Behavioral Finance

1. Behavioral Finance Economics 437

2. Two Main Categories • Hedge Funds • Private Equity Funds

3. Long History with Private Investors • Hedge Funds • Originally begun in 1970s to circumvent two Investment Act of 1940 rules: • Prohibition of short selling • Prohibition of “performance fees” • Private Equity • Simple (limited) partnership structure (so are hedge funds) • Became the modern form during early “buyouts”

4. What do they have in common • Commitment and Performance Fees • “two and twenty” • Though, over time, the trend is more toward “one and fifteen” • How does it work? • Suppose you commit $ 100 million to a hedge fund - cost to you per year is $ 2 million, regardless of performance • Each year, hedge fund retains 20% of any gains, but does not share in losses. • So, if you make $ 10 million during the year, the hedge fund gets paid $ 2 million in performance fees.

5. Private Equity is More Complicated • Suppose you commit $ 100 million to a pe fund • Initially you give them zero money • You wait: until the “call” for money • Suppose you get a “capital call of $ 20 million, you then send them $ 20 million, but the remaining $ 80 million is known as “Uncalled Capital” • You pay 2 % fees on total commitment, whether called or not: $ 2 million per annum

6. PE Continued • During the year, there may be more capital calls: $ 20 million, then $ 10 million, etc. • But there may also be distributions: random - $ 21 million from the first call, etc. • Could be gains or losses • PE firm gets 20% of “gains.” • How do you define gains? It varies

7. How They Differ? • Liquidity for investor • PE – very illiquid • Typically, 7-10 year “lockup” of funds (other than distributions) • Not uncommon that at the end of the fund, investor ends up with ownership percentages of companies that were never sold by the fund • Hedge Funds – more liquid • Periodically, once a quarter, once a year, an investor can request “withdrawals” • But, “gates” can prevent withdrawals

8. The End