Corporate Governance and Hedge Fund Management

Bruce N. Lehmann
Economic Review, Vol. 91, No. 4, 2006

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Conventional thinking about governance issues for hedge funds is to view them as mutual funds or money managers. This article proposes an alternative view—that hedge fund governance is best understood by looking at limited partnerships or public firms that are similar in terms of either their assets or liabilities. This reasoning suggests that most hedge funds can be classified into only two groups for the purpose of understanding governance issues: funds that engage in proprietary trading and those that are more like private equity partnerships.

The analysis implicitly explains why proprietary-trading-like hedge funds replaced the unlimited liability partnerships of the Wall Street investment houses that preceded them: Unlimited liability partnerships require higher opportunity costs of capital than hedge funds with strong incentive contracts.

Similarly, the separation of ownership and control associated with proprietary trading in a public firm suggests that this organizational form is viable only for those entities that have substantial franchise values based on reputation. From this perspective, private-equity-like hedge funds are much like niche firms in the larger private equity universe.

The analysis in this article provides the scaffolding for assessing the net burden of regulation, the author concludes, but the real heavy lifting requires a more detailed explication of the nature of and limits to contractibility in these markets.

December 2006

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