Proceedings of 34th International Business Research Conference
4 - 5 April 2016, Imperial College, London, UK, ISBN: 978-1-925488-02-9
Optimal Hedge Fund Performance Fees
Minli Lian and Peter Klein1
This paper investigates the relationship between hedge fund performance fees and risk
adjusted returns. Existing literature claims that performance fees induce excessive risktaking behavior from hedge fund managers because higher risk increases the value of
the performance fee option. This paper argues that the relationship between the investor
and hedge fund manager is similar to the relationship between shareholders and
corporate managers. We apply principal-agent theory to this issue and show that the
performance of hedge funds and the payoff of the performance fee contract are
endogenously determined by the fund manager’s effort. The excess returns are shared
between the investor and manager and there is a natural bound of risk. Empirically, we
find that performance fees are positively associated with returns and risk adjusted returns
which is consistent with our theory.
JEL Classification:
Keywords: Hedge Funds; Performance Fees; Incentive Contract
1
Lian is at Kwantlen Polytechnic University and Klein is at Simon Fraser University.
E-mails: minli.lian@kwantlen.ca and pklein@sfu.ca.