High Water Marks in Competitive Capital Markets

Abstract

We analyze the effectiveness of hedge funds' high-water mark provisions (HWMs) at mitigating moral hazard and adverse selection, when the supply of capital is competitive. We show that the HWM does not allow better managers to distinguish themselves ex ante. Regarding moral hazard, we find that precision of beliefs about a manager's ability is crucial to the HWM's effectiveness. When precision is low, the HWM encourages shirking. However, if precision is high, and the beliefs themselves are high as well, then the HWM encourages costly effort by the manager. Furthermore, the HWM boosts the initial fund size, depresses initial expected returns and increases subsequent expected returns.

Keywords: Hedge funds, High water marks, Efficient contracts, Adverse Selection, Moral Hazard, Learning, Competitive Capital

JEL Classification: G20, G23