The Impact of Competition on Manager Compensation: Theory and Evidence in Hedge Funds

The hedge fund (HF) industry has experienced dramatic changes since late 2007. Before then, HF managers faced little or no competition because of affluent capital in the market. Since then, however, large redemption because of the financial crisis has forced managers to compete for capital, leading to a transfer of bargaining power in managers' compensation contracts from the managers to the investors. In this paper, we investigate the impact of competition on managers' compensation using a signaling game model. We show that, when the bargaining power is on the investors' side, managers are less willing to offer a high-water mark. These findings are further validated in an empirical study.