Profit Sharing in Hedge Funds

Abstract

In a new scheme for hedge fund managerial compensation known as the first-loss scheme, a fund manager uses her investment in the fund to cover any fund losses first; by contrast, in the traditional scheme currently used in most U.S. funds, the manager does not cover investors' losses in the fund. We propose a framework based on cumulative prospect theory to compute and compare the trading strategies, fund risk, and managers' and investors' utilities in these two schemes analytically. The model is calibrated to the historical attrition rates of U.S. hedge funds. We find that with reasonable parameter values both fund managers' and investors' utilities can be improved and fund risk can be reduced simultaneously by replacing the traditional scheme (with 10% internal capital and 20% performance fee) with a first-loss scheme (with 10% first-loss capital and 30% performance fee). When the performance fee in the first-loss scheme is 40% (a current market practice), however, such substitution renders investors worse off.

Keywords: cumulative prospect theory, portfolio selection, hedge funds, managerial incentive, first-loss scheme

JEL Classification: G02, G11