Optimal fees in hedge funds with first-loss compensation

Abstract

Hedge fund managers compensated by first-loss fee structures charge a management fee and a performance fee as in the traditional scheme but they also guarantee to cover a certain amount of investors’ potential losses. Applying the expected utility framework, we compute the set of first-loss fee structures that are Pareto optimal for the manager and the investor. We find that the traditional scheme of a management fee of 2% and a performance fee of 20% is not Pareto optimal. First-loss fee structures commonly used in the hedge-fund sector are not Pareto optimal either. We also investigate how the manager and the investor can agree on a preferred fee structure by maximizing the hedge-fund’s Sharpe ratio on the set of Pareto optimal fee structures. Using the same market parameters as in He and Kou (2018), we derive the preferred first-loss scheme and compare it to the traditional scheme as well as other reported first-loss fee structures. We observe that the preferred first-loss fee structure significantly reduces the hedge-fund’s market risk. As a general rule we find that the more risk-averse the investor, the higher the preferred performance fee and the first-loss coverage guarantee should be.