Hedge Fund Manager Compensation Contracts During Financial Crisis

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.