Capacity Constraints and the Opening of New Hedge Funds

Abstract

In this paper we propose that hedge funds’ capacity constraints may play a significant role on the decision of fund families to open a new hedge fund. We argue that hedge fund families face diseconomies of scale because of the non-scalability of their investment strategies and, as their existing funds approach critical size, they prefer opening new hedge funds rather than allowing their existing funds to grow. Our empirical analysis shows that fund families’ propensity to open new funds increases with the degree of capacity constraints faced by the existing funds of the families. We find that fund families' strategy of starting new hedge funds is correlated with a decrease in fund flows to their existing funds, and that the introduction of new funds leads to an improvement in the performance of the existing funds within the same family.