The Economics of Hedge Funds : Alpha , Fees , Leverage , and Valuation ∗

Hedge fund managers charge management fees on assets under management (AUM) and incentive fees indexed to the high-water mark (HWM). We study the effects of fees and alpha on managerial dynamic leverage choice and valuation. Our main results are: (i) high-powered incentive fees encourage excessive risk taking, while management fees have the opposite effect; (ii) agency conflicts have significant effects on dynamic leverage choices and valuation of managerial rents and investors’ payoffs; (iii) the manager’s optimal leverage critically depends on the history of the fund’s performance; (iv) investors’ options to withdraw and/or liquidate funds following sufficiently poor fund performance substantially curtail managerial risk-taking and can give rise to strong precautionary cash holding; and (v) managerial ownership concentration has strong incentive alignment effects.