High Watermark and Hurdle Rate

If you are evaluating a performance-based portfolio management fee, two technical terms are among the key factors in assessing  whether the structure is well-designed and aligned with your interests:

the high watermark and the hurdle rate. They sound bureaucratic, but their absence — or weak implementation — has been the source of significant  disputes between investors and managers. This article explains exactly what each term means, how they work in combination, where the common traps lie, and what to verify in your management agreement before you sign. The objective is not theory; it is to leave you better prepared to ask precise questions when discussing fees with any portfolio manager.

IMPORTANT DISCLAIMER. This article is provided for general information and educational purposes only. It does not constitute investment advice, a personal recommendation, an offer or a solicitation to buy or sell any financial instrument, or to enter into any investment service. Nothing in this article should be relied upon as a forecast, projection, or guarantee of future results. Investing in financial instruments involves risk, including the risk of losing part or all of the capital invested. Past performance is not a reliable indicator of future results, and any figures or examples shown elsewhere on this website are historical and do not represent any guarantee of comparable outcomes in the future. Skanestas Investments Limited is regulated by the Cyprus Securities and Exchange Commission (CySEC) under licence number CIF251/14. Independent professional advice should be sought as needed. Any reference to specific products or services is for illustrative purposes; suitability is determined through the regulatory suitability assessment carried out during onboarding.

 

What Is a Hurdle Rate?

A hurdle rate is the minimum return a portfolio must achieve in a given measurement period before the manager becomes entitled to a performance fee. It is, in effect, a threshold: profits below the hurdle do not generate a performance fee; profits above the hurdle do. The economic logic is straightforward — capital deployed into a managed portfolio is designed to  at least clear the return an investor could obtain from a low-risk alternative before the manager earns a share of incremental gains.

The level at which a hurdle is set varies by firm and by strategy. Common forms include an absolute percentage (for example, 4% or 5% per year), a benchmark-linked rate (for example, EURIBOR plus a spread), or a hurdle indexed to the strategy’s reference benchmark. There is no single correct level. What matters is that the hurdle is meaningful — a 0.5% hurdle in a normal-rate environment offers little protection, while a 4% hurdle reflects the expectation that the strategy must clear an  alternative-cost-of-capital threshold.

Hard Hurdle vs. Soft Hurdle

Two structurally different hurdle types are in common use, and the distinction matters.

Hard Hurdle

Under a hard hurdle, the performance fee is calculated only on the portion of profit that exceeds the hurdle. If the hurdle is 4% and the portfolio returns 10%, the performance fee applies to the 6% above the hurdle. The first 4% is reserved entirely for the investor. This structure results in a lower performance fee for the investor compared to a soft hurdle.

Soft Hurdle

Under a soft hurdle, once the portfolio clears the hurdle, the performance fee is calculated on the entire profit, including the part below the hurdle. If the hurdle is 4% and the portfolio returns 10%, the performance fee applies to the full 10%. The hurdle functions as a trigger rather than a deduction. This structure results in a higher performance fee for the investor compared to a hard hurdle.

Marketing materials sometimes refer simply to a ‘hurdle rate’ without specifying which type. Always confirm the design in writing. The two structures can produce materially different outcomes for the investor over time.

What Is a High Watermark?

A high watermark records the highest portfolio value at which performance fees have previously been charged. After a drawdown, the firm cannot earn additional performance fees until the portfolio has recovered above that prior peak. The principle is simple: the firm does not earn fees on the same dollar of profit twice — first when the portfolio rose to the peak, and again when it recovers from a subsequent loss.

Consider a portfolio worth EUR 1,000,000 that rises to EUR 1,200,000. A performance fee is charged on the EUR 200,000 of profit, and the high watermark is set at EUR 1,200,000. The portfolio then falls to EUR 1,050,000. There is no performance fee in this period because the portfolio is below the watermark. The portfolio recovers to EUR 1,180,000 — still below the watermark, so still no performance fee. Only when the portfolio exceeds EUR 1,200,000 does the firm again become entitled to a performance fee, and only on the increment above the watermark.

Without a high watermark, the firm could charge a performance fee on the rebound from EUR 1,050,000 to EUR 1,180,000, even though the investor has not generated any new profit  relative to where they were when the prior fee was paid. The high watermark addresses this by preventing fees from being charged on the recovery of prior losses.

How They Work Together

Hurdle rate and high watermark are complementary, not redundant. The hurdle rate ensures that the firm only earns when the portfolio has actually outperformed a meaningful threshold within a measurement period. The high watermark ensures that the firm does not earn on profits that simply restore prior peaks across measurement periods. Together they form  the structural foundation of a well-designed  performance fee.

A worked example illustrates the combined effect. Assume a hurdle of 4% per year and a high watermark, with a 25% performance fee on profits above the hurdle.

Year 1: Portfolio starts at EUR 1,000,000 and ends at EUR 1,150,000 (15% gross). Profit above hurdle: 11%, equal to EUR 110,000. Performance fee: 25% × EUR 110,000 = EUR 27,500. New high watermark: EUR 1,122,500 (after fee). Investor net: 12.25%.

Year 2: Portfolio falls from EUR 1,122,500 to EUR 1,000,000 (-10.9%). No performance fee — portfolio below watermark and below hurdle for the period. Investor experiences the loss; the firm earns nothing.

Year 3: Portfolio recovers from EUR 1,000,000 to EUR 1,200,000. Recovery to high watermark of EUR 1,122,500: no performance fee (this is recovery, not new profit relative to prior fee-charging point). Profit above watermark: EUR 1,200,000 – EUR 1,122,500 = EUR 77,500. The hurdle for year 3 is 4% on the period start, so 4% × EUR 1,000,000 = EUR 40,000. Profit above both hurdle and watermark: EUR 77,500 – EUR 40,000 = EUR 37,500. Performance fee: 25% × EUR 37,500 = EUR 9,375. Note that fee accounting can vary in detail across firms; this example illustrates the principle, and the exact methodology is set out in the management agreement.

The combined effect is that the firm earns only on net profits above the hurdle  threshold, that have not previously been subject to a performance fee. . The investor pays a performance fee on outperformance above the hurdle, not on volatility or recovery of prior losses.

Common Pitfalls

Resetting the High Watermark After a Drawdown

Some agreements include provisions to reset the high watermark after a defined period of underperformance — sometimes after one year, sometimes after two. Resetting significantly reduces  the protection of the high watermark and may allow the firm to earn fees on the recovery of prior losses. This is a clause to identify and discuss explicitly during contract review.

No Watermark on New Capital Contributions

When an investor adds new capital to an existing managed account, the watermark calculation must be adjusted carefully. If the watermark is simply increased by the contribution amount without proper accounting, the firm can earn fees on returns that the new capital has not yet generated. Firms should use proper net contribution and high-watermark adjustment methodologies; the methodology should be documented and confirmed during the onboarding.

Calculating the Hurdle on the Wrong Base

The hurdle is typically calculated on the period-start net asset value of the portfolio, with appropriate adjustments for capital flows. Some agreements calculate the hurdle on a rolling average or on a notional reference value that does not reflect actual capital deployed. These variations can produce meaningful differences in the fee outcome.

Crystallisation Frequency

Performance fees are ‘crystallised’ — that is, definitively charged — at specified intervals, typically annually or quarterly. More frequent crystallisation reduces the protective effect of the high watermark, because the firm captures fees on each interim peak rather than waiting for sustained outperformance. Annual crystallisation is generally considered more investor-protective for volatile strategies.

What to Verify in Your Management Agreement

Before signing any portfolio management agreement that includes a performance fee,  ensure the following are explicitly addressed in the agreement itself.

First, what is the exact hurdle rate, and is it hard or soft? Is it absolute or benchmark-linked? Is it calculated on the period-start NAV?

Second, is there a high watermark, and how is it calculated? Is it perpetual, or does it reset after a specified period? How is it adjusted for capital contributions and withdrawals?

Third, when is the performance fee crystallised — annually, quarterly, or on another schedule? Annual crystallisation is generally more investor-favourable for volatile strategies.

Fourth, what other costs apply on top of the performance fee? Execution fees, custody fees, third-party costs, and FX conversion charges all reduce net returns. The total cost of ownership provides the most complete basis for comparison across firms.

Fifth, how are these fees disclosed on an ongoing basis? Under MiFID II, firms must provide standardised ex-ante and ex-post cost disclosures. Confirm you will receive these and review them when they arrive.

How Skanestas Implements These Concepts

Skanestas operates a profit-sharing model that incorporates both a hurdle rate and a high watermark.. The performance fee is scaled — under 4% profit, no performance fee; on profits between 4% and 30%, a 25% performance fee; on the portion above 30%, a 50% performance fee. A high watermark applies, as documented in the Company’s management agreement and other disclosures. Crystallisation frequency, calculation methodology, and execution fees are documented in the firm’s disclosures and the management agreement. This is one example of how the principles in this article translate into a specific contract; investors should review their own agreement carefully and ask questions until every term is clear.

FAQ

Is a 4% hurdle rate standard?

There is no industry-wide standard. Common ranges are 3% to 6% on absolute hurdles. The appropriate level depends on the strategy, the prevailing risk-free rate, and the structure (hard vs soft).

Can I negotiate hurdle rate or high watermark terms?

Sometimes. Negotiation is more common for larger accounts and professional clients than for retail mandates with standardised terms. Even where the rate is fixed, the methodology details often remain a legitimate subject of clarification.

What happens to the high watermark if I withdraw funds?

The watermark is typically adjusted proportionally for withdrawals, in the same way it is adjusted for contributions. The methodology should be specified in the management agreement.

Are these terms required by EU regulation?

Hurdle rates and high watermarks are not specifically mandated by MiFID II, but the principles of fair, clear, and not misleading fee structures, and the obligation to act in clients’ best interests, are consistent with structures that incorporate these features. . ESMA and national regulators have issued guidance encouraging alignment of incentives.

Conclusion

A performance fee with a hard hurdle and a perpetual high watermark is designed to align with the manager’s compensation with the investor’s actual outcomes. . A performance fee without these features may create compensation structures that are less directly tied to the investor’s actual outcomes.. Whether you ultimately choose a flat-fee or performance-based structure, understanding exactly what  term in your management agreement means, how it is calculated, and what edge cases it covers will place you in a better position to make an informed decision. Ask. Verify. Read the agreement before you sign.

 

About this article: This material is published for general informational purposes by Skanestas Investments Limited, a Cyprus Investment Firm authorised and regulated by the Cyprus Securities and Exchange Commission under licence CIF251/14. The content reflects general industry practice and the firm’s documented service framework as of the date of publication and may be updated without notice. The article does not establish a client relationship and does not replace the formal suitability assessment, investment declaration, and management agreement that govern any portfolio management or brokerage relationship with the firm. Risk warning: Investing carries risk and the value of investments may rise or fall. You may receive back less than the amount invested. Please review the firm’s Risk Disclosure Statement and other regulatory documents before engaging with any service.