Hedge Fund Incentive Fees and the “Free Option”

Abstract

One of the ironies of hedge fund investing is that investors can provide conflicting incentives to the hedge fund manager. While hedge fund managers earn a management fee, which is a constant percentage applied to the amount of assets managed in the hedge fund, they receive an incentive fee, which is a form of profit sharing when a profitable return is earned for their investors. The standard Black-Scholes analysis is used to determine the value of the call option on hedge fund incentives. The article also discusses how this call option might provide an inconsistent incentive compared to the desires of investors in the hedge fund.