Updated July 13, 2023
What is Hedge Fund?
Hedge Fund is one type of Alternate investment vehicle wherein Hedge fund managers pool capital from wealthy and sophisticated investors to invest in various asset classes using complex strategies. For example, these strategies can be Equity Long-Short, Event-driven, Distressed Asset, Convertible Arbitrage, etc.
Due to its inherent style, strategies are highly risky, mostly leveraged and illiquid, and require Investors to understand the risk behind the same. Also, due to limited regulations governing Hedge Funds, these are not as transparent, unlike Mutual Funds.
Explanation
Typically it is formed as a Limited Liability firm with two parties, one Investor and another Sponsor. Investors are sophisticated high net worth individuals who are part of the Hedge Fund in the capacity of Limited Partners.
Similarly, the sponsors act in the capacity of General Partners with the main objective of managing the activities. In short, the Limited Partners invest funds in the Hedge Fund, which Sponsors manage, i.e., General Partners, and investments are made per stated objectives in line with complex investment strategies that vary from Fund to fund.
How Does Hedge Fund Work?
It typically works with Investors acting in the capacity of Limited Partners and Sponsors acting as General partners who are responsible for managing the activities of the Fund. Hedge Fund enters into various Investment Strategies based on the acceptable risk to generate positive alpha for its partners. Some of the popular strategies are:
- Event-Driven
- Distressed Securities
- Convertible Arbitrage
- Global Macro
- Emerging Markets
- Fixed Income Arbitrage
- Merger Arbitrage
- Convertible Arbitrage
General Partners perform such strategies depending upon global outlook, the correlation among asset classes, risk appetite, global liquidity outlook, and the tactical shift inflow of funds from a developing to a developed nation and vice versa. They are usually paid as per their fee structure to achieve their stated objectives. Common fee structure includes two components, namely:
- Management Fees are a fixed percentage of Assets under management at the end of the year. The higher the Market Value of assets at the end of the year, the higher the management fees will be.
- Incentive fees are charges on profit that may be net of management fees, or they can charge on profit before management fees, depending upon the agreement.
The most common fee structure prevalent globally is the “Two and twenty” structure which implies two percent management fees and twenty percent incentives. Also, Hedge Funds can get a share of profits as incentives only when the profits exceed the previous period’s high (popularly known as the High watermark). Accordingly, Hedge Funds first need to recover losses, if any, and attain their high watermark before they become eligible for additional incentive fees, which makes the working even more dynamic. Incentive fees are usually paid based on whether hard hurdle rate (which means returns generated by the fund more than the hurdle rate) or soft hurdle rate (which means total return generated by the fund).
Due to the unregulated scope and low disclosure requirements, investors undertake more stringent due diligence, which takes both qualitative and quantitative forms. Quantitative disclosures include periodic reviews of returns generated, performance measure appraisals, and hedge fund performance since inception to understand the consistency and investment strategy. Qualitative disclosure consists of a background check of managers, any past legal issues, the longevity of the fund, and all legal matters.
Example of Hedge Fund
ABC International LLC is a registered Hedge Fund undertaking an Equity Long-Short strategy to generate client returns. The fee structure is “2 and 20,” in which the fund charges two percent of Management fees per the Asset under management and twenty percent as incentive fees for the annual return.
At the beginning of 2019, there were total Assets under management of $100 million. During the year, the fund generated a return of twenty percent. Based on the above fees structure, the compensation is computed as follows:
| Particulars | (Amt in USD Million) |
| Asset Under Management at the Beginning of 2019 (A) | 100 |
| The return generated during the year(B) | 20% |
| Asset Under Management at the end of 2020 (C) = (A) * (B) + (A) | 120 |
| Management Fees in percent (D) | 2% |
| Management fees based on Asset under Management at the end of 2020 (E) = (C)*(D) | 2.4 |
| Incentive fees in percent (F) | 20% |
| Incentive fees (G) = (F)*(C-A) | 4 |
| The total remuneration of Hedge Fund (H) = (G)+((E) | 6.4 |
Benefits of Hedge Fund
- It offers diversification benefits to investors as Hedge invests in different asset classes and a wide array of long-short strategies to benefit from movement on both sides.
- It enables investors to obtain expert advice and enter into complex strategies that would not have been possible for standalone investors.
- Another advantage is that it helps investors reduce their losses in a market crash due to their inbuilt asset allocation strategies, which are usually not prevalent in Mutual Fund Investments.
- It also has a higher investment threshold, limiting entry to only sophisticated investors who have the knowledge and acumen to understand and benefit from the strategies adopted by such funds.
Conclusion
Hedge Fund is an Alternative Investment vehicle, and it works through the pooling of capital by sponsors from Accredited Sophisticated Investors. Normally these funds are established as LLCs and deploy various strategies to meet the high watermark level. Among the many fee structures, the most common and widely used structure is “2 and 20,” which reflects two percent total asset size management fees and a twenty percent incentive fee. Despite the many benefits that the Hedge fund offers, investors need to undertake proper due diligence and continuously monitor the activity of general partners (fund managers) to ensure that investor interest is given the utmost priority.
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