Hedge Funds in a Nutshell

Hedge Fund Center's Definition of a Hedge Fund

A hedge fund is a private investment limited partnership that invests in a variety of securities. There are two types of partners in a hedge fund, a general partner and limited partners. The term hedge fund is misleading in that a hedge fund does not necessarily have to hedge. The term "hedge fund" now means any type of private investment partnership.
The general partner is the individual or entity who started the hedge fund. The general partner also handles all of the trading activity and day to day operations of running a hedge fund. The limited partners supply most of the capital but do not participate in the trading or day to day activities of running the hedge fund.

Hedge Funds are pooled investments, all the partner's capital amounts are pooled together for the purpose of trading in securities. All hedge funds follow some sort of trading strategy and are pretty much free to use any financial instrument they wish. Some hedge funds do not utilize leverage and the rest utilize leverage at an average of 2:1. In rare cases, hedge funds like Long-Term Capital Management manage to exceed the 2:1 ratio.

How does the general partner get compensated and how are gains/losses and expenses allocated to all the partners?

For all the services that the general partner provides, he/she will normally receive an incentive fee. The incentive fee is usually 20%of the net profits of the partnership. The incentive fee determination will vary from hedge fund to hedge fund. Determination of the incentive is dictated by the partnership agreement. The general partner will also normally charge an administrative fee, this fee is usually 1% of the year's net asset value. This fee is also dictated by the partnership agreement. Hedge fund managers are only rewarded for performance. If they make money they do well, if they are flat or lose money they will receive little or no money. The management fee will usually not cover the expenses of operating a hedge fund.

The remainder of the profits/losses are allocated to all the partners in the partnership based on their percentage ownership.

Hedge Funds are prohibited from advertising, that's why there is little information about particular hedge funds. Hedge funds will raise money through the use of consultants or word of mouth, the consultants will have accredited or qualified purchaser clients that they solicit various hedge funds to. The consultants in some cases will conduct background checks as well as due diligence for their clients on the hedge fund managers. this means that on behalf of the potential investors, the consultant will visit the hedge funds, gather background information, gather references, collect performance data, conduct statistical and analytical reviews of the funds. They will then have a database of reviewed funds that they can present to their clients.

Comments (11)

16y
buysideanalyst, what's your opinion? Comment below:

Hedge fund refers to a certain compensation structure, not an investment style.

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10y
brandon st randy, what's your opinion? Comment below:

"The term "hedge fund" now means any type of private investment partnership." Not really. A more precise description would be that hedge fund nowadays refers to any type of private investment partnership that operates OPEN ENDED funds.

That is essentially the difference between a HF and a PE or real estate investment firm since the latter manage close ended funds with definitive and pre-determined investment period and fund life time, in addition to hurdle rates when applicable.

Also hedge funds (and private equity firms as well as all other investment vehicles) are now ALLOWED to advertise with the passing of the JOBS act. Whether or to what extent will the passage of this legislation affect the fundraising M.O of most GPs is not yet clear.

Too late for second-guessing Too late to go back to sleep.
  • 4
10y
BTbanker, what's your opinion? Comment below:
brandon st randy:

Also hedge funds (and private equity firms as well as all other investment vehicles) are now ALLOWED to advertise with the passing of the JOBS act. Whether or to what extent will the passage of this legislation affect the fundraising M.O of most GPs is not yet clear.

I've always been curious as to how HFs would even go about reaching out to essentially .1% of Americans. Private jet catalogs, Golf Channel commercials, pages in The Economist?

10y
ky0ung, what's your opinion? Comment below:
BTbanker:
brandon st randy:

Also hedge funds (and private equity firms as well as all other investment vehicles) are now ALLOWED to advertise with the passing of the JOBS act. Whether or to what extent will the passage of this legislation affect the fundraising M.O of most GPs is not yet clear.

I've always been curious as to how HFs would even go about reaching out to essentially .1% of Americans. Private jet catalogs, Golf Channel commercials, pages in The Economist?

lol, CNBC ad

10y
brandon st randy, what's your opinion? Comment below:
BTbanker:
brandon st randy:

Also hedge funds (and private equity firms as well as all other investment vehicles) are now ALLOWED to advertise with the passing of the JOBS act. Whether or to what extent will the passage of this legislation affect the fundraising M.O of most GPs is not yet clear.

I've always been curious as to how HFs would even go about reaching out to essentially .1% of Americans. Private jet catalogs, Golf Channel commercials, pages in The Economist?

In its early days the HF industry was geared mostly toward HNW individuals, trusts and family offices. Nowadays however, the biggest source of LPs for HFs and PE firms are actually public institutional investors, especially pension funds.
CALPERS alone manages over $230 billion, a good chunk of which is allocated to alternative investments. This makes them one of the biggest, if not indeed the biggest, investor in HF products. How well Bridgewater performs has as much impact on a trust fund babe in Manhattan as it does to a retired teacher in TX.

As such, the industry has been actively reaching out to the pension funds and their advisors. Before JOBS, there was a massive gray area as to how should the funds solicit and get themselves in front of the public LPs without appearing as if they were "advertising" their products. Even thou technically it might be considered illegal, most everybody was still doing it anyway.

With the JOBS act in effect, fund managers can now openly reach out to LPs,meeting with them to showcase their funds and generally more openly talk about how great they are and why prospective LPs should invest with them when they speak at conferences, roundtable discussions etc.

Too late for second-guessing Too late to go back to sleep.
  • 3
10y
The Kid, what's your opinion? Comment below:
BTbanker:
I've always been curious as to how HFs would even go about reaching out to essentially .1% of Americans. Private jet catalogs, Golf Channel commercials, pages in The Economist?

Build up a sales team that goes out and sells themselves to Institutional and HNW client advisors in hopes that these advisors will in turn sell their clients on investing in the fund.... sales sales sales!

I think its all relative, large scale (hedge fund, private equity fund, etc) and small scale (mutual funds, annuities, etc) still have the same macro business model (although the clients/target markets are different so that does change things a bit). Like an Edward Jones mom and pop advisor... he has mutual fund and annuity sales guys pestering him 24/7 to set up a meeting. I have a hard time believing that any significant business is generated from someone who sees a Prudential annuities commercial on TV that says "ask your financial advisor if..." What really happens is the Pru rep has season tickets to every sports team in the area and access to all the country clubs, so the next time a client walks in the Edward Jones advisor says "hey I have to tell you about this new annuity strategy from Prudential!"

10y
Macro Arbitrage, what's your opinion? Comment below:
brandon st randy:
Also hedge funds (and private equity firms as well as all other investment vehicles) are now ALLOWED to advertise with the passing of the JOBS act. Whether or to what extent will the passage of this legislation affect the fundraising M.O of most GPs is not yet clear.

Was just about to post that.

To one of your other points, Calpers has been scaling back heavily on its alternative investments and fund seeding platform, although most of the assets raised in this industry stem from behemoth pension funds, rarely HNW individuals. Most funds have minimum investments of at least 10mm.

10y
brandon st randy, what's your opinion? Comment below:

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