The economics of hedge funds

Hedge fund managers are often compensated via management fees on the assets under management (AUM) and incentive fees indexed to the high-water mark (HWM). We develop an analytically tractable model of hedge fund leverage and valuation where the manager maximizes the present value (PV) of future management and incentive fees from current and future managed funds. By leveraging on an alpha strategy, a skilled manager can create significant value for investors. However, leverage also increases the likelihood of poor performances, which may trigger money outflow, withdraw/redemption, and forced fund liquidation, causing the manager to lose future fees. Intuitively, the ratio between AUM and HWM, w, measures the optionality of the long position in incentive fees and the short position in investors’ liquidation and redemption options. Moreover, w determines the manager’s optimal leverage and dynamic valuation of fees. Our main results are (1) managerial concern for fund survival induces the manager to choose prudent leverage; (2) leverage depends on w and tends to increase following good performances; (3) both incentive and management fees contribute significantly to the manager’s total value; (4) performance-triggered new money inflow encourages the manager to increase leverage and has large effects on the manager’s value, particularly on the value of incentive fees; (5) fund restart and HWM reset options are valuable for the manager; (6) managerial ownership has incentive alignment effects; (7) when liquidation risk is low, the manager engages in risk seeking and the margin requirement/leverage constraint binds. Our framework allows us to infer the minimal level of managerial skill, the un-levered break-even alpha, demanded by investors in a competitive equilibrium for a given managerial compensation contract. ∗First Draft: May 2010. We thank Andrew Ang, George Aragon, Patrick Bolton, Pierre Collin-Dufresne, Kent Daniel, Darrell Duffie, Will Goetzmann, Rick Green, Jim Hodder, Bob Hodrick, Jason Hsu, Tim Johnson, Lingfeng Li, Bing Liang, Stavros Panageas, Lasse Pedersen, Chester Spatt, René Stulz, Suresh Sundaresan, Sheridan Titman, Laura Vincent, Jay Wang, Zhenyu Wang, Mark Westerfield, and seminar participants at ASU, Brock, CMU Tepper, Columbia, McGill, New York Fed, UIUC, PREA, SUFE for helpful comments. †Cornerstone Research. Email: [email protected]. ‡Columbia Business School and NBER. Email: [email protected]. §Columbia Business School and Shanghai University of Finance & Economics (SUFE). Email: [email protected].