Perverse incentive of high water marks

Performance fees are typically only paid on increases in a fund's net asset value over the previous high water mark (the highest net asset value to date). At first glance, this aligns incentives because it prevents fund managers from charging performance fees on the same gains more than once.

But, if a fund suffers a significant drawdown during a performance period, managers are incentivized to take extra risk in the hopes of passing the current high water mark to earn their additional performance fees or to to shut down the fund and raise a new one.

Both of these outcomes are bad for their investors. Taking extra risk to try to pass the current high water mark changes the nature of the investment. And if the manager shuts down the fund, the investors' assets are at risk during the wind-down.

More reading: Hedge Fund Law Blog