Hedge fund managers with the first-loss scheme charge a management fee, a
performance fee and guarantee to cover a certain amount of investors' potential
losses. We study how parties can choose a mutually preferred first-loss scheme
in a hedge fund with the manager's first-loss deposit and investors' assets
segregated. For that, we solve the manager's non-concave utility maximization
problem, calculate Pareto optimal first-loss schemes and maximize a decision
criterion on this set. The traditional 2% management and 20% performance fees
are found to be not Pareto optimal, neither are common first-loss fee
arrangements. The preferred first-loss coverage guarantee is increasing as the
investor's risk-aversion or the interest rate increases. It decreases as the
manager's risk-aversion or the market price of risk increases. The more risk
averse the investor or the higher the interest rate, the larger is the
preferred performance fee. The preferred fee schemes significantly decrease the
fund's volatility.Comment: 32 pages, 17 figure