Reward for failure and executive compensation in institutional investors

- We characterize optimal incentives when alternative investments are delegated.
- It considers a reward for risk-taking and a counter-intuitive reward for failure.
- This property follows from compensating extreme returns, even low ones.
- Our results provide a rationale for golden parachutes and golden coffins.
- Implementation through equity and bonuses is also analyzed.

We propose a model of delegated portfolio management specialized in alternative investments, i.e., those with a high-return and high-risk profile. It is shown that in this context, as a reward for risk-taking scheme is optimal, a counter-intuitive reward for failure can also be desirable. This property emerges because it can be optimal to compensate extreme returns (even low ones) to encouraging managers to shape highly innovative portfolios. It is argued that this structure resembles compensation practices questioned in the context of the last financial crisis, such as golden parachutes and golden coffins. Implementation via equity and bonuses is also analyzed.