Indirect Incentives of Hedge Fund Managers

Indirect incentives exist in the money management industry when good current performance increases future inflows of new capital, leading to higher future fees. We quantify the magnitude of indirect performance incentives for hedge fund managers. Flows respond quickly and strongly to performance; lagged performance has a monotonically decreasing impact on flows as lags increase up to two years. Indirect incentives for the average fund are at least 1.6 times as large as direct incentives from incentive fees and managers’ personal stakes in the fund. For new funds, indirect incentives are seven to fourteen times as large as direct incentives. Combining direct and indirect incentives, for each dollar generated for their investors in a given year, manager wealth increases by at least forty-one cents. The performance of older and capacity constrained funds has a considerably weaker impact on future flows, leading to weaker indirect incentives. Contact information: Jongha Lim, Department of Finance, California State University Fullerton, Fullerton, CA 92834, email: [email protected]; Berk A. Sensoy, Department of Finance, Fisher College of Business, Ohio State University, Columbus, OH 43210: email: [email protected]; Michael S. Weisbach, Department of Finance, Fisher College of Business, Ohio State University, Columbus, OH 43210, email: [email protected]. We thank Neng Wang for graciously providing code for evaluating the Lang, Wang, and Yang (2013) model. We thank Andrea Rossi for excellent research assistance. For helpful comments on and discussions of an earlier draft, we thank Jack Bao, Jonathan Berk, Niki Boyson, Yawen Jiao, Michael O’Doherty, Tarun Ramadorai, Josh Rauh, Ken Singleton, Luke Taylor, Sterling Yan, two anonymous referees, an anonymous associate editor, and seminar and conference participants at the 2014 AFA meetings, the 2014 Spring NBER Corporate Finance Meeting, American University, California State University at Fullerton, Fordham University, Harvard Business School, Ohio State University, the University of Missouri, Northeastern University, and the University of Oklahoma.