Hedge fund managers are motivated to perform better when their own money is on the line — to the extent that they will limit investments from outsiders in order to keep returns high, according to a new paper from the National Bureau of Economic Research.
After analyzing the performance and investor characteristics of 720 hedge funds, authors Arpit Gupta and Kunal Sachdeva found that managers tend to invest their own money in their least-scalable strategies — strategies that deliver “superior returns” compared with the firms’ other funds. These high-performing funds are typically open to a limited amount of outside capital, or closed to outside investors completely, according to the findings.
“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,” Gupta and Sachdeva wrote.
Previous research has shown that raising additional capital tends to dampen a fund’s investment performance — a trend Gupta and Sachdeva said hedge fund managers “internalize” when deciding how to invest their own money. “Personal capital commitments better align the incentives of managers and outsiders, providing greater incentives for managers to scale their funds less aggressively in a manner which results in greater returns to investors — but at the cost of capital participation by outside investors,” they explained.
[II Deep Dive: Having Skin in the Game Isn’t So Easy Anymore for Private Equity Managers]
One possible cause of higher returns, according to the paper, is that hedge fund managers prioritize those funds that contain more of their personal investments — putting those funds under the charge of their best portfolio managers, for instance.
“An alternate and complementary explanation for the relationship between inside investments and fund performance is that inside investors are simply better informed about managerial ability within the fund family, and they allocate their capital to the better fund managers,” the authors added.
Either way, Gupta and Sachdeva found that a one-standard-deviation increase in investment by the fund’s manager resulted in 1.4 to 1.7 percent in excess returns annually — leading to a boost in performance for those investors who are able to get a piece of the action.
“Some investors are able to co-invest with insiders and earn superior returns due to smaller fund size and the alignment of interests,” Gupta and Sachdeva concluded. “However, the smaller scale of insider funds can have detrimental consequences on other outside investors, who are rationed out of fund participation.”