First-Loss Capital

X. He

In most U.S. hedge funds, the managers take a performance fee, such as 20%, for any profit they generate for the investors but do not pay in case of a loss. In China private equities and also in some new hedge funds in the United States, the managers, however, need to provide a first-loss capital to absorb the investors’ loss and charge a performance fee at a higher rate, e.g., 40%. We study how the first-loss capital can reduce fund risk, improve the well-being of the managers and  investors, and separate skilled managers from unskilled ones.