The mission of an unmanned air vehicle (UAV) tethered to a small unmanned surface vehicle (USV) is considered. As opposed to the majority of existing tethered UAV work, which assumes a taut tether, this paper addresses the challenge of tether management for a slack, hanging tether in a dynamic ocean environment up to sea state 4 on the Douglas scale. A prototype smart reel system for a UAV–USV team was designed and experimentally validated in controlled and uncontrolled dynamic environments. A reference model for tether control based on static catenary cable theory was extended and shown to be valid through the entire operational envelop. A Kalman filter was developed to fuse slow (4 Hz) differential GPS (dGPS) relative position measurements with fast (100 Hz) inertial measurements, to output a 100 Hz estimate of relative position, relative velocity, and inertial sensor bias. A relative velocity‐based gain‐scheduled proportional‐derivative (PD) controller was developed, and demonstrated robustness to heave, pitch, and roll motion of the USV. Experimental testing with a UAV surrogate showed successful decoupling of heave motion from the UAV altitude in a controlled indoor environment. Taut tether control, in contrast, exhibited 12 times more tether tension at the UAV compared to the controller proposed here. The performance of the tuned controller with feedback from the Kalman filter exhibited minimal deviation from static catenary cable theory during the dynamic experiments. Indoor flight testing showed the developed reference model and controller essentially decoupled the dynamic motion of the USV from that of the UAV; the measured deflections of the UAV altitude and position essentially matched that of untethered flight. Outdoor flights validated the effectiveness of the controller in an unknown dynamic environment, for a larger relative position between the UAV and USV, using the dGPS Kalman filter solution to measure relative position. Initial experimental results look promising for continued on‐water testing of hanging‐tether UAV/USV teams.