The Incentives of Hedge Fund Fees and High-Water Marks

Abstract

Hedge funds are associated with markedly asymmetric compensation: managers receive in performance fees a large fraction of their funds' profits, paid when a fund exceeds its high-water mark. We study the consequences of such incentive contracts, solving the portfolio choice problem from the viewpoints of managers and investors. We find that managers with constant relative risk aversion and constant investment opportunities, maximizing utility of fees at long horizons, choose constant Merton portfolios, with an effective risk aversion shrunk towards one in proportion to performance fees. In particular, the risk shifting implications are ambiguous and depend on the manager's own risk aversion. In a competitive equilibrium with a representative investor and heterogeneous funds, we find that funds with equal investment opportunities but different performance fees and managers' risk aversions coexist with the resulting leverage being an increasing function of fees. This theoretical prediction is verified empirically.