Corporate and investment management law are replete with doctrines intended to put the interests of investors (principals) ahead of those of managers (agents). Such doctrines include fiduciary duty, the duty of care, the duty of loyalty and anti-fraud rules. However, such doctrines routinely run up against human nature. While generosity, especially in the form of tax-deductible charitable giving, is a noteworthy and laudable trait among the managerial class, selflessness in zero-sum situations – where my loss is your gain – generally is not a defining characteristic of corporate or investment managers. That’s not why people get into this business. Yet selflessness among managers is precisely the ideal to which the foregoing doctrines aspire. The tension between this aspiration and reality is the stuff of daily business news. In its most tame variety, this tension plays out in the ongoing debates about compensation of executives of public companies. And in its most extreme incarnation, the tension manifests itself in lurid investment adviser frauds and Ponzi schemes. Economists call this tension the principal-agent problem. The problem is that corporate or investment managers have the legal right to decide what to do with assets they do not own, and therefore may take actions that benefit themselves (the managers) but that are not in the best interests of the owners. The separation of ownership and control is a common feature of public companies, where the equity owned by management is small relative to the equity over which management exercises day-to-day control. Even in many mutual funds, the management company or individual portfolio manager often only owns a small investment. By contrast, a distinguishing feature of the hedge fund business model is substantial investment by the hedge fund manager – the individual portfolio manager as well as partners and employees of the management company – in its own funds. While such investments are not legally required, they are a tradition and an expectation among institutional investors. Indeed, in its 2009 annual report, the Yale endowment (a pioneer among institutional investors in hedge funds) noted: “An important attribute of Yale’s investment strategy concerns the alignment of interests between investors and investment managers. . . . [M]anagers invest significant sums alongside Yale, enabling the University to avoid many of the pitfalls of the principal-agent relationship.” See “Lessons for Hedge Fund Managers on Liquidity, Allocations, Marketing and More from Yale’s 2009 Endowment Report
,” Hedge Fund Law Report, Vol. 3, No. 14 (Apr. 9, 2010). This article analyzes various aspects of investments by hedge fund managers in their own funds, including: the rationales for such investments from both the investor and manager perspectives; the “market” for the amounts of such investments (as a percentage of the individual manager’s liquid net worth); the concern among investors where the manager has invested too little or too much in its own funds; reinvestment of bonuses in managed funds; the terms of manager investments; when, where and in what level of detail to disclose manager investments and redemptions; whether and in what circumstances managers have a duty to update representations regarding their fund investments; and how investors can verify managers’ representations with respect to their investments.