The Separation of Funds and Managers: A Theory of Investment Fund Structure and Regulation

This Article offers a broad theory of what distinguishes investment funds from ordinary companies, with ramifications for how these funds are understood and regulated. The central claim is that investment funds (i.e., mutual funds, hedge funds, private equity funds, and their cousins) are distinguished not by the assets they hold, but by their unique organizational structures, which separate investment assets and management assets into different entities with different owners. In this structure, the investments belong to "funds," while the management assets belong to "management companies." This structure benefits investors in the funds in a rather paradoxical way: it restricts their rights to control their managers and to share in their managers' profits and liabilities. The fund investors accept these restrictions because certain features common to most investment funds make these restrictions efficient. Those features include powerful investor exit rights that substitute for control rights and economies of scope and scale that encourage managers to operate multiple funds at the same time. This understanding illuminates a number of key areas of contracting and regulation and refutes the claims of skeptics who say that fund investors would be better off if they employed their managers directly. AUTHO R. Associate Professor of Law, Yale Law School. This paper benefited from workshops at the American Law and Economics Association Annual Meeting, Columbia Law School, UCLA Law School, the University of Illinois College of Law, the University of Virginia School of Law, and Yale Law School. It also benefited from comments by Douglas Baird, William Birdthistle, Anthony Casey, Quinn Curtis, Jonathan Greenstein, Henry Hansmann, Richard Hynes, Bruce Johnsen, Paul Mahoney, Peter Molk, Larry Ribstein, Roberta Romano, and Andrew Verstein. Stephen Sovinsky provided excellent research assistance.