Incentives in Hedge Funds

Abstract

We investigate a game of delegated portfolio management such as hedge funds featuring risk-neutrality, hidden types, and hidden actions. We show that capital gain tax plays the decisive role in solving the incentive problem. We characterize the constrained optimal fee scheme and capital gain tax rate; the fee after taxation must be linear and affected by gains and losses in a low-powered and symmetric manner. We argue that high income tax incentivizes managers to select this scheme voluntarily. The equity stake suppresses the distortion caused by solvency.