Role of Managerial Incentives, Flexibility, and Ability: Evidence from Performance and Money Flows in Hedge Funds

Abstract

Delegated portfolio management, either through mutual funds or through hedge funds, is invariably associated with agency problems. These problems, inter alia, take the form of potential conflict of interests and abuse of managerial decision-making freedom. The agency theoretic literature suggests two possible solutions - offer the fund manager incentives for better alignment of interests, and monitor to minimize the misuse of managerial freedom. Interestingly, mutual funds and hedge funds deal with these problems differently. To address the problem of conflict of interests, hedge fund investors pay performance-linked incentive fee and require co-investment by the manager, while mutual fund investors typically do not have such arrangements. To mitigate the problem of abuse of managerial latitude, mutual fund investors use regulation, disclosure, and tracking error vis-a-vis benchmark. In contrast, hedge fund investors do not seem to view this as a serious problem (partly due to potentially lesser conflict of interests). In fact, they recognize the beneficial effects of managerial discretion and accept impediments to capital withdrawal (through lockup, notice and redemption periods) to provide the manager with greater investment flexibility. These different approaches have important implications for fund performance and money flows from investors. This paper contributes to the literature by addressing two research questions. How do the cross-sectional differences in managerial incentives and flexibility relate to the performance of hedge funds? How do managerial ability (captured through the fund's past performance), incentives, and flexibility relate to money flows in hedge funds? The answers to these questions are important as they shed light on the efficacy of the contractual arrangements in the hedge fund industry. Interestingly, there are similarities between these arrangements and those found in the executive compensation contracts. This paper uses hedge funds as a unique laboratory to answer some of the questions in the corporate finance literature, hitherto unanswered due to endogeneity problems and/or lack of suitable proxies, thereby contributing to that strand of literature as well. Using a comprehensive database of hedge funds, we find that hedge funds with greater managerial incentives (larger value of the delta of option-like incentive fee contract and presence of high-water mark provision) and higher degree of managerial flexibility (in terms of longer lockup, notice, and redemption periods) are associated with better performance. Further, we find that hedge funds with better managerial incentives and greater managerial ability (superior past performance) receive greater money flows while funds with greater managerial flexibility experience lower flows.