The Separation of Investments and Management

Abstract

Investment funds — including hedge funds, private equity funds, venture capital funds, mutual funds, exchange-traded funds and closed-end funds — have unusual corporate structures: They separate investments and management. In a typical set-up, all of the investment assets belong to one entity (a “fund”) with one set of owners, and all of the managers, workers and operational assets belong to a different entity (a “management company” or “adviser”) with a different set of owners. These funds also radically limit investors’ control. For example, many funds cannot fire and replace their management companies or their employees — not even by unanimous vote of the funds’ boards and equity holders. This paper shows for the first time that the separation of investments and management is a defining feature of all investment funds and explains for the first time why it occurs. It occurs because, for several reasons unique to investment funds, fund investors value the way that the separation of investments and management limits their control over their managers and their exposure to their managers’ earnings and liabilities. This understanding offers broad perspective on many puzzling features of investment funds’ organization. It also helps us to define what exactly investment funds are and to discern the basic purposes of fund regulation.