November 11, 2005
The Future of Hedge Fund Regulation
Posted by Victor Fleischer

I've been working on a paper on hedge funds.  There I sneak in the clever point that the SEC rule requiring registration has the perverse effect of making things worse:   by defining hedge funds as funds that have a short lock-up period (unlike venture and buyout, which lock up capital for 10-12 years), the rule is having the predictable effect of leading to longer lock-ups.  At least I thought it was a clever point until the WSJ, Ribstein and Bainbridge wrote about it this week.  Maybe it's an obvious point.  Still, I'd rather be obvious than wrong.  (Incidentally, anyone reading up on this should check out Skeel & Oesterle's debate, which is a great read.)

My paper focuses on compensation design and incentives for hedge fund managers; I examine the reputational mechanisms that help police hedge funds, such as consultants and funds of funds.  The SEC rule isn't the end of the world, as low quality funds will have trouble getting long lock-ups.  Reputational intermediaries can help investors distinguish between high-quality and low-quality funds.  At least some of the time.

The central claim of the paper is that investors rely heavily on reputation to balance some misaligned incentives, but reputation may not work as well as we often assume because of institutional differences between the hedge fund world and venture/buyout.

But as long as we're all talking about the SEC rule ... Where to go from here, assuming the rule stays?  A hedge fund industry SRO should develop consistent standards for identifying managers and disclosing returns.  This would help investors compare apples to apples and weaken the case for further SEC regulation.  Alternatively, if we must involve the SEC, perhaps it should focus on facilitating rather than substituting for the reputation market.  (I think this is similar to what Troy Paredes has in mind.  But see this post by Todd Henderson.)

For those who are interested, you can read (most of) my introduction below the fold.   The introduction is too long -- but I'm waiting until I finish the paper before rewriting the intro.  So my apologies in advance for being long-winded.

Hedge funds are famous for the massive bonuses their managers earn through performance fees. A hedge fund manager typically takes home 20 to 30 percent of the profits of the fund. For a moderately successful fund, this arrangement translates into tens of millions of dollars split among a handful of investment professionals. And this gravy is ladled on top of already substantial management fees. It is, as they say, nice work if you can get it. The hefty size of this compensation does not necessarily make it a bad deal for investors. What matters most from a legal perspective is not so much the size of the compensation, but its design.

But there is indeed adequate reason to worry. The industry-standard fee structure creates a troubling moral hazard risk that could lead to inefficient managerial risk-taking. Because managers receive an asymmetric payoff – they share in the upside of the fund but bear little downside risk – they might be tempted to make overly risky bets with investors’ money. Hedge fund agreements, in other words, allow an apparently severe distortion of incentives in the contract between managers and investors.

This Essay considers the mechanisms that hedge fund investors use to bridge this incentive gap. No compensation scheme can perfectly align incentives, of course. What makes the problem interesting, then, is not just the presence of imperfect incentives, but the unique set of institutional responses that constrain managerial behavior in the hedge fund context. For example, one might expect investors to respond to this moral hazard risk by directly monitoring management more closely. Savvy investors could, in theory, review and approve portfolio strategies, studying market movements alongside the fund managers. But to do so would be prohibitively costly. Instead, we argue, hedge fund investors rely primarily on something extremely squishy – reputation – to ensure that managers will act in the best interests of the investors.

Reputation at first seems like a laughably inadequate solution to the problem. Performance-based fees, of course, do most of the work, ensuring that the incentives of hedge fund managers are roughly aligned with those of their investors. When incentives diverge, however, few contractual or legal provisions prevent managers from acting to further their own self-interest, to the detriment of investors. Perhaps surprisingly, we argue here, reputation is often enough to get the job done, despite the fact that it is non-contractual in nature and not enforceable in court.


Hedge fund compensation design is in tension with their otherwise carefully-engineered risk management strategy. After all is said and done, hedge fund managers still have something to gain if things go well, but little to lose (at least at first glance) if things go badly. And so notwithstanding the implicit or explicit agreement to manage risk carefully according to pre-defined strategies, the fund managers have a strong financial incentive to increase the volatility of the fund, as such strategies increase the present value of their compensation.  [...]

The key to cracking the moral hazard problem, we argue, is the common hedge fund feature of redemption on demand. Hedge fund investors do not try to limit tightly the set of appropriate investments or trading strategies, nor do they closely monitor the daily activities of the fund. Instead, investors rely on one important (albeit imperfect) check against risky managerial behavior: at any time following a short initial lock-up period, investors can withdraw their capital and invest elsewhere. In contrast, venture funds and buyout funds typically contain long lock-up periods. If investors bail out, the managers lose not only the option value of the current fund, they also lose the present value of the future stream of management fees in the current fun, and they face higher reputational hurdles in trying to attract capital for their next fund. Redemption on demand creates a risk aversion that at least partially offsets the risk-seeking incentives of the asymmetric payoff of the profits interest.

 This threat of investor withdrawal is important to reducing the agency costs created by the separation of ownership and control. Indeed, we argue that without redemption on demand, investors might shy away from hedge funds altogether. Instead, because investors can walk away, managers have an incentive to create and maintain a reputation for following agreed-upon strategies. To facilitate this check, investors increasing rely on reputational investigators in the form of consultants, investing through funds of funds, or both.

So far so good. But how can we be sure that reputation is acting as an effective substitute for contractual constraints? Reputation is widely understood to be an effective mechanism to defend against opportunism in small, homogenous communities. [...]

But unlike Sand Hill Road or 47th Street, “hedge fund land” is only a geographic metaphor. The network of hedge fund managers and investors is not as small, nor is it as geographically concentrated, as the network of diamond dealers in New York, venture capitalists in Silicon Valley, or cattle ranchers in Shasta County. In hedge fund land, reputational constraints do not blossom organically. Instead, the industry has cultivated a complex mix of contractual and institutional mechanisms designed to facilitate a market in reputation. Investors widely rely on two reputational intermediaries – fund of funds and consultants – to reassure themselves that managers will pursue sensible investment strategies.   

These reputational mechanisms have allowed the hedge fund industry to thrive in recent years. Institutional investors continue to increase their investments in the sector, with the investments of the Harvard, Yale, and Stanford endowments, for example, each topping a billion dollars. As the hedge fund sector continues to expand, however, the bonds of reputation are stretched awfully thin, and they are occasionally snapping apart.

At the same time that personal reputation is failing to serve as an effective constraint, we are witnessing the increased professionalization of the industry. Institutional reputation of fund managers, not the personal reputation of individual professionals, is starting to matter more. As the industry grows, in other words, we can expect the incentive to engage in strategic behavior by individual managers to increase, but this incentive may be somewhat mitigated by increased professionalization, which may rein in some of this bad behavior.

What the SEC should do in response to all of these changes is hardly self-evident. Relying on the private ordering of reputation markets alone seems inadequate to protect investors. Yet many commentators believe a full blown mandatory disclosure system would be costly, cumbersome, and unlikely to help. Mutual funds, after all, are hardly the model of an industry without agency costs problems. As a middle ground, we argue, the SEC may wish to consider a limited mandatory disclosure system that focuses on facilitating rather than substituting for reputation markets. For example, mandatory disclosure of fees and fee structures, past performance, and other hard and soft data would help investors compare apples to apples. Alternatively, if it is concerned that limited disclosure would be just the first step down the slippery slope, the industry could develop a self-regulatory organization to improve the operation of reputation markets.

Ironically, the SEC’s modest attempt to regulate hedge funds by having them register as investment advisors is likely to hurt rather than help matters. To distinguish hedge funds from other private investment funds like venture capital funds and buyout funds, the proposed regulation defines a hedge fund as a fund with a lockup period of less than two years. The industry response, predictably enough, has been to extend lockup periods beyond two years. To make reputation markets work, investors must be able to redeem their investment (or credibly threaten to leave) at the first sign of trouble.  The fear of triggering a “run on the bank” is an important element of keeping hedge fund managers in line. The SEC’s proposed rule, then, encourages funds to remove the one element of hedge fund oversight that seems to work, namely, the oversight of reputation markets.

 This is not the end of the world. Investors recognize the value of redemption-on-demand, and they will resist longer lock-up periods suggested by fund managers without high-quality credentials. What the SEC could do to help out here would be to facilitate a system to make it easier for investors to assess the credentials of the managers.

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