For a first-time hedge fund manager, there can be many confusing terms relating to the fund’s operations. This article is intended to shed some light on these terms and their underlying concepts.

General Partner: The entity that has overall responsibility for the fund’s operations.

Limited Partners: The investors that invest in the fund.

Investment Manager: The entity that is responsible for selecting and executing on the fund’s investments. In most cases, the Investment Manager is the General Partner. The Investment Manager is often referred to as the fund manager.

Management Fee: The fee charged by the fund manager for managing the fund, expressed as an annual percentage fee (for instance, 2% of the fund’s assets under management). The management fee is paid to the fund manager regardless of the fund’s performance.

Performance Fee: The percentage of the fund’s gains paid to the fund manager, expressed as a percentage of the fund’s realized and unrealized gains (for instance, 20% of all gains, calculated and allocated on an annual basis). This is calculated on an investor-by-investor basis, to account for the fact that investors are admitted to the fund at different times.

High water mark: The level to which a fund’s performance must reach before the fund manager is entitled to a performance fee. It is most relevant when the fund experiences a decline after experiencing gains. For instance, assume a fund with 10 investors at $1 million apiece, with all investors having invested on the first day of its operation (this is an unrealistic assumption, since investors come and go in funds, but it is necessary for purposes of this example). Assume further that the fund experiences a gain of 10% in its first month of operation (both realized and unrealized gains), so that each investor’s interest in the fund is now worth $1.1 million. Consequently, the fund manager is entitled to a 20% performance fee (we are also assuming that the performance fee is allocated on a monthly basis; some funds only do so on a quarterly or annual basis). After this profitable month, let’s say the fund experiences investment losses of 5%, so that each investor’s interest is now worth $1,045,000. Is the fund manager entitled to another performance fee? After all, each investor’s interest in the fund is worth more now ($1,045,000) than it was when it initially invested ($1,000,000). The answer is no, because of the high water mark. The fund manager will not be able to charge a performance fee until each investor’s interest in the fund surpasses $1.1 million.

Hurdle rate: The minimum level of return that an investor must earn in the fund before the fund manager is entitled to a performance fee. For instance, a fund may provide that each investor must make an annual rate of return of 8% before the fund manager is entitled to any performance fee. This is the same concept as a preferred return in a private equity fund or real estate fund.

Leverage: Debt undertaken by a fund to purchase investments. For hedge funds, this is usually in the form of margin lending.