Hedge funds are often misunderstood, frequently confused with hedging or private equity funds. In this article, we aim to demystify hedge funds by explaining their key characteristics, structures, and strategies.
What is a Hedge Fund?
Hedge funds are distinct from hedging strategies. While hedging aims to reduce risk, hedge funds primarily seek to maximize investment returns. These funds typically invest in publicly traded securities and derivative instruments, allowing their portfolios to be marked to market. Investors can both invest in and redeem their interests in hedge funds, although certain limitations may apply. Some hedge funds allocate a portion of their assets to illiquid securities through “side pockets,” but this practice is less common. In contrast, private equity funds invest in securities of private companies, making them less liquid and subject to strict investment and exit restrictions, often with fund terms lasting up to ten years.
Hedge Fund Structures
- Single Domestic Fund:
A standalone domestic hedge fund typically takes the form of a Delaware limited partnership or a Delaware limited liability company (LLC). Investors become members, and the investment manager serves as the fund’s manager or general partner. If structured as an LLC, the manager enjoys limited liability protection; however, this protection is absent if the fund is structured as a limited partnership (LP). To minimize personal liability, it’s essential to establish a separate investment management entity as an LLC.
- Fund of Funds:
Fund of funds structures have gained popularity recently. These investment vehicles do not directly invest in securities but allocate capital to other hedge funds, private equity funds, or various fund types. Some fund of funds diversify across a wide range of assets, offering risk mitigation through their underlying portfolio funds. Investing in fund of funds provides access to funds with high minimum investment requirements, albeit at potentially higher management costs due to layered management fees.
- Parallel Funds:
Parallel funds encompass both onshore and offshore funds that directly invest in an underlying portfolio of assets. The onshore fund designates a pass-through entity for U.S. federal income tax purposes, paying management fees and incentive allocations to the general partner or managing member. The offshore fund mirrors this structure but pays incentive fees to an affiliated management company. Tax changes in 2008 affected the timing of incentive fee receipt, leading some offshore funds to introduce mini-master structures.
- Master-Feeder Funds:
In a master-feeder structure, onshore and offshore feeder funds each hold an interest in a partnership treated as a partnership for U.S. federal income tax purposes, the master fund. Investors in both onshore and offshore feeders participate in the same investments and compensation arrangements for fund managers. Some master-feeder funds feature incentive allocations to the general partner or managing member of the master fund, along with management fees paid to the management company. However, this structure has become less common.
- Parallel Funds with Mini-Master:
Parallel funds with mini-master structures retain the onshore fund’s structure seen in parallel funds but modify the offshore fund’s structure. As the offshore fund is considered a corporation for U.S. federal income tax purposes, it cannot make incentive allocations. Instead, it pays an incentive fee to the management company. To address this, a mini-master structure is introduced, where the offshore fund serves as the sole limited partner in a partnership (mini-master). The general partner of the mini-master matches the onshore fund’s general partner or its affiliate, allowing the offshore fund to make incentive allocations.
These hedge fund structures provide flexibility and address various tax and regulatory considerations. While these are simplified explanations, they serve as a foundation for understanding hedge funds. In our next blog post, we will explore the types of investors who participate in these funds and the legal aspects of dealing with different investor profiles. Subsequent articles will delve into setting up funds from a legal perspective and the relevant laws and regulations governing both funds and fund managers. Stay tuned for more insights in our fund blog series.