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Indirect Incentives of Hedge Fund Managers

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  • JONGHA LIM
  • BERK A. SENSOY
  • MICHAEL S. WEISBACH

Abstract

Indirect incentives exist in the money management industry when good current performance increases future inflows of new capital, leading to higher future fees. We quantify the magnitude of indirect performance incentives for hedge fund managers. Flows respond quickly and strongly to performance; lagged performance has a monotonically decreasing impact on flows as lags increase up to two years. Conservative estimates indicate that indirect incentives for the average fund are four times as large as direct incentives from incentive fees and returns to managers' own investment in the fund. For new funds, indirect incentives are seven times as large as direct incentives. Combining direct and indirect incentives, for each dollar generated for their investors in a given year, managers receive close to another dollar in direct performance fees plus the present value of future fees over the expected life of the fund. Older and capacity constrained funds have considerably weaker relations between future flows and performance, leading to weaker indirect incentives. There is no evidence that direct contractual incentives are stronger when market-based indirect incentives are weaker.
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Suggested Citation

  • Jongha Lim & Berk A. Sensoy & Michael S. Weisbach, 2016. "Indirect Incentives of Hedge Fund Managers," Journal of Finance, American Finance Association, vol. 71(2), pages 871-918, April.
    • Handle: RePEc:bla:jfinan:v:71:y:2016:i:2:p:871-918
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    File URL: http://hdl.handle.net/10.1111/jofi.2016.71.issue-2
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    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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