Establishing a Hedge Fund: An Overview

Launching a hedge fund is the culmination of years of hard work, research, and dedication. However, the process is complex: from choosing the right fund structure and jurisdiction to navigating state and federal securities regulations, tax considerations, and investor requirements. This guide provides an updated overview of the essential legal, structural, and practical elements you should consider before starting your own hedge fund.

I. Selecting the Right Fund Structure

The structure and jurisdiction of a hedge fund primarily depend on:

1. The tax status and home country of your prospective investors (e.g., U.S. taxable individuals, U.S. tax-exempt entities, non-U.S. citizens).
2. The investment strategy that you, as the manager, intend to employ.

A. U.S. Domestic Funds

For managers whose investors are primarily U.S. taxable investors, a common structure is a domestic hedge fund formed as a limited partnership (LP) or limited liability company (LLC) under the laws of a business-friendly state such as Delaware. Typically:

• An LLC serves as the General Partner (GP) or Managing Member.
• The underlying fund itself is organized as a Delaware LP (if using a partnership structure) or a Delaware LLC (if using a limited liability company structure).

Key benefits include:

• Limited liability for investors and managers.
• Pass-through taxation (i.e., profits and losses pass through to members or partners) to avoid corporate double taxation.

B. Offshore Funds

If your target investors include non-U.S. investors or U.S. tax-exempt entities (such as certain pensions or endowments), you will often set up an offshore vehicle in a low- or zero-tax jurisdiction. Popular jurisdictions include the Cayman Islands and the British Virgin Islands, with other options such as Bermuda, Ireland, and Luxembourg also available.

1. Single Offshore Fund

• Designed for non-U.S. and U.S. tax-exempt investors.
• Managed from either the U.S. or offshore.
• Typically overseen by an offshore management entity.

2. Side-by-Side Structure

• Involves two separate funds—a domestic fund for U.S. taxable investors and an offshore fund for non-U.S. or U.S. tax-exempt investors—managed in tandem.
• Can be less efficient for trading-intensive strategies since you must often split trade tickets across two funds.

3. Master-Feeder Structure

• Both U.S. and offshore “feeder” funds invest directly into a single “master” fund (commonly offshore).
• Streamlines portfolio management: the manager executes trades at the master level, and returns flow back to each respective feeder fund.

II. Management Fees, Performance Compensation, and Expenses

A. Management Fees

Most hedge funds charge an annual management fee—often between 1% and 2% of the fund’s net asset value—to cover the operating expenses of the General Partner or investment manager (e.g., salaries, technology, office rent).

B. Performance Compensation (“Carry” or Incentive Allocation)

What distinguishes hedge funds is the performance-based component of the manager’s compensation—commonly around 20% of the fund’s net profits, calculated over any losses (i.e., net of high-water marks). Performance allocations are typically measured:

• Quarterly, semiannually, or annually, and
• May include high-water marks, ensuring no performance fees are taken until prior losses are recouped.
• May include hurdles, requiring the fund’s performance to exceed a certain return level before incentive fees apply.

C. Fund and Organizational Expenses

• Organizational Costs: Legal, accounting, and other startup expenses are often borne by the fund and can be amortized over a period (e.g., one to five years).
• Ongoing Costs: The fund typically pays recurring legal, administrative, audit, and brokerage fees.
• Marketing / Capital Raising: Third-party marketers or solicitors may receive a portion of management and/or performance fees (commonly 20% of each fee type attributable to their introduced capital).

Side Letters: A manager may offer investors bespoke terms (e.g., reduced fees, enhanced reporting) through confidential “side letters,” often used to incentivize critical seed investors or large capital commitments.

III. Contributions, Withdrawals, and Termination (Liquidity Terms)

Hedge funds, unlike mutual funds, are not required to offer daily liquidity. The frequency of investor redemptions is dictated by the fund’s investment strategy and the liquidity profile of its holdings:

• Monthly or Quarterly Redemptions: More common for funds investing in liquid assets (e.g., large-cap equities).
• Semiannual or Annual Redemptions: Common for funds with less liquid portfolios (e.g., private credit, real estate, specialized strategies).

Typical liquidity management tools include:

1. Lock-Ups: Require investors to keep their capital in the fund for a set period (e.g., 1–2 years) before redemptions are allowed.
2. Gates: Limit the percentage of total fund assets that can be redeemed on a given date (e.g., 10–15% of net asset value), preventing large simultaneous redemptions that could harm remaining investors.
3. Key Man Provisions: Allow investors to redeem if a designated lead manager departs or becomes incapacitated.

IV. Regulatory and Legal Considerations

Hedge funds, their managers, and offerings are subject to various U.S. federal and state securities laws, primarily:

• Securities Act of 1933 (“1933 Act”)
• Securities Exchange Act of 1934
• Investment Advisers Act of 1940 (“Advisers Act”)
• Investment Company Act of 1940 (“Company Act”)

However, certain exemptions allow hedge funds to avoid the full scope of public registration and related requirements.

A. Offering and Investor Qualifications

Most hedge funds rely on Regulation D, Rule 506 of the 1933 Act to privately place their interests with eligible investors without registering as public offerings. Key points:

• Accredited Investors: An unlimited number of accredited investors may invest. Although definitions evolve, accredited investors typically include individuals with:
• Net worth over $1 million (excluding primary residence), or
• Annual income exceeding $200,000 (or $300,000 with spouse) for the last two years (with a reasonable expectation of the same in the current year).
• Certain other categories also qualify (e.g., individuals with specific professional certifications/licenses and “knowledgeable employees” of private funds).
• Non-Accredited Investors: Up to 35 sophisticated (non-accredited) investors may invest under Rule 506(b), but this triggers more extensive disclosure requirements. In practice, most hedge funds avoid accepting non-accredited investors.
• General Solicitation (Rule 506(c)): Since 2013, managers can engage in general advertising, provided all purchasers are accredited and the manager takes “reasonable steps” to verify accreditation (e.g., reviewing tax returns, obtaining third-party verifications).

Form D: While no full registration is required, a Form D must be filed electronically with the SEC within 15 days after the first sale of interests under Regulation D.

B. Manager Registration (Advisers Act)

Under the Advisers Act, hedge fund managers must either:

1. Register with the SEC as an investment adviser, or
2. Rely on an exemption (e.g., the “private fund adviser exemption” for those managing private fund assets under $150 million, often called “exempt reporting advisers”).

Even if exempt at the federal level, managers may be subject to registration or reporting in the states where they conduct business.

C. Fund Registration Exemptions (Company Act)

Hedge funds avoid registering as mutual funds (regulated investment companies) via these primary exemptions:

• Section 3(c)(1): Limits the fund to 100 beneficial owners (or fewer), all of whom invest through a private placement.
• Section 3(c)(7): Allows up to 499 beneficial owners, all of whom must be “qualified purchasers” (generally individuals with $5 million in investments, or institutions with $25 million).

D. Performance Fees

For SEC-registered and certain state-registered investment advisers, Rule 205-3 under the Advisers Act allows performance fees only if investors are “qualified clients.” As of recent updates, “qualified clients” include those with:

• $1.1 million under management with the adviser immediately after investing, or
• Net worth of more than $2.2 million (excluding primary residence), or
• Certain employees, officers, or directors of the adviser.

V. Essential Service Providers

Even the most talented manager needs a strong operational foundation to attract and retain capital. Core service providers typically include:

1. Legal Counsel or Fund Consultant: An attorney with deep securities law experience is indispensable for drafting offering documents (PPM), forming legal entities, and ensuring compliance with federal and state requirements.
2. Prime Broker: Offers custody, trade execution, financing, and risk reporting services. Larger prime brokers also provide capital introduction and a broad range of fund support.
3. Fund Administrator: Maintains the fund’s books and records, calculates monthly or quarterly net asset value (NAV), and may handle investor subscriptions/redemptions.
4. Auditor: Although not always legally mandated unless registered as an adviser (and choosing certain accounting rules), an independent annual audit is standard in the industry to satisfy investor due diligence.

VI. The “Incubator Fund” Alternative

For emerging managers with limited resources or track records, an incubator fund can be a strategic first step:

• Stage 1: Form the legal entities (fund and management company) and trade exclusively with your own capital—no outside investors. This establishes a verifiable performance record in a managed, fund-like structure.
• Stage 2: After six to twelve months, once you have a performance history, prepare formal offering documents (PPM) and solicit external investors under the usual regulatory rules.

Incubator funds are a lower-cost, lower-complexity option for demonstrating your strategy’s viability before going fully operational.

Final Thoughts

Starting a hedge fund is a sophisticated undertaking requiring sound legal, regulatory, and operational frameworks. Your choice of structure—domestic, offshore, or a master-feeder—hinges on your investor base and strategy. Thoughtful liquidity terms, properly aligned incentives, and compliance with evolving regulations are critical to building credibility and attracting institutional capital. By assembling a team of experienced advisors, prime brokers, fund administrators, and auditors, you create a robust foundation on which your hedge fund formation can thrive.

Disclaimer: This guide is for informational purposes only and does not constitute legal or financial advice. Always consult with qualified legal, tax, and financial professionals before establishing or marketing any investment fund.