on the same increase in NAV.

This was a fairly positive sign! Resetting the high-water mark lower to allow getting back to business more or less normally is an indication of not doing any of the following:

  1. Calling Vegas, putting the entire value of the fund on red and then either celebrating clearing the high-water mark, or proceeding to step two.

  2. Shutting down Melvin Capital, touring Europe for a year on bicycle, then launching a brand-new hedge fund called Nelvin Capital which is not currently below its high-water mark. 4

One of the hardest things in investing is cutting a loser5. When you are down, there is a pretty good chance that volatility in whatever you owned that got you to this point is pretty high. Even if the story has moved against you, the incentive to hold on and hope that volatility swings prices in your favor is immense. Melvin seems to have done the right thing early on during its meme-mageddon, taking the pain to cut risk, knowing full well that they were crystallizing losses that would leave them below their high-water mark.

To my knowledge, most of Melvin’s AUM6 has not been locked in since before meme-mageddon, it’s there because investors chose to keep it there. And in that context, talking about resetting a high-water mark seems like talking about prudent risk management, not anything fucking wacky.

  1. Details details, etc etc, not relevant for this example. ↩︎

  2. Yes, the LP had $180, not $200, but again, not the point at the minute. ↩︎

  3. To be fair, that 2% is still a comically high number, and the source of a disproportionately high share of all fees collected. The average management fee has been below 2% for some time now. ↩︎

  4. This may require being cute about whom the principals of the new fund are, but it would almost certainly be fine. If the story about the old performance was decent, new investors would be found despite knowing about Nelvin’s questionable heritage. ↩︎

  5. My favorite Buffett-ism on the subject: “You don’t have to make it back the same way you lost it.” ↩︎

  6. Most of your AUM is very different from most of your investors, of course. I am being a bit cavalier in ignoring this distinction. ↩︎

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