Performance Fees and Asset Prices in Equilibrium

The paper examines the effects of exogenous changes in the performance fees paid from terminal investors such as households to intermediaries managing their assets, on endogenous variables such as the risky asset volatility and risk premium, in the context of a dynamic equilibrium asset pricing model. The importance of the household behavior is highlighted by comparing two settings, one in which households are naive and perceive the investment opportunities as constant, and one in which households are more sophisticated and perceive the true opportunity set conditionally on the state variables. Intermediaries receive performance-based fees that are convex in the actual performance. These fees have a component proportional to performance, as well as a component capturing the convexity of fees as a function of performance. When households are naive, a higher proportional fee coefficient implies higher asset volatility and risk premium, as well as higher volatility in these variables. Moreover, a higher convex component has little impact on the volatility, but reduces the risk premium. In contrast, when households are sophisticated, a higher proportional fee component has little impact on the economy dynamic, but a higher convex component increases stock volatility and risk premium, as well as the volatility of these variables. If changes in the fee structure are important, the economic effects can be significant. Empirically, hedge fund performance fees are related to market returns and volatility in ways consistent with the framework where households are naive