So You Want To Start A Hedge Fund

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Setting up a hedge fund used to be so easy that almost anyone could complete the process for about $500 (not including staff or a prime brokerage, but still). Post-crisis, the landscape has a changed a bit, and Riveles Law Group has put together a brief guide on what’s involved in setting up shop for yourself.

Realistically, if any fund manager hopefuls are reading this for tips instead of just contacting a lawyer, you can count me as deeply concerned. But now that hedge funds have gained mainstream acceptance as an important part of most portfolios it’s important to know how they are structured so you know what questions to ask when comparing funds.

Hedge fund structure

A hedge fund that wants to take investments from US taxpayers (which doesn’t only include citizens) is generally set up as general partnership with a limited liability company organized in the fund manager’s home state so that everyone can benefit from pass-through taxation. For non-US taxpayers (foreign clients, non-profits, endowments) it’s more common to set up an offshore fund somewhere with a low tax rate (like the Cayman Islands).

If a hedge fund wants to accept investments from both groups, then the manager can either choose a side-by-side or master-feeder structure. A side-by-side structure is where the manager simply maintains two separate funds but makes the same trades for each of them, although this is logistically difficult for strategies that involve active trading. A master-feeder structure lets domestic and offshore investors use separate feeder funds to invest in the same master offshore fund.

Headge Fund: Compensation and liquidity

Hedge funds traditionally used a 2-20 fee structure: 2% management fee plus a 20% performance fee. These days, the increased competition has put a lot of pressure on the management fees, and they fall in the 1% – 2% range (though still closer to 2% on average). Performance fees have mostly stayed at 20%, but it is now common to use high water marks (losses must be recouped before performance fees are assessed) and hurdles (minimum rates of return must be hit or performance fees are forfeit).

From a manager’s point of view, one of the main advantages of running a hedge fund is that investors can’t simply pull their money out when things look rough. A lock-up period of one or two years is normal, and even after that investors may only be allowed to take out funds every quarter, half, or year. Gates limit the total outflow from the fund at any given time (say, 10%) so that if the total requested withdrawals are higher than the gate, investors will only get a portion of what they request until the next redemption period.

Incubator fund

For a young professional investor without much of a public track record to entice investors, an incubator fund gives him the opportunity to start trading (often with his own money) and building a reputation. This involves setting up the fund’s legal structure, but with lower overhead (staff, legal counsel, auditors) until the investor has generated enough interest to start looking for investors.

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