These are the status quo within the industry now and they assure investors that profit sharing will be calculated based on a fair valuation of returns earned. Many hedge funds collect a 2% fee on all assets and then a 20% performance fee, meaning that if the fund gains 100% in one year the hedge fund gets to keep 20% of those profits and the investor keeps the other 80%. A high water mark is the highest net asset value previously seen at the end of the fiscal year.
High Water Mark Example: An investor gives a hedge fund $500k in 2006 and that investment's value falls to $300k. In 2007 the hedge fund produces 100% returns and that investment is now worth $600k. This individual would only have to pay performance fees on that gain between the $500k and $600k, not the full 100% gain ($300k) for that year.