Managerial Incentives and Hedge Fund Performance

In our recently accepted Journal of Finance paper Role of Managerial Incentives and Discretion in Hedge Fund Performance, we demonstrate empirically that, in the case of hedge funds, managerial incentives and discretion are associated with better performance. While the prior corporate finance literature has examined this question, the results are hard to interpret given significant endogeneity concerns. We believe that the hedge fund industry offers a more appropriate setting to examine these issues for a number of reasons. First, we are able to empirically test theoretical predictions that are difficult to test in the corporate finance setting, such as the incentive effects of out-of-the-money options. Second, we believe that our measures of managerial incentives and managerial discretion create fewer endogeneity concerns than typically arise in a corporate finance setting, since the compensation contract are set at the fund’s inception and do not change during the life of the fund. Similarly, the durations of the lockup period, the notice period, and the redemption period—our proxies for managerial discretion—are chosen at the inception of the fund.

We examine our research questions using a comprehensive database created by the union of four large hedge fund databases: CISDM, HFR, MSCI, and TASS. Our findings are as follows. First, we find that higher values of delta, our overall pay–performance sensitivity measure, and not higher incentive fee rates, are associated with higher future returns. In support, we find that the incentive fee rate has no explanatory power for future returns once we control for delta, whereas delta continues to be a significant predictor of future returns. This finding holds even when we use a subsample of funds charging the same incentive fee rate of 20%. Second, when we use managerial ownership as well as the manager’s option delta to capture incentives, we find both to be positively related to performance. This lends support to the industry wisdom that requires co-investment by the manager. Third, we find that funds with high-water mark provisions produce higher returns. Also, the presence of a hurdle rate provision is positively related to future returns, although this relation is not statistically significant. Fourth, we find that our proxies for managerial discretion are always positively related to performance. This suggests that providing flexibility to the manager should be beneficial, provided that appropriate incentives are in place.

Our results are robust to various alternate specifications, including the use of alternative performance measures (such as gross-of-fees returns and risk-adjusted returns) and controlling for different data-related biases. Our findings demonstrate the efficacy of financial contracts in alleviating agency problems, and we believe that they have important implications for contracting not only with asset managers but also with executives managing corporations.

The full paper is available for download here.