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What Is A Hedge Fund?

Every day almost 900 people in America ask Google that very question. So, what are hedge funds and how do they operate?

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The Definition

So, what is a hedge fund? In layman’s terms, a hedge fund is a private investment company that pools money from investors to trade a variety of asset classes, with an aim of maximizing returns and reducing risk. The aim of the game for the hedge fund manager is to produce returns for their wealthy investors that will ideally make them even richer than they were before. Pretty simple, right?

Even if you’re not super familiar with the topic, you’ve probably heard of some of the more infamous hedge fund failures of the past, such as the Bernie Madoff scandal of the late 2000s. Bernie was a fund manager responsible for what is referred to as the largest financial fraud of all time, by running what was essentially a giant Ponzi scheme masquerading as a hedge fund.

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What Do Hedge Fund Managers Do?

Christian Bale’s portrayal of eccentric hedge fund manager Michael Burry in 2015’s The Big Short introduced many non-finance people to life as a hedge fund manager (as well as creating a flood of pseudo experts on the American housing market). Although Burry’s risky long-term bet was a strategic outlier (as well as both angering and confusing his investors) Burry did in fact end up making hundreds of millions of dollars for his investors and himself.

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Success and riches of that magnitude are by no means guaranteed for every hedge fund manager, but the movie did accurately portray a multitude of the challenges and intricacies of the role. As a hedge fund manager your days are spent monitoring the market, analyzing investments, and creating and running your investment strategies.

Hedge funds are so named because the strategies historically employed by fund managers ‘hedged risk’ by buying both long and short stocks in order to generate high returns regardless of market conditions. The strategies used are typically more risky or aggressive than those of other fund structures. Every action taken and decision made leads to one ultimate goal: increasing returns for the investors. It’s still considered by some to be high-risk investing but if they’re good at what they do, hedge fund managers can make a boatload of cash. And who doesn’t want that?

How Do Hedge Funds Make Money?

Hedge funds make money by charging fees, specifically management fees and performance fees. For the most part, hedge funds traditionally stick to the 2% and 20% fee structure. Let’s look at this in more detail by using our friend Bill as an example.

Bill is a talented hedge fund manager and I, a wealthy investor, have decided to invest $1 million dollars of my hard-earned cash into Bill’s fund.

The Management Fee

With an investment of $1 million dollars, I must now pay Bill 2% as a management fee. So, Bill is up $20,000 and it’s time for me to sit back and wait for him to work his magic.

There is typically a set minimum amount of profit that Bill must make before he can charge me a performance fee. This is called the Hurdle Rate.

In this example, Bill does his thing and increases my investment to $1.2 million (thanks Bill!). We agreed on a Hurdle Rate of 10% so now I must pay Bill a performance fee of $20,000 for the excess $100,000 return. Great! Everyone is happy. 

Next month the fund experiences much more volatility. At first, Bill loses $250,000 which brings our investment down to $950K.

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Luckily, he has a comeback and makes $350,000 for me, which brings my total investment up to $1.3MM. This is when a High-Water Mark comes into play.

The Performance Fee

A high-water mark refers to the highest point my investment has previously reached, which in this example was $1.2 million. With Bill now increasing my investment to $1.3 million, I must only pay him a performance fee on anything above the high-water mark, which is 20% of the $100,000 above $1.2 million. This ensures that I don’t have to pay Bill a performance fee twice for the same increase in performance.

Fee structures can also include a catch-up clause which means the fund manager is paid the agreed-upon performance fee but only after the investor has received back 100% of the expected returns.

As a fund manager, it’s in Bill’s best interest to ensure that his fund consistently performs well so he can keep raking in the big bucks and ensure that I (and his other investors) don’t get mad at him.

How Are Hedge Funds Structured?

The goal when launching a hedge fund is to create a private investment company that is exempt from certain SEC registration requirements. With an exemption, you can avoid the increased cost, time, and additional reporting requirements that comes with registering. The reasoning behind this is complex, so we’ve broken it down into the main points.

The Investment Advisers Act of 1940

This Act was implemented to regulate investment advisers. Those who advise others about investments were required to register with the Securities and Exchange Commission (SEC) and abide by their regulations. 

Hedge fund managers can use the Private Fund Adviser Exemption to claim ERA status when launching their hedge fund.

An ERA is an Exempt Reporting Adviser

As an ERA you will not be required to register as an investment adviser. 

On the other hand, if you ARE planning to give investment advice you would have to register as an RIA. Before you can register you’ll also have to brush up on your securities law knowledge and take the Financial Industry Regulatory Authority (FINRA) Series 65 exam.

An RIA is a Registered Investment Adviser

The Investment Company Act of 1940

This Act defines what an investment company is and regulates how they are organized. When it was implemented in 1940 the SEC was given the power to regulate those in the investment industry. Any fund that is defined as an investment company must meet specific SEC regulatory and reporting requirements.

A private fund is exempt from registering as an investment company if it does not make a public offering of securities AND satisfies the requirements of either Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940.

Section 3C1

Section 3(c)(1)) exempts a hedge fund from being labeled as an investment company as long as it has 100 or fewer investors. The SEC also requires that the majority of investors in a hedge fund are accredited investors, (basically, someone with plenty of cash to splash around) although realistically in most 3(c)(1) funds there are almost no non-accredited investors.

Let’s say you want to invest in our old friend Bill’s hedge fund:

  • Do you have a net worth that is greater than $1 million (not including your primary residence)?
  • Do you make more than $200,000 per year (or $300,000 with your spouse)?

If you can answer yes to either of these questions, you could be classed as an accredited investor and you can likely invest in Bill’s fund.

Section 3(c)(7)

If you plan to have more than 100 investors then section 3(c)(7) is relevant for your fund. This section exempts a hedge fund from certain SEC regulations and it also enables the fund to have an unlimited number of investors, as long as those investors are qualified purchasers. A qualified purchaser is someone that has even more cash to splash around than an accredited investor (owns more than $5 million in investments).

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The Securities Act of 1933

This Act was implemented to protect investors by increasing transparency and reducing fraudulent activities. Companies that offer and sell securities must register with the SEC or meet an exemption. The relevant exemption for hedge funds is Reg D.

Reg D (Regulation D) allows companies to raise capital through selling securities without registering with the SEC

If a company meets the requirements to be exempt, they must file disclosure document Form D after the first securities are sold. Reg D is advantageous for hedge funds as it allows them to raise capital quickly.

Hedge fund managers can opt for an exemption through either Rule 506(b) or Rule 506(c). The option you select will have a major impact on how you source investors. We’ve highlighted the pertinent points below:

506(b)

If you choose the 506b route then you can’t advertise or market the fund. At all. So no talking about it online and certainly no tweets or Facebook posts trying to source investors. If you’ve come across a website for a hedge fund previously and you think it seems particularly vague and nondescript, chances are they opted for 506(b).

You may be asking yourself why anyone would set up a 506b fund if they can’t market it? And that is a very good question. The answer is that with a 506b fund you can rely on your investors to self-verify that they are accredited. If you go the 506b route you can utilize your existing network to raise capital and you can do it fairly quickly as you don’t have to go through the process of verifying those investors yourself. You do however have to have a pre existing relationship with your investors before you broach the subject of investing. 

506(c)

With a 506c fund, yes you can market on any channel that you choose to, but you also have to verify that all investors are accredited, which can be challenging and take an extremely long time. You’re also on the hook if you verify them and they are actually not accredited. For this reason, most hedge funds operate as 506(b) funds.

If you select the 506(c) route then you can advertise your fund but it will take longer to get up and running as you’ll have to verify that each and every investor is accredited.

How Can I Launch a Hedge Fund?

Let’s be honest, launching a hedge fund sucks. It’s time consuming, complicated, and the endless legal jargon can be soul-destroying.

Here at Repool we LOVE all that stuff. Seriously, it’s what we live for. We’ve modernized and automated the launch process so it’s now much faster and easier to start your fund.

If you’ve been thinking about launching your own hedge fund, we’d love to talk. You can get in touch with us any time.

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