The term “hedge fund” has no precise legal definition, yet a hedge fund is commonly referred to as an actively managed, open-end, unregistered, pooled investment fund that employs one or more investment strategies. Most hedge funds are private funds that are open only to a limited number of accredited investors. The general partner and investment manager of the fund generally receive compensation from fees based on the total value of the assets under management and a performance-based fee based on the profits generated over a period of time.
Capital raising strategies of hedge funds vary widely. Some fund managers raise capital through family and friends while others are formed with the backing of a large investor or marketed primarily to institutional investors, such as pension plans. Your capital raising strategy may vary over time based upon your success to different types of investors and your fund’s performance and track record.
In contrast to closed-end private equity funds, a typical hedge fund invests in liquid assets. Using a limited partnership structure, the general partner allocates capital on behalf of the limited partners into assets that have a potential to gain or lose value. Limited partners become investors in the fund and have capital accounts, where the balance reflects each investor’s pro-rata share of the fund’s total investments and liabilities. Each capital account increases in value when the investor makes additional capital contributions or profits are generated by the fund and subsequently allocated to the capital account. Conversely, the investor’s capital account decreases in value when expenses or losses are allocated to the capital account or the investor makes withdrawals or redemptions.
For information about other fund structures, see the following links:
An efficient, well-designed hedge fund is typically structured to achieve maximum tax efficiencies for its investors. Generally, most domestic, US-based hedge funds are set up as a Delaware limited partnership. The limited partnership will have a general partner, most likely to be set up as a limited liability company and a separate investment manager, also likely to be set up as an additional limited liability company. The general partner typically exercises full control over all of the activities of the fund, including management of the fund’s portfolio and business affairs, while the investment manager is generally responsible for raising capital and making recommendations on which assets to purchase and sell and when the fund ought to take such action. Hence the reason why the management fees and performance allocations are split and paid to two separate entities: the performance allocations to the general partner and the management fees to the investment manager. Hedge fund managers will likely enjoy greater fees and other benefits when the hedge fund outperforms other attractive indices or mutual funds because of their unique strategies or edge. Hedge funds generally charge a low management fee (around 1-3% per year) based on the net asset value of the total assets under management, and receive performance allocations (typically 20%) as a share of the profits generated over a specific time period. Thus, hedge fund sponsors have a greater incentive to generate higher profits so as to increase their performance allocation.
Hedge fund managers may pursue varying strategies to meet their investment objectives. A distinguishing feature of most hedge funds is that they invest primarily in liquid securities. Some of the most common hedge fund investment strategies include:
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