Effort, Risk and Walkaway Under High Water Mark Contracts

Abstract

We model a hedge fund style compensation contract in which management fees, incentive fees and a high water mark (HWM) provision drive a fund manager's effort and risk choices as well as walkaway decisions by both the fund manager and the investor. We calibrate the model to observed data and use the calibrated model to consider welfare implications of changes to the standard 2/20 contract. Welfare results highlight the critical role higher management fees play in such contracts in terms of improving the manager's risk taking and effort expenditure decisions. In particular, a higher management fee and lower incentive fee (e.g. a 2.5/10 contract) leads to Pareto improvement in the calibrated model. The calibrated model also suggests that renegotiation of the HWM is Pareto optimal for both the investor and the fund manager ex post, once a fund is below the HWM. However, admitting the possibility of renegotiation ex ante, while the fund is still near the HWM, removes the the threat of being below the HWM, with its associated lower incentive fees and potential investor withdrawals. This in turn leads to significantly higher risk and lower effort choices by the fund manager and substantially decreases investor welfare.