determinants of hedge strongfundstrong internal controls and fees.pdfVIP

Determinants of Hedge Fund Internal Controls and Fees* Gavin Cassar The Wharton School University of Pennsylvania Joseph Gerakos Graduate School of Business University of Chicago October, 2008 ABSTRACT We investigate the determinants of hedge fund internal controls and their association with the fees that funds charge investors. Unlike other investment vehicles, hedge funds are subject to minimal regulation, allowing fund managers to voluntarily choose and implement internal controls, and managers and investors to freely contract on investor fees and manager compensation. Using a proprietary database of due diligence reports, we find that funds domiciled offshore are more likely to adopt stronger control mechanisms that decrease the likelihood of fraud and financial misstatements, and are more likely to use reputable outside service providers and incorporate stricter authority over the transfer of funds. We also find that internal controls vary systematically by fund leverage and fund age, and whether the fund pursues a short selling investment strategy; consistent with agency costs and the protection of proprietary information explanations, respectively. With respect to internal control outcomes, managers of funds that have restated performance receive lower management fees. Further, we find a positive association between internal controls and performance based fees, which is co