Three essays on hedge funds and distress risk

This dissertation examines failure risk and its impact on future performance in the hedge fund industry, industry-wide distress risk and its impact on future returns in the stock market, and the interaction between managed assets and share restrictions in equity-oriented hedge funds. The first essay shows that hedge funds fail slowly rather than through sudden crashes. I model a fund's probability of failure using a dynamic logit regression and find that fund failures are predicted by past performance and fund flows measured with a lag of at least seven months. Hedge funds fail as poor performance over a period of time leads to fund withdrawals by investors. A fund's failure risk negatively predicts the fund's future returns. Sorting hedge funds into quintiles by their predicted failure probability based on information lagged by seven months, I find that the return spread between the two extreme quintiles is 7.2 to 8.3% per year after adjusting for nine commonly used hedge fund risk factors and a return smoothing effect over the period from July 1996 to December 2008. The negative failure risk effect on future fund returns is sharply higher for funds with weak share restrictions and is not subsumed by the findings of the prior literature.;The second essay finds significant industry-wide distress effects when forecasting corporate failures and predicting future stock returns. Modeling a firm's failure probability using a dynamic logit regression with both firm-specific and industry-level variables as failure predictors, I find that industry fundamentals forecast corporate failures. A firm is more likely to fail when it is in a distressed industry, even after accounting for firm-specific fundamentals. I then compute ex ante distress probabilities and relate these to future stock returns. The anomalous negative relation between firm-level distress and stock returns exists only in distressed industries. Cross-sectional regressions show that only the interaction term between firm distress and industry distress matters when predicting future stock returns. My results highlight the importance of an industry perspective in potential explanations for the negative premium associated with firm distress risk. I investigate plausible risk and mispricing explanations and find evidence mostly consistent with investor underreaction to distress risk in high distress industries.;The third essay studies the interaction between managed assets and share restrictions in the context of equity-oriented hedge funds. Small-cap/value oriented funds manage less liquid assets, take higher liquidity risk, and are more likely to use a lockup restriction than large-cap/growth oriented funds. Moreover, I find positive interaction effects of managed assets' illiquidity and share restrictions on fund performance. Small-cap/value funds with strong share restrictions outperform both small-cap/value funds with weak share restrictions and large-cap/growth funds with strong share restrictions. Empirical results suggest that the outperformance is mostly driven by two components: first, small-cap/value funds earn a higher risk premium from greater exposure to the SMB, HML, and liquidity risk factors, and second, strong share restrictions are helpful for small-cap/value funds by mitigating a fire-sale problem as these hedge funds suffer the most from low market liquidity.