Economic thought began observing “ideals” (price-takers, perfect competition, Perfect Information, good-faith transactions - meaning no “cheating”) with Adam Smith and Free-Market capitalism. This schema clearly portrays markets as if they most often operated without a “hitch.” Eventually, Ronald Coase released “The Nature of the Firm” (1937), which, amongst many impacts, bore life to Contract Theory. In posing and providing insight on questions such as: “Why does a firm organize in the first place - wouldn’t Smith argue all individuals should simply contract with others as if everyone acts in their self-interest, the market will naturally ensure the best outcome for all.” and ”What are the costs and benefits of organizing into a firm?”, Coase laid the foundation for the Principal-Agent Problem. He argued that firm boundaries (their degree of vertical/horizontal integration) are marked by transaction costs, which are always minimized, assuming profit maximization (MR: P* = MC). Specifically, transaction costs associated with a firm’s inability to exhaustively account for each contingency of adverse behavior (agency costs) from a contracting partner (contract costs associated with limited information/monitoring) will be relevant to this paper. The natural evolution of these lines of inquiry combined the study of agency costs (how agents can alter their behavior post-contract agreement) and contract costs (how to appropriately delegate tasks to agents with inevitably limited information) into the formal Principal-Agent Problem. “For we must consider that we shall be a city upon a hill, the eyes of all people are upon us” John Winthrop (1630); this air of exceptionalism towards our domestic capital market often forces us to neglect deeper institutional issues such as suboptimal contracting in the face of incentive misalignment and imperfect monitoring in the wealth management sector. The impact of such a classically American bravado gives rise to hedge-fund managers not acting in their principals’ (LPs’) best financial interests in several key ways. We brand ourselves as this capitalistic “City upon a hill,” an economy to be emulated and replicated by any nation that aspires to the same level of economic success, yet everything is not as it seems.
The Principal-Agent Model at the core of this paper involves a principal that delegates a task (investing their capital) to an Agent (Hedgefund manager/investor) for a price. Ronald Coase and Kenneth Arrow’s contributions to contract theory birthed the idea that mutually welfare-enhancing contracts align agents’ interests with the principal, when contracting costs can often present inefficiencies in market outcomes. The hedge fund industry employs a standard fee structure known as the 2-20 rule, including a 2% assets under management fee to cover operational expenses (fixed costs, salaries, administrative expenses) and a 20% performance fee for the fund’s profits above a threshold profit percentage that is predetermined known as the hurdle rate (majority of the Hedge Fund industry’s profits) which presents its own principal-agent problem. The individual investment's hurdle rate or opportunity cost comprises a metric representing a company’s average cost of capital, understandably equivalent to a minimum required rate of return, added with a firm-specific risk premium. This minimum rate of return is a hypothetical industry-specific investment with zero risk. This deceptive benchmark predetermines the viability of investing in a stock in the most lucrative and generous light towards managers’ checkbooks from the principals’ wallets. While managers earn incentives for profit, this option-like payoff of the performance fee of upside gains without direct consequences for downside risk encourages risk-seeking behavior, often at the expense of long-term LP returns. For one, performance fees are usually calculated annually, encouraging managers to prioritize year-end gains through chasing the hurdle rate. As risk premiums vary from hedge fund to hedge fund, based on their investing philosophy, they act as a form of risk-tolerance product differentiation because managers are incentivized to surpass this threshold to earn more money, ensuring that the limited partner (LP) or principal earns at least this profit percentage (this doesn’t account for subsequent dips in value below the hurdle rate, LP will still be required to pay the performance fee for previous profits even if unrealized). There are conflicts of interest in this fee-structuring, as the hurdle rate’s imperfections skew investors to focus on short-term performance. Sunit M. Shah writes in The Principal-Agent Problem in Finance, “The [LP] whose funds are used to purchase all … of the resulting securities must ensure that the asset manager who executes those purchases does so to benefit the investment goals of the investor rather than the manager’s own personal fee stream.” This presents a uniquely high monitoring cost within the class of contracting costs Coase outlined, it is impossible to stipulate for every individual contingency of inequitable behavior towards the principal by the investor, when the investor can exploit the 20% performance fee at the cost of long-term returns for the LP.
The 20 in the 2-20 structure creates asymmetric incentives between the LP and the manager. The performance fee of the 2-20 incentive structure is known as market-based compensation, and this is at the core of what is commonly referred to as the “Financial Incentive Bubble,” with the term bubble suggesting that the incentive structure is overvaluing particular manager’s ability to generate alpha (profit above hurdle rate) due to skill rather than luck associated with natural market volatility as its very difficult to truly distinguish the two with such “noisy” data dependent on so many factors. This undeserved compensation can lead to certain less-skilled managers creating misallocation of financial, real, and human capital, which will not cease until the bubble is “popped.”
Ideally, any good contract aligns the incentives of the principal and the agent, which in this case would mean compensating the manager in whichever way encourages them to reasonably generate as much alpha as possible while also appropriately considering risk. If the fee structure included the “equity”-reminiscent asset under management 2% fee alone, the LP would have no motivation to contract with the Hedge Fund, as the manager would likely generate small profits without added performance-based incentives other than a flat interest rate encouraging risk-neutral investment philosophy, not justifying paying money that could better be spent by the LP investing on their own. Still, the quasi-equity aspect does align the manager’s risk tolerance with the LP, as they earn less from the management fee alone if the managed capital drops below its original value (there are disincentives for being “too risky”). This can be thought of as the porridge that is “too cold” in a profit-generating, risk-taking sense in the “Goldilocks and the Three Bears” analogy as if the manager is exactly as risk-averse as the LP; a rational LP would not expend capital through a fee to the hedge fund manager when their capital could maximize profit more effectively if invested through a different asset class. In theory, market-based compensation (performance fee) rectifies the “maintain baseline” attitude of the management fee, as managers will be motivated to push the upside of the margins as far as possible. In practice, managers behave almost as if the fund were a call option (“High-Water Marks and Hedge Fund Management Contracts” Goetzmann, Ingersoll, and Ross (2003)) due to their lack of consequences if the fund dips below the hurdle rate after already profiting, they face no repercussions and the LP still has to pay the performance fee on profits that are never realized. This is known as “underwater” performance fees, as the fee is attributed towards a profit of a stock that subsequently has value below the hurdle rate (these subsequent net losses negate smaller past gains). Ben-David et al. (2023) found that “around 60% of the profits that the subset of profitable hedge funds have generated have been offset by losses: by subsequent losses experienced by those same funds and by losses of other funds. … This means that, in the aggregate, investors have paid incentive fees for dollar returns that have not been ‘brought home.’” In practice, this asymmetric fee structure can lead to both LPs reaping less than 80% of the profit above the hurdle rate and the manager often taking on unreasonable risk, leading to additional losses for the LP. In fact, the headline finding of Ben-David et. al in The Performance of Hedge Fund Performance Fees, “Overall, hedge funds consume 64% of the gross returns on investors’ capital and are only weakly correlated with actual long-run performance in the cross-section of funds. … As a result, the effective incentive fee rate is 50% vis-à-vis the nominal 20% rate.” This large discrepancy between the effective incentive fee rate and nominal “expected” rate by investors suggests due to the short-term skew, return chasing, option-like attitude of managers, they are far more incentivized to act in the best interest of maximizing their own individual surplus in a zero-sum sense extracting large amounts of surplus (64 cents to every dollar of profit) directly from investors. This contract is suboptimal as it doesn’t adequately disincentivize the agents’ behavior that is adverse to the principals’ goal (maximizing portfolio profit long-term).
There is a vast body of empirical evidence substantiating the harsh reality that aggregated to the long-term, the 2-20 incentive structure promotes risk-seeking behavior in managers to the detriment of LPs, suggesting that this contract structure is suboptimal as it doesn’t properly account for the agent’s (LP’s) adverse behavior towards the principal (contract costs). This asymmetric performance fee in the 2-20 rule represents the porridge being “too hot” or the manager being too risk-tolerant to the ultimate detriment of the LP’s financial capital, causing inefficient allocation. You may ask, how, with the high-watermark or hurdle rate stipulation for the 20% rule, is the LP not implicitly able to recover losses? Within the 2-20 rule, LPs are conventionally issued performance fee credits if losses fall below the hurdle rate, meaning they are exempt from paying additional incentive fees until they recoup their original losses. Insidiously, to the detriment of LPs, this is nullified if managers quickly disinvest capital from one fund following losses in the original fund and reinvest in a new fund to increase their net return. The issue with this is that the LP is still “in the red” for the loss originally incurred by the risk-seeking behavior of the manager and will have to pay new incentive fees on whatever capital was left over transferred into the new fund. This phenomenon is known as return chasing and is a clever but deceptive way for managers to effectively extract even more than the nominal 20% performance fee in surplus from the LP. In “The Performance of Hedge Fund Performance Fees” by Ben-David, Birru, and Rossi (2020), the ex-post realization of long-term payoffs was studied to figure out the real or effective performance fee over time. A representative sample of 6,000 hedge funds from 1995 to 2016 was analyzed to calculate the effective performance fee rate over that period by taking the ratio of gross performance fee payoffs over that period divided by gross profits in excess of the management fee and average capital cost (hurdle rate minus risk premium) coming out to 49.6% or about 2.5 times the original rate (managers indirectly extract surplus rightfully owed to LP through return-chasing). Over that period, LPs earned $228.2 bn in aggregate gains on hedge fund investments while paying $113.3bn towards incentive fees. If the effective incentive fee were the same as the “on-the-book” nominal rate of 20%, LPs would’ve paid a monumental $69.8 bn fewer dollars. This raises significant alarm bells indicating that LPs are optimizing w/r/t profit maximization incorrectly on the investor’s behalf (instead for themselves) if such a “real” capital discrepancy exists. To elaborate, tying it to consumer theory, LPs with profit expectations of 80% minimum (100-nominal incentive fee) may be able to allocate their capital in other financial instruments better if they knew they would get closer to 50% real profit share, less than the profit rate they would require to rationally allocate capital to the hedge fund investment. This misallocation means their capital undoubtedly could be more utility/profit-generating elsewhere.
The inefficiencies discussed earlier (misallocation of financial, real, and human capital) suggest that the hedge fund industry urgently requires an incentive structure that is “just right” to finish off the Goldilocks analogy. Currently, wherever we are in the goldilocks continuum clearly doesn’t rationally justify investing with hedge funds, the HFRI Fund Weighted Composite Index, maintained by HFR aggregating 1,400 single-manager funds between 1994-2010 reports 7.3% after fees, while the S&P 500 is reported on their website to be ~8.2% over the same period. A rational investor would expect to reap better returns than what is essentially baseline guaranteed profit in terms of benchmarking with the S&P 500, while in reality, the hedge fund industry not only underperforms the S&P 500 but the lower rate of return (0.9% lower than industry standard) is fractional (36 cents on every dollar of profit) due to the effective performance fee imposed on LPs as discussed earlier. In other words, a solution could possibly compromise between the conservative risk-averse “equity” reminiscent 2% asset-under-management fee and the risk-tolerant, alpha-generating 20% (in actuality, 50%) performance fee in order for there to be an optimal incentive alignment between the LP and the hedge fund manager for the agent to act overall in the principal’s best interest. This inherent incentive-misalignment problem presents itself in part because of the LP’s inability (asymmetric info between LP and manager) to perfectly monitor all information pertaining to how their capital is managed (the specific task the principal delegated to the agent), which prevents the LP from adequately accounting for all agency cost contingencies (or all possible adverse changes in behavior ex-post to contract agreement - supported by effective performance rate being 2.5x larger than 20%) leading to the possibility of larger-than-expected losses. If they were physically looking over the LP’s shoulder at the trading desk during all work hours, they could describe specific stipulations requiring the manager not to take on irresponsible risk in real time. As explained in “The Incentive Bubble” by Mihir A. Desai (2012), this Goldilocks compromise in risk-tolerance for determining an adequate fee structure could possibly take the form of an indexed market-compensation model, I believe this would further approach a more optimal (incentive-aligned and relatively more mutually welfare-enhancing) contract than the status quo. Within the realm of finance, the metrics Alpha (how much a stock moves above the overall market direction) and Beta (how much a stock moves correlated to the overall market direction) can help distinguish gains derived from natural background market volatility (luck) and gains independent/above natural market volatility (skill in recognizing meaningful signals (factors that generate profit above expected). If compensation is indexed to pay the performance fee based on profit minus the beta metric, leaving solely the gains independent of the overall market direction, then this could provide more profitable and responsible investment strategies from managers that better align with LPs, posing a potential solution to the Principal-Agent problem with hedge fund managers and LPs.
Bibliography:
1. Rossi, Andrea, et al. “The Performance of Hedge Fund Performance Fees.” The Harvard Law School Forum on Corporate Governance, 31 Aug. 2020, https://corpgov.law.harvard.edu/2020/08/31/the-performance-of-h edge-fund-performance-fees/. 2. Ben-David, Itzhak, et al. The Performance of Hedge Fund Performance Fees. 3637756, 1 June 2020. Social Science Research Network, https://papers.ssrn.com/abstract=3637756. 3. “What Are Agency Costs? Included Fees and Exampple.” Investopedia, https://www.investopedia.com/terms/a/agencycosts.asp. Accessed 6 Mar. 2025. 4. Shah, Sunit. The Principal - Agent Problem in Finance. 2574742, 1 Mar. 2014. Social Science Research Network, https://papers.ssrn.com/abstract=2574742. 5. Mihir A. , Desai. “The Incentive Bubble.” Harvard Business Review, vol. March 2012, 1 Mar. 2012. hbr.org, https://hbr.org/2012/03/the-incentive-bubble. 6. My IO Notebook - Ishii 7. Goetzmann, William N., et al. High-Water Marks and Hedge Fund Management Contracts. 57933, 18 Apr. 2001. Social Science Research Network, https://doi.org/10.2139/ssrn.57933