How Hedge Funds Are Structured


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This presentation offers users a simple guide to learning the basic structure of hedge funds. Guiding users through hedge fund structures, covering topics such as:

• Hedge funds’ typical partnership structure
• Organizational structure at many hedge funds
• Due to their structure, only certain types of investors can invest with hedge funds
• The role of portfolio managers
• The typical role of general counsels, auditors, and administrators at hedge funds
• How prime brokers interact with hedge funds
• Executing brokers and their role in the hedge fund industry
• Fee structure at hedge funds

Learn more about the global hedge fund industry at:

Published in: Economy & Finance
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How Hedge Funds Are Structured

  2. 2. How Hedge Funds Are StructuredContents Table of Contents: Executive Summary Hedge Funds’ Unique Structure 3 A hedge fund is an investment vehicle that Typical U.S. Hedge Fund Structure 4 can employ a wide range of investment Most Hedge Funds Are Established As 5 and trading activities to maximize Limited Partnerships performance returns while minimizing Investors 6 investment risk. Portfolio Managers 7 Most hedge funds are established as General Counsel, Auditors & Administrators 8 limited partnerships between the fund Prime Broker 9 manager and investors. While the specific structure can vary from fund to fund, there Executing Broker 10 are a few characteristics that are Organizational Structure 11 applicable across the industry. General/Limited Partnership Model 12 This presentation provides a brief Fee Structure 13 overview of some of the structures of Term Structure 14 hedge funds in the marketplace today. Graphic Illustrating Typical Fee Structure 15 2
  3. 3. How Hedge Funds Are StructuredHedge Funds’ Unique Structure Unique to the investment community, hedge funds are a partnership formed between the fund manager and the investors. Typically hedge fund managers invest a significant amount of personal capital - in some cases in excess of 50 percent of the total assets in the fund - aligning their interests with that of their investors.Source: Nocera, Joe (16 May 2009). "Hedge Fund Managers Farewell". The New York Times. Retrieved 16 March 2011. 3
  4. 4. How Hedge Funds Are StructuredMost Hedge Funds Are Established As Limited Partnerships. Investors share in the partnership’s income, expenses, gains and losses; each partner is taxed on its respective share of the partnership. Key Players: Determines strategy and makes investing decisions and allocations. The portfolios manager is also in the fund and is compensated via a modest Portfolio management fee, as well as a performance fee based on the fund’s annual Manager(s) performance. Fund managers only get a performance fee if the fund makes money. Funds must secure their loans with collateral to gain margin and secure Prime trades. In turn, each broker (usually a large securities firm) uses its own risk Broker matrix to determine how much to lend to each of its clients, acting as a de facto regulator. Ensure fund compliance; verify financial statements Auditors as required by federal law. *Note all hedge funds and managed futures firms are required by law to be registered with the SEC/CFTC or local and state regulators if they make over 4 $100 million.
  5. 5. How Hedge Funds Are StructuredTypical U.S. Hedge Fund StructureHere is an example of the structure Auditors andof a typical U.S. hedge fund: Administrators Portfolio Manager Investors Investors Prime Broker Hedge Fund Investors Executing Broker Investors Legal Advisors, Registrar and Transfer Agent 5Source: “Hedge Funds and Other Private Funds: Regulation and Compliance” Thomson West, 2010
  6. 6. How Hedge Funds Are StructuredInvestors Because hedge funds are highly regulated, by the SEC and CFTC in the U.S., fund managers can only accept investment capital from accredited investors or qualified purchasers, including: 1. Public employee retirement plans 2. Corporate employee retirement plans 3. University endowments 4. Foundations and non-profit organizations 5. Family offices and high-net-worth individuals. Regulatory qualifications for high-net-worth individuals are outlined below. High Net Worth Individual: An individual whose net worth, or joint net worth with the person’s spouse, exceeds $1 million at the time of the purchase, excluding the value of their primary residence Individuals with a yearly income of $200,000 or higher in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year. 6 Source: SEC, “Defining the Term "Qualified Purchaser" under the Securities Act of 1933.”
  7. 7. How Hedge Funds Are StructuredPortfolio Managers What is the role of a Portfolio Manger? • The portfolio manager makes daily investment decisions for the fund, choosing where and when to allocate investment capital. • Portfolio managers may be either direct employees of the hedge fund management firm or employees of another firm hired by the hedge fund management firm to provide investment advice pursuant to a sub- advisory agreement. 7
  8. 8. How Hedge Funds Are StructuredGeneral Counsel, Auditors, and Administrators What is the role of a General Counsel? The role of the General Counsel has evolved greatly in this new era of Dodd-Frank and increased regulation by the SEC. In addition to providing legal support and guidance, General Counsels now play a significant part in successfully managing a fund’s operations, returns, fundraising, and reputation. What are Auditors and Administrators? The offshore fund entity that manages the back office work and individual accounts for the fund. 8
  9. 9. How Hedge Funds Are StructuredPrime Broker A brokerage firm provides multiple services to a hedge fund that are beyond the scope of those offered by a traditional broker, such as: • Clearing and Settlement of Securities Transactions • Financing • Recordkeeping • Custodial Services (oversight of subscription and redemption order processing) • Research Capabilities Below are examples of Prime Brokers: 9
  10. 10. How Hedge Funds Are StructuredExecuting Broker An executing broker is a type of financial dealer or broker that is accountable and responsible for the completion and processing of an order that is requested by a client. As part of the process, brokers of this type will evaluate the order to make sure it is in line with all current policies and procedures and in compliance with any regulations set by the market. Below are examples of Executing Brokers: 10
  11. 11. How Hedge Funds Are StructuredOrganizational Structure The range of investment strategies available to hedge funds and the types of John Smith positions they can take are quite broad General Partner and in many cases, very complex. The typical hedge fund structure is really a two-tiered organization. The general/limited partnership model is the most common structure for the pool of investment funds that make up a State Retirement Plan/ hedge fund. University/ High Net Hedge Fund X Worth Individual 11
  12. 12. How Hedge Funds Are StructuredOff-Shore Organizational Structure General Partner of In structuring a hedge fund, a principal concern General Partner Investment Manager LLC LLC is to provide the most favorable tax result for the investors and the fund manager itself. Taxable Fund managers will seek to utilize entities U.S. Investment Investors Manager LP domiciled in jurisdictions which have clear and predictable laws, quality service providers, and Domestic are familiar to investors. It is for these reasons Hedge Fund LP that off-shore hedge funds are often Offshore Non-U.S. & Hedge Fund Tax-Exempt established. U.S. Investors Ltd . There are a number of structural approaches employed by off-shore hedge funds to accommodate different investors. This diagram Investments is an example of one type of typical off-shore Investments hedge fund structure. Source: "Structuring Offshore Hedge Funds,“ Hedge Fund Fundamentals, November 30, 2012. 12
  13. 13. How Hedge Funds Are StructuredGeneral/Limited Partnership Model In the general/limited partnership model, the general partner is responsible for the operations of the fund. General Operational Partnership While limited partners can make investments into the partnership and are liable only for their amounts paid-in. Limited Investors Partnership The second element of the two-tiered structure is the arrangement of the general partnership. The general partner is the typical structure used for a limited liability company. The general partners responsibility is to market and manage the fund, and perform any functions necessary in the normal course of business. Source: "Hedge Fund Organizational Structure," Investopedia, 2009. 13
  14. 14. How Hedge Funds Are StructuredFee Structure Hedge funds fee structures differ from other types of investment vehicles. Hedge funds typically charge investors a management fee, usually 1-2% of the assets managed. Most hedge funds also charge an incentive (or performance) fee of anywhere between 10-20% of fund profits. The idea of the incentive fee is to reward the fund manager for good performance. Managers only collect an incentive fee when the fund is profitable, exceeding the funds 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. 14
  15. 15. How Hedge Funds Are StructuredGraphic Illustrating Typical Fee StructureFund Performance for Investor New High Water Mark 20% 15% Manager collects performance fee on gain 10% High Water Mark Manager 5% collects performance feeValue of initial on gain Below high water investment mark: no performance fee - 5% Below high water - 10% mark: no performance fee -15% -20% Year 1 Year 2 Year 3 Year 4 15
  16. 16. How Hedge Funds Are StructuredTerm Structure The actual terms of partnership vary according to the fund, however they are usually based on a few factors. Subscriptions and redemptions: A hedge fund subscription is when the investor applies to join a particular fund. A hedge fund redemption is when the investor withdraws part or all of their investment from a particular fund. Unlike other investment vehicles, hedge funds do not have daily liquidity. Some hedge funds offer subscriptions and redemptions monthly, while others accept them only quarterly or annually. A typical subscription would be for example, a pension fund investing $200 million in a hedge fund. Lock-Ups: A lock-up is the time period that an initial investment cannot be redeemed from the fund. The most common lock-up is limited to one year. In certain cases, it could be a “hard lock”, which prevents the investor from withdrawing funds for the full time period, while in other cases, an investor can pay a penalty fee to withdraw funds before the expiration of the lock-up period. 16
  17. 17. How Hedge Funds Are StructuredSummary Hedge funds offer qualified investors a unique partnership, with the ability to invest alongside the fund manager and across a variety of financial instruments. Hedge funds’ market-neutral, or balanced, approach to investing helps seek out positive returns and minimize risk by investing in varied instruments over long- and short-term periods. Hedge funds’ investor base has evolved significantly over the years, with 65% of global hedge fund assets currently held by institutional investors such as pensions, endowments and foundations. Most hedge funds are created as limited partnerships between the fund manager and investors. While the specific structures of hedge funds can vary, there are a few organizational characteristics that are applicable across the industry. 17
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