Hedge fund fee structure and risk exposure

We provide a closed-form solution for the optimal investment strategy of a hedge fund manager compensated by a management fee and a high-water mark (HWM) contract. The fraction of the assets under management (AUM) allocated to equity is an increasing and convex function of distance to the HWM, with the size of the incentive fee rate enhancing the convexity effect. Importantly, the management fee induces more risk-taking behavior because it provides insurance to the fund manager. Beating the HWM by small amounts is optimal because it mitigates the ratchet feature of the HWM and smooths revenue. The decomposition of revenues between the two fee types is also examined. An extension introduces fund termination triggered by a large AUM drawdown. Risk exposure is either a decreasing or a hump-shaped function of the distance to the HWM.