In an earlier post we asked whether the "2 and 20" compensation system (2% of assets and 20% of profit) aligns the incentive of hedge fund managers with the profit goals of hedge fund owners. Colleague Nick Bollen and his student Veronika Krepely Pool have a working paper (abstract) that finds evidence of earnings manipulation by hedge fund managers to attract investors.
Hedge funds differ from mutual funds in that they are not valued every day. In addition, managers have discretion about how they value the (often illiquid) assets. Because young hedge funds find it easier to attract investors if they do not report negative returns, they choose valuation methods that avoid negative returns. Frequent auditing reduces earnings manipulation.