FRM Part II · FRM Exam Part II · Risk, Regulation and Organizational Structure
A multi-strategy hedge fund manager runs a flagship fund with a 20% performance fee and a high-water mark, and a new side fund with a lower fee but the same strategy. A limited investment opportunity arises. The manager allocates all of it to the flagship fund, which is far below its high-water mark, and none to the side fund. Which description best fits this situation?
This is an allocation conflict between funds. The manager has an incentive to steer limited opportunities toward the fund where incentive fees offer the most upside, here the flagship fund needing recovery, at the expense of side fund investors. Fair allocation policies and oversight are the usual controls.
- AAn allocation conflict between funds, since the manager favors the fund where incentive fee upside is greatestCorrect
- BA liquidity mismatch between funds with different redemption terms
- CStyle drift in the side fund
- DCounterparty concentration with the prime broker
Explanation
A fund far below its high-water mark has an option-like fee structure with potential to earn large performance fees if it recovers, and the manager may favor it when allocating scarce opportunities. This disadvantages side fund investors, creating a cross-fund allocation conflict. Nothing indicates liquidity mismatch, drift or counterparty concentration.
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