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30 Yale J. Reg. Online [i] (2012)

handle is hein.journals/jregb30 and id is 1 raw text is: The Institutionalization of Hedge Funds and the Asymmetric Price of Reputation: Could Hedge Funds Be Spending Too Much To Prevent Fraud? Chris Laboskyt I. Introduction Over the past decade, operating costs in the hedge fund industry have ballooned as the rate of new institutional investment in hedge funds has rapidly accelerated. These new institutional investors are demanding greater portfolio and operational transparency, more conscientious compliance, and tighter internal controls.' This correlation-between the institutionalization of hedge funds and their rising operating costs-can be explained by reference to the perverse incentives created by the prevailing principal-agent relationships of the industry. Because institutional investment managers put their reputations at risk through their investment decisions, they face higher fraud costs than the beneficiaries of the funds they manage (retail investors). They thus have an incentive to over-monitor their hedge fund investments in order to decrease the risk of fraud. The dramatic acceleration of institutional money entering the hedge fund industry has resulted in monitoring costs that are likely much higher than the real cost of fraud to ordinary retail investors. This inefficiency can be characterized as an agency cost of institutional investing. II. Agency Costs and Monitoring in the Hedge Fund Context Agency relationships impose significant costs on the parties to a principal- agent arrangement. When a principal entrusts an agent with authority over the disposition of his assets, the risk that an agent will abuse that authority to the detriment of the principal imposes transaction costs on both parties. Even when low, the mere presence of this risk invites a rational principal to expend resources to monitor the agent. At the margins, if the cost of monitoring appears to exceed the surplus to be gained by the relationship, it may even dissuade a principal from entering an otherwise -positive -net-present-value 2 relationship with a potential agent. Both results are inefficient. The present structure of the hedge fund industry provides an interesting case study in how layering principal-agent relationships can result in further inefficiencies. As explained below, where principals in the first instance are in turn agents of a third party, monitoring costs themselves may be inefficiently inflated, constituting a further agency cost for the contracting parties. In the hedge fund context, the primary risk that principals (investors) seek to avoid through monitoring is the risk of loss from fraud perpetrated by their agents (hedge fund managers).3 Since the industry is very lightly regulated (largely by the common law principles of contract and fiduciary duty) investors in hedge funds bear the monitoring costs associated with their investments voluntarily-when these expenditures are lower than their fraud costs would be in the absence of monitoring.4

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