Working Paper: NBER ID: w27454
Authors: Itzhak Bendavid; Justin Birru; Andrea Rossi
Abstract: We study the long-run outcomes associated with hedge funds' compensation structure. Over a 22-year period, the aggregate effective incentive fee rate is 2.5 times the average contractual rate (i.e., around 50% instead of 20%). Overall, investors collected 36 cents for every dollar earned on their invested capital (over a risk-free hurdle rate and before adjusting for any risk). In the cross-section of funds, there is a substantial disconnect between lifetime performance and incentive fees earned. These poor outcomes stem from the asymmetry of the performance contract, investors' return-chasing behavior, and underwater fund closures.
Keywords: Hedge Funds; Performance Fees; Incentive Fees
JEL Codes: G11; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| effective incentive fee rate (G11) | nominal rate (E43) |
| poorly performing funds cannot offset gains in well-performing funds (G23) | effective incentive fee rate (G11) |
| discontinuation of investment activity following losses (G33) | underwater incentive fees (G19) |
| asymmetry in performance contract (L14) | poor outcomes for investors (G24) |
| liquidation of funds following losses (G33) | crystallization of underwater incentive fees (G19) |
| fund managers are more likely to liquidate after losses (G33) | destruction of potential fee credits for investors (G24) |