Existing literature claims that performance fees induce excessive risk-taking behavior from hedge fund managers because higher risk increases the value of the performance fee option. In this paper it is argued that the relationship between investors and hedge fund managers is similar to the relationship between shareholders and corporate managers. Principal-agent theory is applied to this issue which shows that the performance of hedge funds and the payoff of the performance fee contract are endogenously determined by the fund manager’s effort. The excess returns are shared between the investor and the manager and there is a natural upper bound to risk. The empirical results indicate that performance fees are positively associated with risk adjusted returns which is consistent with the theory.
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