The Economics of Hedge Funds

46 Pages Posted: 20 Mar 2012 Last revised: 21 Sep 2012

See all articles by Yingcong Lan

Yingcong Lan

Cornerstone Research - New York Office

Neng Wang

Columbia Business School - Finance and Economics

Jinqiang Yang

Shanghai University of Finance and Economics

Date Written: September 6, 2012

Abstract

We develop an analytically tractable model of hedge fund leverage and valuation where the manager maximizes the present value (PV) of management and incentive fees from current and future managed funds. By leveraging on alpha strategies, skilled managers create value. However, leverage also increases fund volatility and hence the likelihood of poor performance, which may trigger money out ow, drawdown/redemption, and involuntary fund liquidation, causing the manager to lose future fees. The ratio between assets under management (AUM) and high-water mark (HWM), w, measures the manager's moneyness and is a critical determinant of leverage and valuation.

Our main results are: (1) despite high-powered incentive fees, the risk-neutral manager often behaves in a risk-averse manner and chooses prudent leverage because downside liquidation risk is quite costly, in contrast to the standard risk-seeking intuition; (2) leverage tends to increase following good performance and to decrease as liquidation becomes more likely despite time-invariant alpha; (3) both incentive and management fees contribute importantly to the manager's total value; (4) performance-linked new money inflow encourages leverage and has large effects on the manager's value, particularly on the value of incentive fees; (5) the manager highly values restart options; (6) managerial ownership has incentive alignment effects; (7) the manager becomes risk loving and the leverage constraint binds as liquidation risk decreases.

Keywords: assets under management (AUM), high-water mark (HWM), alpha, management fees, incentive fees, conflicts of interest, agency, liquidation option, redemption, drawdown, managerial ownership, money flow, margin requirement, risk seeking

JEL Classification: G11, G20

Suggested Citation

Lan, Yingcong and Wang, Neng and Yang, Jinqiang, The Economics of Hedge Funds (September 6, 2012). AFA 2013 San Diego Meetings Paper. Available at SSRN: https://ssrn.com/abstract=2024669 or http://dx.doi.org/10.2139/ssrn.2024669

Yingcong Lan

Cornerstone Research - New York Office ( email )

599 Lexington Avenue
New York, NY 10022
United States

Neng Wang (Contact Author)

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

Jinqiang Yang

Shanghai University of Finance and Economics ( email )

777 Guoding Road
Shanghai, AK Shanghai 200433
China

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