Introduction to Hedge Funds

Introduction to Hedge Funds

Hedge funds and private equity funds are subject to constant speculation and media interest. They're complicated, challenging and highly specialized investments vehicles that aren't always easily understood. Recently they've been popping up in the news ranging from train fare evading hedge fund managers in the City of London to New York based funds trying to reclaim losses in Argentina. So, at the risk of sounding a bit dry, I thought I would try and outline some of their main features.

Alternative investment funds such as Hedge Funds ("HF") occupy a key area within a large, diversified portfolio combining the promise or allure of above market returns and innovative, highly sophisticated investment strategies. A HF is, in essence, a pooling of private capital (fancy word for 'money') contributed from varied high-net-worth individuals, families or trusts, private and public companies and institutional investors into a single investment vehicle ('the fund'). HF's are administered by professional fund managers who engage in a variety of listed securities or commodities trading as well as futures, option contracts or shorting tactics (again, specialised strategies, not recommended for general members of the public!) amongst others. The fund is typically open ended and investors can redeem or purchase units in it at any time during the life of the fund subject to contractual restrictions or minimum contributions.

In terms of their actual legal structure, a hedge fund is normally structured as limited liability partnerships ("LLP") or as a limited liability company ("LLC").An LLP or LLC is a form of organization in which one or more of the owners are 'general partners' who are personally liable (they can be sued up to High Heaven) to any creditors the business may have and who manage the interests of the business. In order to shield fund managers or owners from the burden of unlimited personal liability, the general partner will itself often be organised as a LLC, a limited partnership or a Subchapter S Corporation (in the United States anyway, home to the majority of hedge funds).

Secondly, an LLP will have 'limited partners' - those who are not personally liable to creditors and have limited day-to-day participation or control over the partnerships' activities. It is the limited partners who provide initial capital contributions and are entitled to any profits the fund makes in proportion to their contribution. They are the investors. However, managers will often co-invest a significant portion of capital alongside limited partners. Limited partners will commit their capital to the fund whilst the general partner will manage the fund in exchange for an annual management fee and a share of the profits. The fees are generally around two and twenty percent respectively. Twenty percent remuneration fee?! Yes, that's correct. It is an industry standard and goes some way to explain why successful hedge fund managers can reap very large fees. Bear in mind though that whenever you read of a hedge fund manager earning a massive fee, the investors are still getting the other eighty percent in profit. That's not often reported as widely.

Such structures are generally known as 'uncorporate forms' in that both HFs use them to take advantage of their inherent flexibility. They rely on specific contractual devices to manage their business activities, remuneration and liabilities and attract minimal oversight from regulatory bodies such as the SEC. Such contractual forms use performance incentives such as high water marks, hurdles, performance based compensation and the use of side letters for significant or 'anchor' investors to customise the fund to the particular needs of that investor. The flexibility of a hedge fund exists thanks to numerous statutory exemptions that allow them to avoid regulatory oversight to a great extent.

Within the USA for example, hedge funds will normally fall within the definition of an 'investment company' under the Company Act. However, the legal structure of a fund serves to limit its application and such funds rely on key legislative provisions to exclude their activities from regulatory oversight and compliance. In brief, so long as a fund has no more than 100 investors and sells its securities through a private sale it will not be defined as an investment company. Secondly, a fund will be excluded if they only sell their securities to a 'qualified purchaser' through a private sale. Such exemptions are broadly justified on the premise that wealthy or sophisticated individual investors can 'fend for themselves' - but that's a whole different kind of article.

HFs seek to produce superior performance relative to other financial institutions and the market as a whole. This is known as an 'absolute return' regardless of market conditions. This is achieved in part to financial ingenuity and innovation as well as managerial skill. It is also made possible by the current legal regime which largely allows such investment vehicles unbridled freedom to pursue and, importantly, reward, such strategies for its manager and investors.

Further reading? A really useful and interesting blog that discusses the business and developments surrounding the ins and outs of hedge funds and private equity funds is that of Timothy Spangler's 'Law of the Market' available here.


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