High-Water Marks and Hedge Fund Compensation

46 Pages Posted: 21 Jan 2010

See all articles by George O. Aragon

George O. Aragon

Arizona State University (ASU) - Finance Department

Jun Qian

Fanhai International School of Finance, Fudan University; University of Pennsylvania - Wharton Financial Institutions Center

Date Written: December 2009

Abstract

We examine the role of high-water mark provisions in hedge fund compensation contracts. In our model of competitive markets and asymmetric information on manager ability, a fee contract with a high-water mark can improve the quality of the manager pool entering the market. In addition, a high-water mark contract can reduce inefficient liquidation by raising after-fee returns following poor performance. Consistent with our model's predictions, we find that high-water marks are more commonly used by less reputable managers, funds that restrict investor redemptions, and funds with greater underlying asset illiquidity. High-water marks are also associated with greater sensitivity of investor flows to past performance, but less so following poor performance. Overall, our results suggest that compensation contracts in hedge funds help alleviate inefficiencies created by asymmetric information.

Keywords: Hedge Fund, High-Water Mark, Adverse Selection, Illiquidity, Lockup.

JEL Classification: G2, D8, G1.

Suggested Citation

Aragon, George O. and Qian, Jun, High-Water Marks and Hedge Fund Compensation (December 2009). Available at SSRN: https://ssrn.com/abstract=1540205 or http://dx.doi.org/10.2139/ssrn.1540205

George O. Aragon

Arizona State University (ASU) - Finance Department ( email )

W. P. Carey School of Business
PO Box 873906
Tempe, AZ 85287-3906
United States

Jun Qian (Contact Author)

Fanhai International School of Finance, Fudan University ( email )

Shanghai
China
86-21-63895501 (Phone)
86-21-62934572 (Fax)

HOME PAGE: http://www.fisf.fudan.edu.cn/show-65-69.html

University of Pennsylvania - Wharton Financial Institutions Center

2306 Steinberg Hall-Dietrich Hall
Philadelphia, PA 19104
United States

HOME PAGE: http://fic.wharton.upenn.edu/fic/

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