Why Hedge Funds Really Want Your Money

(March 20, 2013) – One might think 2-and-20 was plenty of incentive in itself (or even the more modern 1.5-and-20), but new research shows that future inflows are in fact a more powerful carrot for hedge fund managers.

Capital markets are nearly as responsive to performance as fee contracts—and much more generous, according to a paper out of Ohio State University's financial economics research unit. Authors Jongha Lim, Berk Sensoy, and Michael Weisbach found that each dollar of alpha generated by a new hedge fund in a given year leads to more than another whole dollar in expected pay for managers via capital inflow. 

The paper divides manager compensation into two categories: direct, which includes same-year fees and returns on managers' own invested capital; and indirect, which comprises future fund flows and the fees arising from them. To calculate the relative weight of these two categories, the authors analyzed a data set covering 2,687 hedge funds from 1995 to 2010.

The indirect incentives are particularly powerful for new funds, as managers must prove themselves as alpha generators early on to attract investors. For an average fund, the study found that a 10% incremental return in a given year produces roughly an additional 22% gain in the fund's assets under management over the next two years. For a new fund, that 10% yields a 41% boost to capital inflows.

The findings suggest that investors are paying close attention. Using annual data, the Lim, Sensoy, and Weisbach found that approximately half of the increase in assets under management occurs in the same year as the outstanding performance.

"Hedge funds managers' interests are generally considered to be well-aligned with those of their investors," the authors wrote, as "they receive a large part of their compensation in the form of incentive fees and often additionally make a substantial equity contribution to the fund. The evidence in this paper strongly suggests that hedge fund managers' pecuniary incentives are substantially higher than is implied by their ownership and incentive fees stakes…Indirect incentives, however, change dramatically as a fund ages." 

'Alignment of incentives' has become a mantra among the most successful institutional investors (as least from what aiCIO has been hearing). It's good news then for emerging managers that massive alignment is already built into their contracts with early investors. And that's before anyone has even tweaked the carry or written in a hurdle. 

Read the entire paper here.