Effort, Risk and Walkaway Under High Water Mark Contracts

We study a hedge fund style contract in which management fees, incentive fees and a high water mark provision drive a fund manager's effort and risk choices as well as walkaway decisions by both the fund manager and the investor. We model this relationship and calibrate the model to observed data. The model yields empirical predictions regarding the impact of a fund's distance from the high water mark (HWM) on effort, risk and walkaway behavior. Testing the model on empirical data, we find that as funds fall from the HWM, future expected returns fall, the incidence of fund closure increases and the variance of future returns increases. All of these effects are most stark for funds closer to the HWM and are milder for funds further away. Additionally, we find that risks taken by funds further below their HWMs tend to generate lower expected returns than those closer to their HWMs. In addition to being consistent with predictions from our model, these results resonate well with the economic intuition that such contracts function as if fund managers hold call options with varying degrees of moneyness (depending on distance from the HWM) on the return stream to the investor's funds. Finally, using the calibrated model, we consider welfare implications of changes to the standard 2/20 contract. We find that lowering incentive fees and increasing management fees (e.g., a 2.5/10 contract) leads to Pareto improvement.