Wednesday, September 2, 2015 | 9:00am-10:30am | Room 335, HSBC Business School Building

Abstract

Foster and Young (2010, Quarterly Journal of Economics) shows that it is very difficult to design performance fee contracts that reward skilled fund managers while screening out unskilled fund managers. In particular, none of the standard practices, such as postponing bonuses and claw back provisions, can separate the skilled and unskilled managers. We show that if (1) there is a liquidation boundary, meaning that the fund investors have the right to be informed and to liquidate their stake as soon as the fund returns is bad enough to hit the boundary, and (2) the fund manager has to use his/her own money to set up a deposit to offset the potential losses from the fund investors, then the skilled and unskilled fund managers can be separated. The deposit can be a combination of cash or an equity stake in the fund. A particular version of this type of contracts, called the first-loss scheme, is quite popular in China, and is emerging in U.S.