Effort, Risk and Walkaway Under High Water Mark Contracts

Abstract:     
We study a hedge fund style contract in which management fees, incentive fees and a high water mark provision drive a fund manager's effort and risk choices as well as walkaway decisions by both the fund manager and the investor. We model this relationship and calibrate the model to observed data. Using the calibrated model, we consider welfare implications of changes to the standard 2/20 contract. Welfare results highlight the critical role higher management fees play in such contracts in terms of improving the manager's risk taking and effort expenditure decisions. In particular, a higher management fee and lower incentive fee (e.g. a 2.5/10 contract) leads to Pareto improvement in the calibrated model.

Keywords: Hedge Funds, Corporate Finance, Contracts

JEL Classifications: G20, G24, C72

Working Paper Series