Optimal fees in hedge funds with first-loss compensation

M. Escobar-Anel, Y. Havrylenko and R. Zagst
Authors registered in the RePEc Author Service: Marcos Escobar Anel ()

Journal of Banking & Finance, 2020, vol. 118, issue C

Abstract: Hedge fund managers with the first-loss scheme charge a management fee, a performance fee and guarantee to cover a certain amount of investors’ potential losses. We study how parties can choose a mutually preferred first-loss scheme in a hedge fund with the manager’s first-loss deposit and investors’ assets segregated. For that, we solve the manager’s non-concave utility maximization problem, calculate Pareto optimal first-loss schemes and maximize a decision criterion on this set. The traditional 2% management and 20% performance fees are found to be not Pareto optimal, neither are common first-loss fee arrangements. The preferred first-loss coverage guarantee is increasing as the investor’s risk-aversion or the interest rate increases. It decreases as the manager’s risk-aversion or the market price of risk increases. The more risk averse the investor or the higher the interest rate, the larger is the preferred performance fee. The preferred fee schemes significantly decrease the fund’s volatility.

Keywords: First-loss fee structure; Hedge fund; Pareto optimality; Utility maximization; Concavification (search for similar items in EconPapers)
JEL-codes: G11 G23 G35 (search for similar items in EconPapers)
Date: 2020
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Working Paper: Optimal fees in hedge funds with first-loss compensation (2023)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jbfina:v:118:y:2020:i:c:s0378426620301503

DOI: 10.1016/j.jbankfin.2020.105884

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