Suppose an account grows from $10 million to $12 million, and 20% of the $2 million gain is charged. The mark is now $12 million. If the account falls to $9 million and recovers to $11.5 million, no incentive fee is due on that recovery, because the investor is still below the previous peak.
The provision prevents the manager being paid twice for the same dollar of gain. It is per-investor, so two people in the same fund can be at different marks depending on when they subscribed.
A deeply underwater mark creates its own problem. A manager far below the mark earns no incentive fee for years, which can encourage either excessive risk-taking to get back or closing the fund and launching a fresh one with a clean mark. Investors often negotiate a modified mark or a reduced fee to realign incentives instead.
Related: performance-fee, hurdle-rate, two-and-twenty, hedge-fund, carried-interest, private-equity