High Water Marks in Competitive Capital Markets

46 Pages Posted: 17 Dec 2008 Last revised: 11 Aug 2020

See all articles by Susan Kerr Christoffersen

Susan Kerr Christoffersen

University of Toronto - Rotman School of Management; Copenhagen Business School

David K. Musto

University of Pennsylvania - Finance Department

Bilge Yilmaz

University of Pennsylvania - Finance Department

Date Written: February 21, 2013

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

Suggested Citation

Christoffersen, Susan E. and Musto, David K. and Yilmaz, Bilge, High Water Marks in Competitive Capital Markets (February 21, 2013). EFA 2009 Bergen Meetings Paper, Jacobs Levy Equity Management Center for Quantitative Financial Research Paper, Available at SSRN: https://ssrn.com/abstract=1314893 or http://dx.doi.org/10.2139/ssrn.1314893

Susan E. Christoffersen (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada
416 946 5647 (Phone)
416 971 3048 (Fax)

HOME PAGE: http://www.rotman.utoronto.ca/schristoffersen

Copenhagen Business School

Solbjerg Plads 3
Frederiksberg C, DK - 2000
Denmark

David K. Musto

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States

Bilge Yilmaz

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-898-1163 (Phone)
215-898-6200 (Fax)

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