In this part, the paper will discuss the compensation structure used by hedge funds. The discussion will include the rationale for this compensation structure, its mechanics and the agency issues that can be associated with the compensation structure. The hedge fund structure is usually composed of general partners who handle all the trading activity from the fund and limited partners who supply the capital that is invested in the fund. Other members include the portfolio manager, who is usually the owner of the management company. The investors in the portfolio are usually between 100 and 150 certified investors who are willing to let the portfolio manager manage their funds for profit. The administrators of the hedge funds maintain the books and records and process all the transactions in the funds. Since the investors are not involved in the day to day handling of the fund, it is up to the hedge fund managers to complete all the transactions in the fund and charge fees to the investors in form of compensation structures. As already stated, the compensation structures used by hedge funds are different from those used by normal mutual funds since they take more fees in a different manner. The managers in the hedge fund use different strategies to create profits from the funds, and the Limited Partners, also known as the investors receive a percentage of the profit. The compensation structure in hedge funds is usually set on two main types of fees; performance fees and management fees. The performance fee in a hedge fund refers to the fee in the investment fund that a manager charges investors as a percentage of the increase in value of the assets in which the funds are invested. The value of the funds investments is periodically calculated and the fund manager gets a performance fee, usually between 20 and 30% of the Net Asset Value, which is the increase in value. The performance fee in hedge funds is similar to that in mutual funds. However, other fees that are in the hedge fund and not in the mutual funds are the management fees. The management fee is usually 1 to 2% of the fixed fee of the assets in the mutual fund, and in addition, an incentive fee of between 10 and 30% of the assets in the fund is also charged. The contentious point about these fees is that the management fee is usually charged regardless of whether the fund has made any profits, which means that the managers will always earn profits even if the fund fails. However, the performance fee can only be charged if the fund makes a pre-specified level of return, which is usually set at a percentage or decided as an index. This level of return is referred to as an hurdle, and the managers strive to increase the level of performance of the hedge fund in order to earn extra fees. Hurdles typically reduce the size of performance fees and increase the reward for better management of the fund, a factor that accounts or its popularity with investors. Another terminology analogous with the compensation structure of hedge funds is the high water mark, a term used to refer to the performance of the fund. The highest value of a hedge fund in a year is called the high water mark, and if the fund’s value falls in the subsequent year, the managers are not paid performance fees. This means that in subsequent years, if the funds increase in NAV but does not exceed the high water mark, no performance is also charged on the investors since they do not make any additional
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