Paper: Role Of Managerial Incentives and Hedge Fund Performance
I’ve always been interested in how hedge fund compensation affects fund performance.
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Abstract (Via SSRN & Harvard Law School):
Using a comprehensive hedge fund database, we examine the role of managerial incentives and discretion in hedge fund performance. Hedge funds with greater managerial incentives, proxied by the delta of the option-like incentive fee contracts, higher levels of managerial ownership, and the inclusion of high-water mark provisions in the incentive contracts, are associated with superior performance. The incentive fee percentage rate by itself does not explain performance. We also find that funds with a higher degree of managerial discretion, proxied by longer lockup, notice, and redemption periods, deliver superior performance. These results are robust to using alternative performance measures and controlling for different data-related biases.
Introduction (Via Harvard Law School):
While the prior corporate finance literature has examined this question, the results are hard to interpret given significant endogeneity concerns. We believe that the hedge fund industry offers a more appropriate setting to examine these issues for a number of reasons. First, we are able to empirically test theoretical predictions that are difficult to test in the corporate finance setting, such as the incentive effects of out-of-the-money options. Second, we believe that our measures of managerial incentives and managerial discretion create fewer endogeneity concerns than typically arise in a corporate finance setting, since the compensation contract are set at the fund’s inception and do not change during the life of the fund. Similarly, the durations of the lockup period, the notice period, and the redemption period—our proxies for managerial discretion—are chosen at the inception of the fund.
Our results are robust to various alternate specifications, including the use of alternative performance measures (such as gross-of-fees returns and risk-adjusted returns) and controlling for different data-related biases. Our findings demonstrate the efficacy of financial contracts in alleviating agency problems, and we believe that they have important implications for contracting not only with asset managers but also with executives managing corporations.
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