Leverage and valuation of hedge funds under model uncertainty

Abstract

ABSTRACT We extend the model of dynamic leverage and valuation of hedge funds [Lan, Y., N. Wang, and J. Yang. 2013. The Economics of Hedge Funds.” Journal of Financial Economics 110: 300–323.] by incorporating model uncertainty. Our theoretical model predicts that concerns about model uncertainty induce risk-neutral managers to behave more endogenously risk-averse and to choose a more conservative leverage strategy. Moreover, it shows that model uncertainty may reduce the valuations of hedge funds, including incentive fees, and total fees for the manager as well as the investors' payoff, while model uncertainty has ambiguous effects on the valuations of managers' management fees. Finally, we find that model uncertainty significantly increases the break-even alpha at the founding of a hedge fund.