If you are planning on starting a hedge fund or if you are already managing one, learning and understanding how are hedge funds structured is essential. The investing climate is often changing, and knowing what works best for your unique situation is often a factor that will lead to the success or failure of an operation.
When setting up a hedge fund, choosing an organizational and legal structure will later define its line of work. In terms of legal structure, hedge funds can fall within different jurisdictions, like domestic and offshore funds, impacting regulation, taxation, and accessibility to investor capital. Organizational structure defines what will be the relationship between the fund managers, investors, and service providers.
Ultimately, the strategy and approach to investments will shape the structure of the fund, so for the best results, stay with us while we dive into a detailed presentation of this interesting but rarely covered topic.
Key Takeaways
- The difference in hedge fund structures comes in the form of different organizational and legal structures. Every form has a unique set of features that makes them better for specific types of fund organizations.
- Organizational hedge fund structure is commonly divided between a general partner, limited partners, and an investment team.
- When looking at the legal structure of a hedge fund, there are a number of options, all coming with their ups and downsides. Most popular include domestic limited partnerships, limited liability companies, umbrella funds, master-feeder funds, and offshore funds.
Defining Hedge Funds
Before we go into detail about hedge fund structures, we need to know the hedge fund basics. They are an investment vehicle, with its form moving into the alternative investment playground. Other types of investment vehicles are accessible to a wide array of investors who have limited access to capital.
Hedge funds, on the other hand, work only with accredited investors. To become one, an individual investor or an institution must have either a high net worth (at least $1 million) or a significant annual income ($200.000). When looking at these figures, it is easy to see that most individual investors do not fit the bill.
The exclusivity of investing in hedge funds comes from several reasons. While all investments come with risks, hedge funds are notorious for their risk levels. Hedge funds employ complex, diverse, and often highly risky investment strategies.
Combining these factors with fee structures that are among the highest in the industry and usually long lock-up periods, hedge funds are with reason reserved for the wealthy. If anybody could have access to hedge funds, dealing with the loss of the last capital would be devastating for many.
On the flip side, hedge funds offer a chance for investors to access diversified portfolio construction, which can also deliver significant gains. Due to the wide range of strategies that hedge fund managers use, investors can seek funds that emphasize their investing priorities.
Hedge Fund Organizational Structures
General Partner
A general partner can be an individual or an entity that is responsible for making investment decisions. Key tasks include creating an investment strategy, allocating assets, and constructing a portfolio. Depending on the fund and the division of activities, general partners also tend to execute important trades and oversee market risk and developments.
Since the GP is at the top of the ladder, it is also held accountable for ensuring compliance with regulations. GPs should also cover the majority of fund operations and keep up with developments.
One of the crucial activities of a GP is raising capital from limited partners. Without attracting new investors or fresh capital, it is difficult to push the fund into new business deals. As a part of attracting capital, GPs must have a knack for marketing their own success through presenting performances and fund operations.
Limited Partners
Unlike GPs, who are active participants, limited partners only provide capital for fund operations. They do not partake in making investment and strategic decisions. Despite not having a direct influence, LPs are drawn into making an investment based on their approach, track record, and future potential.
As we mentioned before, to invest in a hedge fund, an investor must be accredited. After fulfilling the necessary conditions, every investor, either an individual or an institution, can place their capital into a fund.
Before LPs decide to invest, they conduct the most important part of the process from their side—conduct due diligence. Every investment company has a unique approach to investing, and with a little digging, it is possible to find something suitable to your needs.
Investment Team
The investment team is composed of portfolio managers, analysts, traders, and risk managers. They are all focused on the same task: maximizing gains for the fund, which benefits both their salaries and investors's returns.
Portfolio managers are making key decisions in constructing portfolios and keeping an eye on their performance. They are following the investment strategy that is already set in place and are accountable for the fund's performance.
Making investment decisions is a series of smaller actions leading to it, including analysis of the market, macroeconomic trends, and asset performances. Managers must have all these under consideration before making a definitive decision to move.
Portfolio managers rely on research analysts who provide in-depth research of the specific industry, companies, or even whole asset classes. Analysts, together with managers, assess every asset before the decision is made.
Depending on the structure of the fund, traders can be hired to conduct trades and optimize trade execution to minimize costs. While they are not exclusively needed in every hedge fund, most larger ones have designated traders.
We touched on the topic of investment risk earlier, and to minimize it, hedge funds employ risk management professionals and even teams. They conduct risk analysis that includes market risk, liquidity risk, credit risk, portfolio concentration risk, leverage risk, and strategy risk analysis.
Risk management professionals also ensure that risk strategies that are implemented are in line with the fund's risk tolerance and regulatory requirements.
Hedge Fund Legal Structures
Domestic Limited Partnership
A domestic limited partnership is led by a general partner who has unlimited liability. Limited partners have liability up to the level of their investments. Income is taxed only at the partner level, so the taxation is pass-through. This approach eliminates a chance for double taxation.
Some of the advantages of this type of legal structure are tax efficiency, investor protection, and flexibility. Income is reported by investors through their tax returns, while the partnership agreement can outline custom profit-sharing terms. Another benefit is that LPs allow the allocation of income tax in a tax-friendly way.
On the flip side, this approach is best suited for US-based investors. Also, it can be cumbersome to organize since it requires significant legal and administrative setup.
Limited Liability Company
Regarding tax treatment, LLCs are treated like partnerships, thus avoiding double taxation, and partners are only taxed on their share of profits. Another plus is that the LLC can elect to be taxed as a corporation. This approach is mostly used by smaller hedge funds or single-manager funds.
It is highly customizable, allowing partners to tailor profit and loss allocation. All members have liability protection, including managers. It is suitable for everyone, so there are no limits on the type or number of members.
Due to its wide applicability and customization, it can be troublesome to follow through compliance-wise in the case of several jurisdictions. Also, it is not often favored by foreign investors.
Master Feeder Funds Structure
The master-feeder structure is used mostly by hedge funds to pool capital from US-based investors and offshore investors. It can be taxable and tax-exempt capital, and it is gathered into a master fund. Every group of investors establishes a fund known as a feeder fund. All feeder funds invest assets into a centralized fund or so-called master fund.
While all investment decisions and portfolio construction are made on the master fund level, performance and management fees are paid on the feeder fund level. The biggest upside of this type of structure is the ease of managing larger capital, with an option to tailor investment strategies by niches for every group of investors.
One of the most sought-after benefits is the consolidation of several portfolios into one entity. Due to their often large size, they also benefit from economies of scale, which include better conditions from prime brokers and other institutions. It also provides tax-advantaged partnership status and is accessible to both domestic and offshore investors.
On the downside, master-feeder funds are subject to a 30% withholding tax on U.S. dividends. Another minus is the sheer range of investors that have different goals, which can be difficult to address in the same manner.
Offshore Funds
Offshore funds are typically incepted in locations like the Cayman Islands, Bermuda, or Luxembourg. The primary drive for investors to choose these locations is no local corporate or income tax. A lot of companies in the hedge fund industry are using these types of funds to offset some of their investments.
An offshore fund also provides the benefit of no US taxation to non-US investors in case of any earnings. Offshore funds are used as alternative investments by non-US investors and US tax-exempt entities like endowments and pension funds. Another upside of investing through the offshore fund is that a usually flexible regulatory environment makes fund operations much easier.
The most obvious risk that comes with investing in offshore funds is not knowing the specific rules. While someone may understand how investing works in the US or Europe, these tax havens have their own unique set of rules. Without proper due diligence, they can end up losing a lot, or everything in these transactions.
Umbrella Funds
An umbrella fund is a complex fund structure that is made out of several smaller funds. While today they are not as popular as they used to be, umbrella funds offer a number of upsides. One of the uses of an umbrella fund is for larger funds in case they do not have a pension plan but would want to establish a retirement fund.
Similar to a master-feeder structure, it can be used to group several smaller funds into one larger structure. One of the benefits of using umbrella funds is saving on trading and operating costs due to the sheer economies of scale that these funds rely on.
Also, they can allow investors flexibility and access to diverse investment products while remaining in the same fund. In another case, an investor would have to pay additional costs while conducting sales and trades through different funds.
Importance Of Hedge Fund Structures
Due diligence plays a crucial part in identifying reliable and acceptable options for investors. Key considerations, besides the strategies that the fund employs, refer also to the structure of the fund.
When the fund has clearly defined roles like general partner or limited partner, it is easier to understand the line of responsibility. This not only works from the outside (investors vs. partners) but also as a clear area of responsibility between employees. When every employee knows their part in the system, there cannot be overlapping and switching guilt for a mistake to other partners.
Different legal structures provide their own unique liability protection features to investors. If the fund is structured as a limited partnership, it protects investors from financial liabilities beyond their investment in the fund.
On the other hand, limited liability company organized funds, besides a similar level of liability protection, also offer more operational flexibility. This structure offers even higher protection to the investor from exposure to risks connected with debt or legal issues.
Since tax policies play an important part in the investment process, master-feeder funds provide tax efficiency through onshore and offshore fund options. Onshore funds provide benefits for U.S. taxable investors, while offshore funds cater to tax-exempt investors or non-U.S.-based investor types.
Challenges In Structuring Hedge Funds
When structuring a hedge fund, an individual must have in mind several factors, including regulations, both domestic and international, licensing and reporting requirements, and compliance with anti-money laundering laws.
On the top of priorities when choosing the best structure is the impact of taxation. Some fund organizations provide some tax benefits that others don't, which can be significant for the company's operations.
And also, one must never forget the investor's preference. Different types of investors, including US taxable investors, non-US investors, and institutional investors, in most cases have different priorities and ways to reach their goals.
