Fund Accounting Interview Questions

High-Water Mark

What is a 'High-Water Mark?'

A high-water mark is the highest peak in value that an investment fund or account has reached. This
term is often used in the context of fund manager compensation, which is performance-based. The
high-water mark ensures the manager does not get paid large sums for poor performance. If the
manager loses money over a period, he must get the fund above the high-water mark before
receiving a performance bonus from the assets under management (AUM).

BREAKING DOWN 'High-Water Mark'

High-water marks ensure that investors do not have to pay performance fees for poor performance,
but more importantly, guarantee that investors do not pay performance-based fees twice for the
same amount of performance.

High-Water Mark in Practice

For example, assume an investor is invested in a hedge fund that charges a 20% performance fee,
which is quite typical in the industry. Assume the investor places $500,000 into the fund, and during
its first month, the fund earns a 15% return. Thus, the investor's original investment is worth
$575,000. The investor owes a 20% fee on this $75,000 gain, which equates to $15,000.

At this point, the high-water mark for this particular investor is $575,000, and the investor is
obligated to pay $15,000 to the portfolio manager.

Next, assume the fund loses 20% in the next month. The investor's account drops to a value of
$460,000. This is where the importance of the high-water mark is noted. A performance fee does not
have to be paid on any gains from $460,000 to $575,000, only after the high-water mark amount.
Assume in the third month, the fund unexpectedly earns a profit of 50%. In this unlikely case, the
value of the investor's account rises from $460,000 to $690,000. Without a high-water mark in place,
the investor owes the original $15,000 fee, plus 20% on the gain from $460,000 to $690,000, which
equates to 20% on a gain of $230,000, or an additional $46,000 in performance fees.

Value of a High-Water Mark

The high-water mark prevents this "double fee" from occurring. With a high-water mark in place, all
gains from $460,000 to $575,000 are disregarded. But gains above the high-water mark are subject
to the performance-based fee. In this example, beyond the original $15,000 performance-based fee,
this investor owes 20% on the gains from $575,000 to $690,000, which is an additional $23,000.

In total, with a high-water mark in place, the investor owes $38,000 in performance fees, which is
$690,000 less the original investment of $500,000 multiplied by 20%. Without a high-water mark in
place, which is below industry standards, the investor owes a 20% performance fee on all gains,
which equates to $61,000. The value of a high-water mark is unquestionable.

High-Water Marks and the "Free Ride" 

Several things can happen when an investor enters a fund during a period of underperformance. For
instance, at Goldman Sachs Asset Management, an investor who buys into the fund at a net asset
value (NAV) below the high-water mark will enjoy the upside from the subscription NAV to the high-
water mark without paying a fee. This situation is known as a "free ride." It allows new investors to
benefit from buying into an underperforming fund without penalizing existing investors. Other funds
may avoid the "free ride" by charging a performance fee for any positive performance.
Performance Fee
What is a 'Performance Fee'
A performance fee is a payment made to an investment manager for generating positive returns.
This is as opposed to a management fee, which is charged without regard to returns. A performance
fee can be calculated many ways. Most common is as a percentage of investment profits, often both
realized and unrealized. It is largely a feature of the hedge fund industry, where performance fees
have made many hedge fund managers among the wealthiest people in the world.

What is a 'Management Fee?'

A management fee is a charge levied by an investment manager for managing an investment fund.
The management fee is intended to compensate the managers for their time and expertise for
selecting stocks and managing the portfolio. It can also include other items such as investor relations
(IR) expenses and the administration costs of the fund.

BREAKING DOWN 'Management Fee'

The management fee is the cost of having your assets professionally managed. The fee compensates
professional money managers to select securities for a fund’s portfolio and manage it based on the
fund’s investment objective. Management fee structures vary from fund to fund, but they are
typically based on a percentage of assets under management (AUM). For example, a mutual fund's
management fee could be stated as 0.5% of assets under management.

The Hurdle rate and high water mark are two types of benchmarks that hedge funds can set as
requirements for collecting incentive or performance fees from investors.

A high water mark is the highest value that an investment fund or account has ever reached. A
hurdle rate is the minimum amount of profit or returns a hedge fund must earn before it can charge
an incentive fee.

For instance, a fund might set up a 5% hurdle rate, allowing it to collect incentive fees only during
periods when returns are higher than this amount. If the same fund also has a high water mark, it
cannot collect an incentive fee unless the fund's value is above the high water mark and returns are
above the hurdle rate. Difference between Hurdle Rate and High Water Mark

What is 'Investor Relations - IR'

An investor relation (IR) is a department present in most medium-to-large public companies that
provides investors with an accurate account of company affairs. This helps private and institutional
investors make informed buy or sell decisions. A company's IR department also serves as a bridge for
providing market intelligence to internal corporate management.

BREAKING DOWN 'Investor Relations - IR'

Investor relations ensures that a company's publicly traded stock is being fairly traded through the
dissemination of key information that allows investors to determine whether a company is a good
investment for their needs. IR departments are sub-departments of public relations (PR)
departments and work to communicate with investors, shareholders, government organizations and
the overall financial community.

The Function of IR Departments

IR teams are typically tasked with coordinating shareholder meetings and press conferences,
releasing financial data, leading financial analyst briefings, publishing reports to the SEC and handling
the public side of any financial crisis. Unlike other parts of PR-driven departments, IR departments
are required to be tightly integrated with a company's accounting department, legal department and
executive management team (CEO, COO, CFO).

In addition, IR departments have to be aware of the changing regulatory requirements, and advise
the company on what can and cannot be done from a PR perspective. For example, IR departments
have to lead companies in quiet periods, where it is illegal to discuss certain aspects of a company
and its performance.

The Need for IR Departments

The Sarbanes-Oxley Act, also known as the Public Company Accounting Reform and Investor
Protection Act, was passed in 2002, increasing reporting requirements for publicly traded
companies. This expanded the need for public companies to have internal departments dedicated to
investor relations, reporting compliance and the accurate dissemination of financial information.

Companies normally start building out their IR departments before going public. During this pre-
initial public offering (IPO) phase, IR departments can help establish corporate governance, conduct
internal financial audits and start communicating with potential IPO investors.

For example, when a company goes on an IPO road show, it is common for some institutional
investors to become interested in the company as an investment vehicle. Once interested,
institutional investors require detailed information about the company, both qualitative and
quantitative. To obtain this information, the company's IR department is called upon to provide a
description of its products and services, financial statements, financial statistics and an overview of
the company's organizational structure.

The largest need, however, is an IR department's interactions with investment analysts who provide
public opinion on the company as an investment opportunity. These opinions influence the overall
investment community, and it is the IR department's job to manage these analysts' expectations.

Crystallization -

The crystallization frequency is the point in time when the fund manager updates the high-water
mark and is paid the incentive fee. The crystallization frequency divers from the accrual schedule,
which is the schedule used to calculate and charge the fee to the fund's profit and loss account.
Whereas the process of fee accrual does not impact investor returns, the same is not true for the fee
crystallization. As the incentive fee crystallization frequency increases, the expected total fee load
charged by the hedge fund manager increases as well.
Corporate Action