In the public company context, before stock options got a bad name via backdating scandals and unintended consequences (a skewing of incentives towards the short-term, unintended windfalls, etc.), they were seen as a potent tool for mitigating the adverse effects of the oft-bemoaned separation of ownership and control. Executive compensation debates, however, are not the exclusive province of commentators on public companies. The credit crisis focused the attention of hedge fund investors on executive compensation at hedge fund managers in a way that good times never could. See “Addressing (and Resisting) Demands for Changes in Hedge Fund Manager Compensation
,” Hedge Fund Law Report, Vol. 2, No. 16 (Apr. 23, 2009). As distinct from discussions of executive compensation at public companies, where the chief criticism often relates to the absolute level of compensation, hedge fund manager compensation discussions more often relate to the structure of compensation. In particular, one of the primary criticisms leveled during the credit crisis was that measuring performance fees over one year failed adequately to reflect the reality of most hedge fund investment strategies, which require more than one year for realization. Similarly, the idea of measuring performance compensation over a single year has been criticized as incentivizing managers to take undue risks and for potentially rewarding negative performance over multiple years. In an effort to better align the incentives of managers and investors, hedge fund managers have been evaluating the viability of fund appreciation rights (FARs), which offer a mechanism of manager compensation analogous to stock options. This article explores this provocative compensation structure, and includes analysis of: the mechanics of FARs; the analogy to call options; how FARs may offer the potential to better align the incentives of managers and investors; the clawback mechanism often built into FARs; a numerical example of how a FARs structure could operate in practice; how FARs can help retain talent, especially in lean years; whether FARs can be used in existing funds in addition to new funds; whether FARs can be used in domestic funds in addition to offshore funds; the tax consequences of FARs; and the market interest in FARs.