Revisiting the Incentive Contracts of Hedge Funds: A Game Theoretic Perspective with Managerial Ownership, Effort and Ability

Abstract

We analyse the combined effects of bargaining power, managerial ability/effort, and risk-taking strategies on the choice of hedge fund (HF) incentive contracts, and hedge fund performance. In our model, the HF manager and outside investors first negotiate over the type of contract (asymmetric or symmetric). Next, the manager chooses between a safe and risky strategy. After that, he exerts effort, which affects the chances of HF-success. Our major contributions are as follows: a) We consider the effect of managerial equity-ownership in the fund, in addition to standard incentive contracts, b) we consider the effect of managerial effort/ability, c) we analyse bargaining power between the manager and outside investors, d) we consider the role of regulation, and e) we outline behavioural factors (particularly, managerial anxiety) which may impact the analysis. Our paper concludes by discussing the policy implications of our analysis, particularly with respect to the ongoing debate on regulation of hedge funds.