Do hedge fund managers crowd out other investors in their funds?

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Copyright : Leung Cho Pan // 123RFIt might seem like hedge fund managers having “skin in the game” by investing personal capital in their funds would be a good thing for outside investors seeking to enter positions alongside them.

But there can be negative consequences, according to a paper co-authored by Arpit Gupta, an assistant professor of finance at the Leonard N. Stern School of Business at New York University and Kunal Sachdeva, assistant professor of finance at the Jesse H. Jones Graduate School of Business at Rice University.

The paper found that funds with more inside investment outperform other funds in the same family, but there are downsides as well.

“Because insiders have superior private information, have discretion over which of their funds to invest in, and may subsequently alter the fund operations; managers with large personal stakes may choose actions which negatively affect their investors,” the paper said.

When insiders allocate to one of their funds, the returns on the capital they invest can be roughly the same as the management or performance fees they’d earn, which the report’s authors suggest means they face a trade-off in choosing how to get paid.

As well, the paper noted that hedge fund managers surely take into account the fact that raising additional capital dilutes how much a given investor will make due to decreasing returns to scale, which would impact where they choose to allocate capital among the funds they manage. “We argue that while inside investment is an important tool to align incentives, it can lead to managers limiting fund scale in ways that maximize returns at the expense of capital participation on the part of outsiders,” the paper said.

The research found that general partners have a tendency to invest in their less-scalable ventures. “We find that managers also limit outsider capital access into their insider funds, sometimes closing access to outside investors completely. The consequence of these managerial capital decisions (on both outside and inside capital) is that insider funds substantially outperform — but are offered on a limited basis to outside investors.”

As as result, the assumption that hedge funds will do better if their managers have a personal stake in them may indeed be true, but it’s of little benefit to outside capital allocators if they can’t get in on the action.

“This improvement in return performance comes at the cost of reduced fund participation by outsiders. We find evidence consistent with the idea that greater inside investment incentivizes managers to better manage the size-performance tradeoff in ways that crowds out outside capital.”

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