Structurally, a hedge fund has some similarities to a mutual fund. For example, just like a mutual fund, a hedge fund is a pooled investment vehicle that makes investments in equities, bonds, options and a variety of other securities. It can also be run by a separate manager, much like a sub-advisor runs a mutual fund that is distributed by a large mutual fund company. That, however, is basically where the similarities end. The range of investment strategies available to hedge funds and the types of positions they can take are quite broad and in many cases, very complex. We will focus on specific strategies later in this tutorial, so for now we'll focus on how hedge funds are structured.
The typical hedge fund structure is really a two-tiered organization.
|Figure 1: Hedge Fund Organizational Structure|
|Source: Investopedia, 2009.|
The general/limited partnership model is the most common structure for the pool of investment funds that make up a hedge fund. In this structure, the general partner assumes responsibility for the operations of the fund, while limited partners can make investments into the partnership and are liable only for their paid-in amounts. As a rule, a general/limited partnership must have at least one GP and one LP, but can have multiple GPs and many LPs. There is an SEC rule, however, that generally limits investors to 99 in order to be excluded from SEC registration. (Learn more about the SEC in Policing The Securities Market: An Overview Of The SEC.)
The second component of the two-tiered structure is the structure of the general partnership. The typical structure used for the general partner is a limited liability company. An LLC is very similar to a subchapter S corporation in that it is a flow-through tax entity and investors are limited in liability to the amount of their investment. The general partner's responsibility is to market and manage the fund, and perform any functions necessary in the normal course of business, including hiring a fund manager (oftentimes a related company) and managing the administration of the fund's operations.
Hedge funds also differ quite radically from mutual funds in how they charge fees. Their fee structure is one of the main reasons why talented money managers decide to open their own hedge funds to begin with. Not only are the fees paid by investors higher than they are for mutual funds, they include some additional fees that mutual funds don't even charge.
The management fee for a hedge fund is for the same service that the management fee covers in mutual funds. The difference is that hedge funds typically charge a management fee of 2% of assets managed – and in some cases even higher, if the manager is in high demand and has had a very good track record. This fee alone makes managing a hedge fund attractive, but it is the next fee that really makes it a profitable endeavor for good fund managers.
Most if not all hedge funds charge an incentive fee of anywhere between 10-20% of fund profits, and some hedge funds have even gone as high as 50%. The idea of the incentive fee is to reward the hedge fund manager for good performance, and if the fund's performance is attractive enough, investors are willing to pay this fee. For example, if a hedge fund manager generates a 20% return per year, after management fee, the hedge fund manager will collect 4% of those profits, leaving the investor with a 16% net return. In many cases, this is an attractive return despite the high incentive fee, but with more mediocre managers entering the industry in search of fortune, investors have more often than not been disappointed with net returns on many funds.
There is one caveat to the incentive fee, however. A manager only collects an incentive fee for profits exceeding the fund's previous high, called a high-water mark. This means that if a fund loses 5% from its previous high, the manager will not collect an incentive fee until he or she has first made up the 5% loss. In addition, some managers must clear a hurdle rate, such as the return on U.S. Treasuries, before they collect any incentive fees.
Hedge funds often follow the so-called "two and twenty" structure – where managers receive 2% of net asset value managed and 20% of profits, though as mentioned, these fees can vary among hedge funds. (For tips on paying fewer fees, see Stop Paying High Mutual Fund Fees.)
The terms offered by a hedge fund are so unique that each fund can be completely different from another, but they usually are based on the following factors:
Subscriptions and Redemptions
Hedge funds do not have daily liquidity like mutual funds do. Some hedge funds can have subscriptions and redemptions monthly, while others accept them only quarterly. The terms of each hedge fund should be consistent with the underlying strategy being used by the manager. The more liquid the underlying investments, the more frequent the subscription/redemption terms should be. Each fund also specifies the number of days required for redemption, ranging from 15 days to 180 days, and this too should be consistent with the underlying strategy. Requiring redemption notices allows the hedge fund manager to efficiently raise capital to cover cash needs.
Some funds require up to a two-year "lock-up" commitment, but the most common lock-up is limited to one year. In some cases, it could be a hard lock, preventing the investor from withdrawing funds for the full time period, while in other cases, an investor can withdraw funds before the expiration of the lock-up period provided they pay a penalty. This second form of lock-up is called a soft lock and the penalty can range from 2-10% in some extreme cases.
There are a variety of different combinations that can be used to structure a hedge fund and its related companies and investors. The above summary briefly describes one very common method used to structure the hedge fund and its management company. There are many others and just as hedge funds are creative with their investment strategies, they can also be very creative with their organizational structure. The takeaway of this section is to stress that each corporate structure is unique and should be evaluated along with all other factors covered in the rest of this tutorial.
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