hff hfstructured 12-2012

HOW HEDGE FUNDS ARE STRUCTURED

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How Hedge Funds Are Structured

Contents

Table of Contents:

Hedge Funds’ Unique Structure 3

Typical U.S. Hedge Fund Structure 4

Most Hedge Funds Are Established As 5

Limited Partnerships

Investors 6

Portfolio Managers 7

General Counsel, Auditors & Administrators 8

Prime Broker 9

Executing Broker 10

Organizational Structure 11

General/Limited Partnership Model 12

Fee Structure 13

Term Structure 14

Graphic Illustrating Typical Fee Structure 15

Executive Summary

A hedge fund is an investment vehicle that

can employ a wide range of investment

and trading activities to maximize

performance returns while minimizing

investment risk.

Most hedge funds are established as

limited partnerships between the fund

manager and investors. While the specific

structure can vary from fund to fund, there

are a few characteristics that are

applicable across the industry.

This presentation provides a brief

overview of some of the structures of

hedge funds in the marketplace today.

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Unique to the investment community, hedge funds

are a partnership formed between the fund

manager and the investors.

Typically hedge fund managers invest a

significant amount of personal capital - in some

cases in excess of 50 percent of the total assets

in the fund - aligning their interests with that of

their investors.

Hedge Funds’ Unique Structure

Source: Nocera, Joe (16 May 2009). "Hedge Fund Manager's Farewell". The New York Times. Retrieved 16 March 2011.

http://gpgnet/sales/Image Bank/Handshake.png

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Most Hedge Funds Are Established As Limited Partnerships.

Investors share in the partnership’s income, expenses, gains and losses; each partner is taxed

on its respective share of the partnership.

Portfolio

Manager(s)

Prime

Broker

Auditors

Determines strategy and makes investing decisions and allocations. The

portfolios manager is also in the fund and is compensated via a modest

management fee, as well as a performance fee based on the fund’s annual

performance. Fund managers only get a performance fee if the fund makes

money.

Funds must secure their loans with collateral to gain margin and secure

trades. In turn, each broker (usually a large securities firm) uses its own risk

matrix to determine how much to lend to each of its clients, acting as a de

facto regulator.

Ensure fund compliance; verify financial statements

as required by federal law.

Key Players:

*Note all hedge funds and managed futures firms are required by law to be registered with the SEC/CFTC or local and state regulators if they make over

$100 million.

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Typical U.S. Hedge Fund Structure

Hedge Fund

Investors

Investors

Investors

Auditors and

Administrators

Legal Advisors,

Registrar and

Transfer Agent

Prime Broker

Portfolio Manager

Executing Broker

Investors

Source: “Hedge Funds and Other Private Funds: Regulation and Compliance” Thomson West, 2010

Here is an example of the structure

of a typical U.S. hedge fund:

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Because hedge funds are highly regulated, by the SEC and CFTC in the U.S., fund managers can only

accept investment capital from accredited investors or qualified purchasers, including:

Investors

1. Public employee retirement plans

2. Corporate employee retirement plans

3. University endowments

4. Foundations and non-profit organizations

5. Family offices and high-net-worth individuals. Regulatory qualifications for high-net-worth individuals

are outlined below.

An individual whose net worth, or joint net worth with the person’s spouse, exceeds $1 million at the time of

the purchase, excluding the value of their primary residence

Individuals with a yearly income of $200,000 or higher in each of the two most recent years or joint income

with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level

in the current year.

High Net Worth Individual:

Source: SEC, “Defining the Term "Qualified Purchaser" under the Securities Act of 1933.”

http://www.sec.gov/answers/accred.htm


http://www.sec.gov/rules/proposed/33-8041.htm


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Portfolio Managers

• The portfolio manager makes daily investment decisions for the fund,

choosing where and when to allocate investment capital.

• Portfolio managers may be either direct employees of the hedge fund

management firm or employees of another firm hired by the hedge fund

management firm to provide investment advice pursuant to a sub-

advisory agreement.

What is the role of a Portfolio Manger?


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General Counsel, Auditors, and Administrators

What are Auditors and Administrators?

The offshore fund entity that manages the back office

work and individual accounts for the fund.

What is the role of a General Counsel?

The role of the General Counsel has evolved

greatly in this new era of Dodd-Frank and increased

regulation by the SEC. In addition to providing legal

support and guidance, General Counsels now play

a significant part in successfully managing a fund’s

operations, returns, fundraising, and reputation.


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Prime Broker

A brokerage firm provides multiple services to a hedge fund that are beyond

the scope of those offered by a traditional broker, such as:

• Clearing and Settlement of Securities Transactions

• Financing

• Recordkeeping

• Custodial Services (oversight of subscription and redemption order processing)

• Research Capabilities

Below are examples of Prime Brokers:


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Executing Broker

An executing broker is a type of financial dealer

or broker that is accountable and responsible for the

completion and processing of an order that is

requested by a client.

As part of the process, brokers of this type will evaluate

the order to make sure it is in line with all current

policies and procedures and in compliance with any

regulations set by the market.

Below are examples of Executing Brokers:

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Organizational Structure

The range of investment strategies

available to hedge funds and the types of

positions they can take are quite broad

and in many cases, very complex.

The typical hedge fund structure is really

a two-tiered organization.

The general/limited partnership model is

the most common structure for the pool

of investment funds that make up a

hedge fund.

State Retirement Plan/

University/ High Net

Worth Individual

Hedge Fund X

John Smith

General Partner

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Off-Shore Organizational Structure

In structuring a hedge fund, a principal concern

is to provide the most favorable tax result for

the investors and the fund manager itself.

Fund managers will seek to utilize entities

domiciled in jurisdictions which have clear and

predictable laws, quality service providers, and

are familiar to investors. It is for these reasons

that off-shore hedge funds are often

established.

There are a number of structural approaches

employed by off-shore hedge funds to

accommodate different investors. This diagram

is an example of one type of typical off-shore

hedge fund structure.

Domestic

Hedge Fund LP

Non-U.S. &

Tax-Exempt

U.S. Investors

Investments

General Partner

LLC

General Partner of

Investment Manager

LLC

Investment

Manager LP

Taxable

U.S.

Investors

Offshore

Hedge Fund

Ltd.

Investments

Source: "Structuring Offshore Hedge Funds,“ Hedge Fund Fundamentals, November 30, 2012.

http://www.hedgefundfundamentals.com/media_posts/structuring-offshore-hedge-funds/

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Source: "Hedge Fund Organizational Structure," Investopedia, 2009.

In the general/limited partnership model, the general partner is responsible for

the operations of the fund.

General/Limited Partnership Model

The second element of the two-tiered structure is the arrangement of the general

partnership. The general partner is the typical structure used for a limited liability

company. The general partner's responsibility is to market and manage the fund,

and perform any functions necessary in the normal course of business.

Operational General

Partnership

Limited

Partnership Investors

While limited partners can make investments into the partnership and

are liable only for their amounts paid-in.

http://www.investopedia.com/university/hedge-fund/structures.asp

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Fee Structure

Hedge funds fee structures differ from other types of investment

vehicles. Hedge funds typically charge investors a management fee,

usually 1-2% of the assets managed.

Most hedge funds also charge an incentive (or performance) fee of

anywhere between 10-20% of fund profits. The idea of the incentive

fee is to reward the fund manager for good performance. Managers

only collect an incentive fee when the fund is profitable, exceeding

the fund's previous high - called a high-water mark. This means that

if a fund loses 5% from its previous high, the manager will not collect

an incentive fee until he or she has first made up the 5% loss.

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Graphic Illustrating Typical Fee Structure

20%

Fund Performance for Investor

15%

-15%

-20%

5%

- 5%

10%

- 10%

Value of initial

investment

Year 1 Year 2 Year 3 Year 4

Below high water

mark: no

performance fee

High Water Mark

New High Water Mark

Manager

collects

performance fee

on gain

Below high water

mark: no

performance fee

Manager collects

performance fee on gain

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Term Structure

The actual terms of partnership vary according to the fund, however they are usually based on a few

factors.

Subscriptions and redemptions:

A hedge fund subscription is when the investor applies to join a particular fund. A hedge fund redemption

is when the investor withdraws part or all of their investment from a particular fund.

Unlike other investment vehicles, hedge funds do not have daily liquidity. Some hedge funds offer

subscriptions and redemptions monthly, while others accept them only quarterly or annually. A typical

subscription would be for example, a pension fund investing $200 million in a hedge fund.

Lock-Ups:

A lock-up is the time period that an initial investment cannot be redeemed from the fund.

The most common lock-up is limited to one year. In certain cases, it could be a “hard lock”, which

prevents the investor from withdrawing funds for the full time period, while in other cases, an investor

can pay a penalty fee to withdraw funds before the expiration of the lock-up period.

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Summary

Hedge funds offer qualified investors a unique partnership, with the

ability to invest alongside the fund manager and across a variety of

financial instruments. Hedge funds’ market-neutral, or balanced,

approach to investing helps seek out positive returns and minimize

risk by investing in varied instruments over long- and short-term

periods.

Hedge funds’ investor base has evolved significantly over the years,

with 65% of global hedge fund assets currently held by institutional

investors such as pensions, endowments and foundations.

Most hedge funds are created as limited partnerships between the

fund manager and investors. While the specific structures of hedge

funds can vary, there are a few organizational characteristics that are

applicable across the industry.


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