UC Irvine

This study examines whether the standard compensation contract in the hedge fund industry aligns managers' incentives with the interests of investors. We demonstrate empirically that managers' compensation increases when fund assets grow, even when there are diseconomies of scale in fund performance. Under the current fee structure, managers' compensation is maximized at a much larger size than is optimal for fund performance. Therefore, hedge fund managers have strong incentives to increase their assets under management. However, to avoid capital outflows and retain fund assets, managers are also motivated to restrict fund growth to maintain style-average performance, which explains why funds sometimes close themselves to new investment.