Hedge Funds in a Nutshell

nychimp
Rank: King Kong | banana points 1,135

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)

Sep 11, 2006

That would be a good entry for wikipedia.

Learn More

814 questions across 165 hedge funds. 10+ Sample Pitches (Short and Long) with Template Files. The WSO Hedge Fund Interview Prep Course has everything you'll ever need to land the most coveted jobs on the buyside. Learn more.

Sep 14, 2006

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

Account Inactive

Sep 19, 2006

Do PE funds take a diff't comp structure (from mgmt/perf fee)?

Aug 11, 2012

"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.

Aug 11, 2012
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?

Aug 11, 2012
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

Aug 11, 2012
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.

    • 1
Aug 11, 2012
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!"

Aug 11, 2012
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.

Aug 11, 2012
Macro Arbitrage:
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.

CalPERS is ready to cut their VC allocation to minimal level as they have been getting abysmal returns from these investments. I was not aware that they are scaling back heavily on other alternative investments as well. I know that they allocate around $34 billion to PE portfolio, including managers of all sizes.
They are sending people to attend the inaugural SALT Asia conference in Singapore this October so presumably they are still looking at these asset classes.

Fundraising from public institutional LPs tend to take considerably longer and more convoluted and you often need to go through their designated consultants first if they hadn't invested with you before. Still they are considered the blue chips of HF and PE investors because they tend to be much more loyal and stable, compared to private fund sponsors. Once they make a commitment to your fund, they tend to stick around and roll over/increase allocation to new funds that you would be raising subsequently, assuming that you don't lose too much of their money and barring other unusual circumstances (e.g. the CalPERS and Centinela saga). So it is usually worth making the effort to get them onboard.

Too late for second-guessing Too late to go back to sleep.

Aug 11, 2012

1-Click to Unlock All Comments - 100% FREE

Why do I need to be signed in?
WSO is a knowledge-sharing community that depends on everyone being able to pitch in when they know something.
+ Bonus: 6 Free Financial Modeling Lessons with 1-Click Signup ($199 value)