A hedge fund begins with the person who serves as the general, or managing, partner of the limited partnership that forms the structure of most hedge funds. This is the person who makes the actual investment choices and decisions for the fund. They are typically an established investment advisor with a proven track record in managing investments and/or a unique, appealing investment strategy. This individual, sometimes with the assistance of some of the initial investors, seeks out potential investors to persuade them to invest in the fund.

Once a fund has accumulated investment dollars it earns money based on assets under management (AUM) as well as on fund performance. The more investment money a hedge fund can accumulate, and the better it performs, the more money it makes for itself.

Key Takeaways

  • Hedge funds seem to rake in billions of dollars a year for their professional investment acumen and portfolio management across a range of strategies.
  • Hedge funds make money as part of a fee structure paid by fund investors based on assets under management (AUM).
  • Funds typically receive a flat fee plus a percentage of positive returns that exceeds some benchmark or hurdle rate.
  • Hedge fund marketing is a key method of bringing in new investor dollars, which adds to the fund's bottom line.

How a Hedge Fund Raises Money

A hedge fund raises its capital from a variety of sources, including high net worth individuals, corporations, foundations, endowments, and pension funds. Hedge funds do not usually look for individual small investors such as the average person who purchases shares in a mutual fund, but instead seek out investors with large amounts of investment capital with whom to form a limited partnership.

A large part of raising investment funds for a hedge fund depends on the initial performance of the fund manager. To get the fund started and establish an investing track record, the fund manager usually invests a substantial amount of his or her own money into the fund. If the fund manager performs exceptionally well, showing excellent returns on investment, the fund then begins to attract the attention of large institutional investors who have substantial amounts of capital available to invest.

Good performance is also likely to elicit investment of additional capital from initial investors. The keys to raising investment capital for a hedge fund are for the fund manager to be able to find and convince some initial investors of his or her ability to manage the fund profitably, and then proceed to do just that so the fund attracts additional investors in the future.

Hedge Fund Fee Structure

Two and twenty (or "2 and 20") is a popular fee arrangement that is standard in the hedge fund industry and is also common in venture capital and private equity. Hedge fund management companies typically charge clients both a management and a performance fee. "Two" means 2% of assets under management (AUM), and refers to the annual management fee charged by the hedge fund for managing assets. "Twenty" refers to the standard performance or incentive fee of 20% of profits made by the fund above a certain predefined benchmark. While this lucrative fee arrangement has resulted in many hedge fund managers becoming extremely wealthy, in recent years the fee structure has come under fire from investors and politicians for varying reasons.

Some hedge funds also have to contend with a high watermark that is applicable to their performance fee. A high watermark policy specifies that the fund manager will only be paid a percentage of the profits if the fund's net value exceeds its previous highest value. This precludes the fund manager from being paid large sums for poor performance and ensures that any losses must be made up before performance fees are paid out

Hedge Fund Marketing

Hedge fund managers are hampered in their efforts to raise funds by regulations that prevent them from publicly advertising a specific fund. They can, however, do things such as set up an informational website that explains their investment strategies and provides information on their backgrounds and experience as investors, investment advisors or money managers. Fund managers often seek publicity by offering specific trading ideas on investment websites.

Hedge funds are often marketed by the fund manager who networks with friends or business acquaintances or through third-party placement agents, who are individuals or firms that act as intermediaries for asset managers such as pension fund managers or investment managers for a foundation or endowment.

Sometimes fund managers offer "seed investment arrangements" to initial investors. In exchange for a substantial investment in the fund, the investor receives a discount on fund management fees or a partial ownership interest in the fund. These initial investors often do their own networking to solicit other investors. Hedge fund managers may produce some basic marketing materials to give prospective investors. Such material, referred to as a "pitch book" or "tear sheet," contains information on the fund's strategy, the fund manager and an outline of the terms for investing in the fund.