Hedge Fund Investing: A Practical Approach to Understanding Investor Motivation, Manager Profits, and Fund Performance

Agency Theory

Agency theorists believe that active monitoring, incentives, or both are needed to align the interest of an agent with a principal. The use of incentives to control or motivate behavior in agents is an imperfect process with varying results. Nonetheless, the case for owners or investors empowering agents to expand organization skill sets and opportunity sets beyond a founder or principal has been widely accepted in the United States and in most, if not all, other capitalist societies (Jensen and Meckling 1976).

Agency theorists believe that agents will pursue their own interests or behave opportunistically unless principals engage in costly monitoring to avoid unwanted behavior. Without costly monitoring, principals are exposed to the additional risk that the agent's actions will not achieve their objectives. They believe that the degree to which a manager will work on behalf of investors is a function of the nature of the task and monitoring devices (Stroth, Brett, et al. 1996) and the stake that the manager has in the performance of the business via co-ownership, premium compensation, or incentives (Jensen and Meckling 1976; Walking 1984; Eisenhardt 1989). Agency theory suggests that principals who provide capital may incur losses when agents produce low-quality outcomes, embark on unwarranted risk taking or financial leverage, or pursue objectives designed only to enhance their own wealth. Principals (or, in this case, investors) therefore need to establish mechanisms ...