Hedge Fund Compensation: Incentive Fees and Performance Intervals

Abstract

Performance fees that are designed to incentivize money managers to exert more effort may also distort a manager's risk choices. In this paper, we analyze the impact of the standard performance fee contract that includes what is known as a high-water mark provision. We investigate the effect the fee collection frequency, manager wealth and fee magnitudes, have on the return to investors. We find that when performance fees are reduced but collected more frequently both the manager and the investor can be better off. We do this by modeling the manager's decision making process as a stochastic control problem with both discrete and continuous controls. We also develop a computational method to solve this class of problems and prove its convergence.