Indirect Incentives of Hedge Fund Managers

• Author: MICHAEL S. WEISBACH,JONGHA LIM,BERK A. SENSOY
• Published date: 01 April 2016
• Date: 01 April 2016
• DOI: http://doi.org/10.1111/jofi.12384

THE JOURNAL OF FINANCE •VOL. LXXI, NO. 2 •APRIL 2016

Indirect Incentives of Hedge Fund Managers

JONGHA LIM, BERK A. SENSOY, and MICHAEL S. WEISBACH∗

ABSTRACT

Indirect incentives exist in the money management industry when good current per-

formance increases future inflows of capital, leading to higher future fees. For the

average hedge fund, indirect incentives are at least 1.4 times as large as direct in-

centives from incentive fees and managers’ personal stakes in the fund. Combining

direct and indirect incentives, manager wealth increases by at least $0.39 for a $1

increase in investor wealth. Younger and more scalable hedge funds have stronger

flow-performance relations, leading to stronger indirect incentives. These results have

a number of implications for our understanding of incentives in the asset management

industry.

HEDGE FUND MANAGERS ARE AMONG the most highly paid individuals today.

Kaplan and Rauh (2010) estimate that, in 2007, the top five hedge fund man-

agers earned more than all S&P 500 firms’ CEOs combined. The payoff to

becoming a top hedge fund manager is therefore enormous. The logic of Holm-

strom (1982), Berk and Green (2004), and Chung et al. (2012) provides a frame-

work for understanding hedge fund managers’ careers. Investors allocate capi-

tal to funds based on their perception of managers’ abilities, which is a function

of fund performance. Good performance increases a manager’s lifetime income

directly, through contractual incentive fees earned at the time of performance.

It also increases a manager’s lifetime income indirectly, through higher future

fees both from increased flows of new investment to the fund and from the

mechanical increase in the fund’s asset base. The extremely high level of pay

for top hedge fund managers thus suggests that indirect incentives are likely

to be a significant component of managers’ total incentives, particularly early

in a manager’s career.

∗Jongha Lim is with California State University at Fullerton. Berk A. Sensoy is with Ohio State

University. Michael S. Weisbach is with Ohio State University, NBER, and SIFR. Wethank Neng

Wang for graciously providing code for evaluating the Lan, Wang,and Yang (2013) model. Andrea

Rossi provided unusually diligent research assistance. For helpful comments and discussions, 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, Arizona State University, Cali-

fornia State University at Fullerton, Fordham University,Harvard Business School, Northeastern

University, Ohio State University, the University of Florida, the University of Missouri, and the

University of Oklahoma. We have read The Journal of Finance’s disclosure policy and have no

conflicts of interest to disclose.

DOI: 10.1111/jofi.12384

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872 The Journal of Finance R

In this paper, we estimate the magnitude of these indirect incentives of hedge

fund managers. In particular, we address the following questions. For an incre-

mental percentage point of returns to investors, how much additional capital

does the market allocate to that hedge fund? How much of this additional cap-

ital do hedge fund managers end up receiving as compensation in expectation?

How does this “expected future pay for today’s performance” compare in mag-

nitude with the direct incentive fees that hedge fund managers earn from the

incremental returns? How do these effects differ across types of funds, and over

time for a particular fund? And what are the implications of the existence of

such indirect incentives for hedge fund investors and for our understanding of

contracting more broadly?

We first estimate the relation between hedge fund performance and inflows

to the fund using a sample of 2,998 hedge funds from 1995 to 2010. As predicted

by learning models of fund allocation and consistent with prior work on mutual

funds and private equity funds, this relation is substantially stronger for newer

funds, whose managers’ abilities the market knows with less certainty. For the

average fund, the estimates imply that a one-percentage-point incremental

return in a given quarter leads to a 1.5% increase in the fund’s assets under

management (AUM) from inflows of new investment over the next three years.

For a new fund, the same incremental return results in a 2.1% increase in

AUM from inflows. In addition, performance has a greater impact on flows for

funds engaged in more scalable strategies. These results are consistent with

the view that investors continually update their assessment of managers and

adjust their portfolios accordingly.

The way in which the inflow-performance relation affects managers’ com-

pensation depends on the fee structure in hedge funds. Typically, hedge fund

managers receive a management fee equal to 1.5% of AUM, together with in-

centive fees equal to 20% of profits above a high-water mark (HWM). Good

performance increases managers’ future income because fees will be earned

on inflows of new investment, and also because the asset value of existing

investors becomes larger and closer to the HWM. Valuing a manager’s com-

pensation requires a contingent claims modeling framework to account for the

fact that incentive fees are effectively a portfolio of call options on the fund’s

assets. We use four such models, which allows us to evaluate the sensitivity of

the estimates to different modeling frameworks and parameter choices.

The first model that we use is the model of Goetzmann, Ingersoll, and Ross

(2003, hereafter GIR). GIR provide an analytical formula for calculating the

fraction of a dollar invested in the fund that, in expectation, will be received

by the fund’s managers over the life of the fund. The other three models in-

corporate two real-world features that are missing from the GIR model and

could have a material impact on a manager’s future compensation: future

performance-based flows and the manager’s endogenous use of leverage in

the fund’s portfolio. Each of these features leads to greater compensation, and

hence greater indirect incentives, than would otherwise be the case. The GIR

estimates therefore provide a lower bound on the magnitude of the indirect

incentives faced by hedge fund managers.

Indirect Incentives of Hedge Fund Managers 873

The second model that we use augments the GIR model to accommodate

future performance-based flows. The third model is that of Lan, Wang, and

Yan g (2013, hereafter LWY), in which the manager can endogenously choose the

amount of leverage to use at each point in time. Finally, we present estimates

using an extension of the LWY model that allows for performance-based flows

as well as endogenous leverage. LWY nests GIR, which assumes no leverage

at any time, as a special case so all of our estimates can be thought of as

implications of different versions of the LWY model.

Each of these models provides an estimate of the present value of man-

agers’ compensation per dollar invested in the fund. Together with the flow-

performance relations, these estimates allow us to calculate the magnitude of

indirect incentives facing hedge fund managers. For an incremental percent-

age point or dollar of current returns to the fund’s investors, we calculate the

present value of the additional lifetime income the fund’s managers receive in

expectation due to inflows of new investment and the increase in the value of

existing investors’ assets.

As a benchmark for assessing the importance of this indirect pay for perfor-

mance, we compare its magnitude to the direct performance pay that managers

receive from incentive fees and changes in the value of their own investment in

the fund. We use the Agarwal, Daniel, and Naik (2009) framework to estimate

the change in the value of managers’ current compensation (coming from both

incentive fees and the manager’s own stake in the fund) for an incremental

return.

Our estimates indicate that a one-percentage-point increase in returns gen-

erates, on average, $331,000 in expected direct incentive pay, consisting of

$142,000 in incremental incentive fees and $190,000 in incremental profits on

managers’ personal stakes. Using the GIR model with parameter choices that

yield lower-bound estimates, we calculate that managers also receive $531,000

in expected future fee income, consisting of $248,000 in future fees earned on

the new investment that occurs in response to the incremental performance

and $282,000 in extra future fees earned on the increase in the value of exist-

ing investors’ assets in the fund. Because a one-percentage-point increase in

return is equal to $2.11 million for an average-sized fund in our data, these

calculations imply that on average managers receive 16 cents in direct pay and

at least 23 cents in indirect pay for each incremental dollar earned for fund

investors. The indirect, career-based incentive effect is thus at least 1.4 times

larger than the direct income that managers receive from incentive fees and

returns on their personal investments. Again, this indirect-to-direct incentive

ratio of 1.4 corresponds to model and parameter choices that lead to a lower

bound of estimates of indirect incentives. Under other plausible choices, the

ratio would be substantially higher. The average indirect-to-direct incentive

ratio is 3.5 across all the models and parameter values we consider.

We next find that indirect incentives are even larger for young funds. For

new funds, we estimate indirect incentives to be six to 12 times as large as

direct incentives given the parameters used in LWY. The importance of indirect

incentives declines monotonically as a fund ages, largely as a consequence of