Skin or Skim? Inside Investment and Hedge Fund Performance

Arpit Gupta is Assistant Professor of Finance at NYU Stern School of Business. This post is based on a recent paper by Professor Gupta and Kunal Sachdeva, Ph.D. candidate in Finance at Columbia Business School.

Our paper, Skin or Skim? Inside Investment and Hedge Fund Performance, publically available on SSRN, examines the decision of insiders to allocate private capital between funds under their control, and the impact of this “skin in the game” on returns received by outside investors. Delegated asset managers are commonly thought of being compensated only through fees imposed on outside investors. However, access to profitable, but limited, internal investment opportunities can also be a form of compensation for managers. Consider the hedge fund industry, which manages over $3 trillion in assets under management, of which $400 billion can be attributed to investments from insiders and related parties. [1] The discretion of where and how to invest this large allocation of insider capital suggests that returns to insider capital is an important, but previously overlooked, component of hedge fund compensation and potential source of conflict of interest between investors.

Discretion over private capital investment can be seen in many fund families, and has been the subject of considerable investor and regulatory interest. For instance, Mary Jo White, SEC Chair said the following during a speech on Oct. 16, 2015: “I will start with fiduciary duty, the cornerstone of our regulatory framework for asset managers. As part of that duty, investment advisers must serve the best interests of their clients and seek to avoid, or at least make full disclosure of, conflicts of interest, including those related to their organization, operation, and management of client assets.” And, “Examiners observed that some hedge fund advisers may not be adequately disclosing conflicts related to advisers’ proprietary funds and the personal accounts of their portfolio managers. Examiners saw, for example, advisers allocating profitable trades and investment opportunities to proprietary funds rather than client accounts in contravention of existing policies and procedures.”

These concerns are counter prevailing views of corporate governance on hedge funds, which feature minimal governance provisions due to strong exit rights among investors, and typical limitations on investment to classes of accredited or well-informed investors. Hedge fund operating agreements typically demand few fiduciary obligations to managers to prioritize one fund over another, or prioritize funds with their own internal capital on the same basis as funds with a greater preponderance of outside capital. For instance, as noted in Nowak (2009) and cited in Morley (2014), the manager, “…is required to devote to the [fund] only that amount of time and attention that the [manager] in its sole discretion deems reasonably necessary to achieve the [fund’s] objectives.” As a result, discretion is typically left in the hands of the manager to handle any conflicts of interest across classes of investors, different funds in a family, or in accepting additional outside capital. Our work examines the consequences of this discretion in internal capital allocation on returns received by outside investors.

This paper takes both a theoretical and empirical approach. The paper first proceeds by extending a standard model of asset management to include several key features which better capture institutional features of compensation structures in hedge funds. In our model, managers face capacity constraints in determining the optimal level of invested capital, can choose to endogenously create new funds with different strategies, and can allocate internal capital across funds. When managing personal capital, managers internalize the fact that raising additional capital is dilutive to existing investors in the sense that it causes the strategy to operate closer to its capacity constraint, lowering the returns for all existing investors. Our model predicts that greater inside investment better aligns incentives between managers and investors and induces managers to limit the size of their fund, resulting in higher alphas even in equilibrium.

In the second part of the paper, we empirically examine these predictions on the relationship between inside investment and fund returns through a novel usage of a comprehensive and survivor-bias free dataset, Form ADV, provided by the SEC. This regulatory form requires all hedge funds with assets over $100m to disclose the fraction of fund assets held by insiders yearly at the fund level. We merge Form ADV data with numerous commercially available datasets on hedge fund returns to understand the connection between “skin in the game” and fund returns.

We first document the extent of inside investment in fund families across the entire universe of hedge funds. We find that inside investment—as measured either by percentage or gross investment—remains an important predictor of excess returns even when comparing different funds within firms. An investor who changes allocation from a fund with zero percent inside investment to one at the same firm with 100 percent inside investment would see a rise in excess returns of 36 basis points a month, or 4.3% annualized. This significant and economically large magnitude indicates that inside investment is an important, and previously neglected, cross-sectional predictor of hedge fund returns.

We also find that high inside investment funds have both different fund flow-performance and return predictability characteristics compared with funds largely catering to outside investors. In response to positive excess returns, they do not accept as much inflows of capital as do outsider funds, and in tandem experience greater persistence of high excess returns. The joint relationship between internal investment, fund flows, and performance suggests that funds better manage capacity constraints when managers have personal capital at stake, leading to superior performance. This finding is consistent with our model explanation that insider funds operate at a smaller scale because managers internalize the costs of fund expansion.

Our results contribute to ongoing debates regarding the presence of managerial alpha and financial rents. Many observers are puzzled at the apparently outsize rents earned by financial intermediaries such as hedge funds, even in the wake of apparently strong competition and the role of fund inflows on diminishing returns. In turn, these managerial rents have driven top-end wealth and income inequality (see Kaplan and Rauh, 2013). We suggest a possible reconciliation of these facts through considering that fund managers have the option to earn management and performance fees, but also the possibility of deploying their own capital in funds they manage.

The complete paper is available for download here.


1For the size of the industry, see figures collected provided by the Securities and Exchange Commission: Inside investment is estimated using the inside ownership measure from Form ADV.(go back)

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