Hedge Fund Manager Compensation Contracts During Financial Crisis

44 Pages Posted: 11 Aug 2012

See all articles by Hui Zhao

Hui Zhao

Purdue University - Department of Management

Xiaoyan Zhang

Tsinghua University - PBC School of Finance

Fei Pan

Purdue University - Department of Management

Kwei Tang

Purdue University - Krannert School of Management

Date Written: August 9, 2012

Abstract

During the recent financial crisis, capital flow to hedge funds plunged, and competition among hedge fund managers intensified. This leads to a transfer of bargaining power from hedge fund managers to investors when negotiating fund managers' compensation contracts. We use a signaling game theoretical model to study the optimal compensation contract design for hedge fund managers during crisis periods. Our model predicts that when bargaining power is on the investors' side, hedge fund managers are better off by lowering fees and dropping high-water mark. Using 2007-2008 hedge fund data, we find that funds which lower incentive fees and drop high-water mark provision have higher survival probabilities, attract more capital flows, and obtain higher returns. To our knowledge, our paper is the first work to focus on compensation contract design in times of crisis and our results provide important guidelines for the industry.

Keywords: Hedge funds, high-water mark, incentive fee, competition, asymmetric information

JEL Classification: G23

Suggested Citation

Zhao, Hui and Zhang, Xiaoyan and Pan, Fei and Tang, Kwei, Hedge Fund Manager Compensation Contracts During Financial Crisis (August 9, 2012). Available at SSRN: https://ssrn.com/abstract=2127841 or http://dx.doi.org/10.2139/ssrn.2127841

Hui Zhao

Purdue University - Department of Management ( email )

West Lafayette, IN 47907-1310
United States

Xiaoyan Zhang (Contact Author)

Tsinghua University - PBC School of Finance ( email )

No. 43, Chengdu Road
Haidian District
Beijing 100083
China

Fei Pan

Purdue University - Department of Management ( email )

West Lafayette, IN 47907-1310
United States

Kwei Tang

Purdue University - Krannert School of Management ( email )

1310 Krannert Building
West Lafayette, IN 47907-1310
United States

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