A hedge fund is a restricted investment fund in which the strategy is to invest in a variety of derivatives, long equity securities and bond positions, and short positions to hedge against losses. The hedge fund manager, who typically has a significant amount of his own capital in his hedge fund, makes the most money when he aggressively makes and preserves money in the fund, not simply when he makes any trade. To start a hedge fund, the manager must take several key steps, including registering as an investment adviser, obtaining seed capital, securing legal services, opening bank and brokerage accounts, and establishing the management company. Additionally, the manager and attorney must carefully draft the private placement memorandum (PPM) and other offering documents, which define the investment strategies and practices of the fund, in order to attract investors to start a hedge fund. Finally, the fund must engage a prime broker, who will provide marketing, custody and clearing services, and if desired, the fund must lease office space.
In most cases, a manager will start a hedge fund as a limited partnership with the fund manager as a general partner and the investors as limited partners. Typically, the organizational and legal development process takes about two to three months to conclude. The fund manager receives a portion of the profits, usually about 20 percent, which the funds call an incentive allocation. In addition, some funds allocate one to two percent of the total assets under management to support operations of the fund. Investment policy audits and asset allocation audits are conducted periodically to make sure that the fund manager is adhering to the policies stated in the PPM.
Potential investors depend substantially on the information contained in the PPM to evaluate the investment opportunity. Terms in the PPM should be carefully defined to avoid misconceptions. The PPM discloses that the hedge fund manager has the freedom to invest funds in hard-to-value securities, occasionally invest outside of the stated strategies, and put money in any stock, bond, commodity, or derivative that will create the most income for the fund. Fund allocations and expenses, lock-up periods, redemption procedures, and soft dollar arrangements are also covered in the PPM. To start a hedge fund off on a sound legal footing, the PPM should also disclose any potential or known conflicts of interest.
Not every investor may participate in a hedge fund. To start a hedge fund, the fund manager needs to attract accredited investors, with personal incomes exceeding $200,000 U.S. Dollars (USD) or joint incomes exceeding $300,000 USD in the two years preceding the investment offering. Additionally, an investor with an individual or joint net worth of over $1,000,000 USD may also qualify. Income may include salary, bonuses, interest, dividends, and income from trusts. Partnerships, corporations, and trust funds may also be deemed accredited investors if the net worth of the partners, stockholders, or the trust meets the minimum requirements.