Hedge Fund Structure

A hedge fund is a type of investment vehicle that pools together money from a group of investors and uses that money to speculate on a variety of assets, such as stocks, bonds, commodities, and derivatives.

Hedge funds are typically structured as limited partnerships or limited liability companies, and are largely unregulated compared to traditional mutual funds.

In a limited partnership structure, the hedge fund has one or more general partners who manage the fund and make investment decisions on behalf of the investors, known as limited partners.

The general partners are responsible for the day-to-day operation of the hedge fund and are typically compensated based on a percentage of the fund’s profits.

The limited partners, on the other hand, are passive investors who provide capital to the fund and share in the profits and losses of the fund, but do not have any say in the investment decisions.

In a limited liability company (LLC) structure, the hedge fund is owned by its members, who are typically the general partners.

The members of the LLC have managerial control over the fund and are personally liable for the debts and obligations of the fund.

However, their liability is limited to the amount of capital they have invested in the fund.

Both limited partnership and LLC structures offer tax benefits to hedge funds, as the fund itself is not subject to corporate income tax.

Instead, the profits and losses of the fund flow through to the individual investors and are taxed at the individual level.

It’s worth noting that hedge funds are generally only available to accredited investors, which are individuals or institutions that meet certain financial thresholds.

This is because hedge funds are considered to be more risky and complex than traditional investment vehicles and are therefore subject to fewer regulatory protections.

In this article, we discuss the various components that make up a hedge fund structure.

Key Takeaways – Hedge Fund Structure

• Choose a Legal Structure
  • Set up as a limited partnership or LLC.
  • The fund manager is the general partner and investors are limited partners.
    
• Establish the Right Domicile
  • Select a jurisdiction like the Cayman Islands, BVI, or Delaware for tax efficiency and regulatory flexibility.
    
• Appoint Key Service Providers
  • Engage a prime broker (for trading and financing), administrator (for NAV and records), auditor, and distributor.
    
• Use a Master-Feeder Structure
  • Set up onshore and offshore feeders that pool into a single master fund to serve US and international investors efficiently.
    
• Handle Tax Flow-Through
  • Ensure profits and losses pass through to investors and are taxed individually.
  • Avoids corporate tax at the fund level.
    
• Market to Accredited Investors
  • Limit offerings to high-net-worth individuals and institutions to comply with regulations and reduce oversight.
    
• Manage Illiquid Assets with Side Pockets
  • Segregate hard-to-value holdings to maintain fairness in redemptions and NAV calculations.

Prime Broker

A prime broker is a financial services company that acts as a single point of contact for hedge funds and other institutional investors when it comes to executing trades, settling transactions, and providing other financial services.

The main role of a prime broker is to facilitate the trading activities of its clients by providing them with a range of services that allow them to manage their investments more efficiently.

Some of the key services provided by a prime broker to its hedge fund clients include:

1. Execution: A prime broker provides access to various exchanges and liquidity pools to help its clients execute trades at the best possible prices.
2. Settlement: A PB handles the settlement of trades on behalf of its clients, which includes arranging for the transfer of securities and funds between parties.
3. Financing: It may provide financing to its hedge fund clients through margin loans or other types of credit facilities.
4. Reporting: A PB provides its clients with detailed trade and account reports to help them track the performance of their investments.
5. Risk management: It helps its clients manage the risks associated with their investments by providing them with tools and resources to monitor and mitigate risk.

In addition to these core services, a prime broker may also provide its clients with a range of other services, such as collateral management, tax reporting, and regulatory compliance support.

The exact services offered by a prime broker can vary depending on the needs of its clients and the capabilities of the prime broker.

Administrator

An administrator in a hedge fund is responsible for the day-to-day operations of the fund and ensures that it is run efficiently and in compliance with regulatory requirements.

This may include tasks such as:

• Maintaining records of fund transactions, portfolio holdings, and investor information
• Calculating net asset values (NAVs) and distributing financial statements to investors
• Facilitating the onboarding process for new investors and managing the redemption process for exiting investors
• Coordinating with external service providers, such as custodians, prime brokers, and auditors
• Assisting with the preparation of marketing materials, such as offering documents and presentations
• Providing support to the fund manager and other investment professionals as needed

In addition to these operational duties, the administrator may also be involved in risk management, compliance, and regulatory reporting.

It is important for the administrator to have a strong understanding of the hedge fund industry and the regulatory environment in which the fund operates.

How To Start A Hedge Fund From Scratch

Auditor

An auditor is a professional who is responsible for independently reviewing and verifying the financial statements of a company or organization.

In the context of a hedge fund, the auditor’s role is to ensure that the fund’s financial statements accurately reflect the fund’s financial position and performance.

This includes reviewing the fund’s accounting records and procedures, testing the accuracy of the financial information, and expressing an opinion on whether the financial statements are presented fairly in accordance with relevant financial reporting standards.

The auditor’s role is critical in helping to ensure the integrity and reliability of the hedge fund’s financial information, which is important for investors and other stakeholders who rely on this information to make informed decisions.

Distributor

A distributor is a company that is responsible for marketing and selling securities, such as hedge fund units or shares, to investors.

In the context of a hedge fund, a distributor plays a key role in the fund’s marketing and securities distribution efforts.

The distributor works with the hedge fund’s management team to develop a marketing plan and to identify potential investors for the fund.

This may involve conducting market research to understand the needs and preferences of different types of investors, and developing targeted marketing materials and strategies to reach these investors.

The distributor may also work with financial advisors and other intermediaries to help promote the fund and to facilitate the sale of securities to investors.

In addition to marketing the hedge fund, the distributor is also responsible for facilitating the actual sale of securities to investors.

This may involve processing and tracking investment orders, providing investors with information about the fund and its investment strategies, and answering any questions or concerns that investors may have.

The distributor may also be responsible for maintaining relationships with existing investors and providing ongoing support and services to them.

Overall, the role of the distributor is to help the hedge fund reach and connect with potential investors, and to facilitate the sale of securities to these investors in a way that is compliant with regulatory requirements and best practices.

Legal Entity

The most common legal entity that hedge funds operate under is a limited partnership.

In a limited partnership, there are two types of partners: general partners and limited partners.

As explained earlier, the general partners of a hedge fund are typically the fund’s management team and are responsible for making investment and management decisions on behalf of the fund. They also have personal liability for the fund’s debts and obligations.

The limited partners, on the other hand, are the investors in the hedge fund and do not have any managerial control over the fund. They are only liable for the debts and obligations of the fund to the extent of their capital contributions.

Limited partnerships offer a number of advantages for hedge funds:

• They provide tax benefits, as the fund’s income is passed through to the partners and taxed at the individual level rather than at the corporate level.
• Limited partnerships also offer flexibility in terms of management and decision-making, as the general partners have broad discretion to make investment and management decisions on behalf of the fund.

Another legal entity that hedge funds may operate under is a limited liability company (LLC).

LLCs offer similar tax benefits to limited partnerships, as well as the added advantage of limiting the personal liability of the members (similar to shareholders in a corporation) for the debts and obligations of the LLC.

Why Hedge Funds Use a Master-Feeder Structure

The master-feeder structure is common.

Here’s what it aims at.

1. Tax Optimization for Different Investor Types

• US taxable investors (e.g., high-net-worth individuals, domestic institutions) typically invest through a US feeder (usually a limited partnership or LLC).
• Non-US investors and US tax-exempt entities (like pension funds or endowments) invest through an offshore feeder (usually domiciled in a tax-neutral jurisdiction like the Cayman Islands or British Virgin Islands).
• Both feeders invest into the master fund, which holds the actual investment portfolio.

Why this matters:

• Tax-exempt and foreign investors want to avoid US effectively connected income (ECI) and unrelated business taxable income (UBTI) that could be generated by direct US investments.
• US investors need structures that maintain pass-through tax treatment.

This setup keeps the different investor classes happy while allowing the manager to run one unified portfolio.

2. Operational Efficiency

• Without a master-feeder structure, the manager would have to replicate trades in multiple portfolios for each investor group.
• The master-feeder setup consolidates the portfolio, so the fund manager can execute a single strategy at scale.
• This results in reduced trading costs, simplified administration, and unified performance reporting.
• Since all trading activity happens within the master fund, auditors and compliance teams only need to review one central portfolio rather than reconciling multiple parallel ones.
  • This reduces the cost and complexity of financial audits, regulatory filings, and internal controls.
• With all assets centralized, the master fund can calculate a single net asset value (NAV), which is then allocated proportionally to each feeder.
  • This avoids discrepancies across multiple portfolios and ensures all investors – regardless of entry point – receive a fair and consistent valuation of their shares.

3. Regulatory Compliance and Flexibility

• US feeders are structured to comply with SEC and IRS rules for domestic investors.
• Offshore feeders are usually not subject to US securities laws, allowing more flexibility in marketing and disclosure requirements abroad.
• The master-feeder structure allows the fund to comply with multiple regulatory regimes simultaneously without needing separate portfolios.
  
• Eases cross-border fundraising by meeting local legal standards without restructuring the core investment strategy.

4. Marketing and Fundraising

• Many hedge funds want to attract global capital – from both US and international investors.
• Offshore feeder funds allow hedge funds to be marketed to international investors without triggering US tax or regulatory obligations.
• US feeder funds allow domestic investors to access the same strategies.

The structure therefore broadens the investor base without diluting strategy or adding tax complications.

Domicile and Taxation

As mentioned, hedge funds are typically domiciled in offshore financial centers such as the Cayman Islands, Bermuda, and the British Virgin Islands (BVI).

Luxembourg, Ireland, and the US are also common hedge fund domiciles.

This is because these jurisdictions often have favorable tax treatment for hedge funds, as well as a high level of financial privacy.

In terms of taxation, hedge funds are generally taxed as partnerships, rather than as corporations.

This means that the income and losses of the hedge fund are passed through to the individual investors in the fund, who are then responsible for paying taxes on their share of the fund’s income.

One of the main advantages of this structure is that it allows investors to defer paying taxes on their share of the fund’s income until they actually receive a distribution from the fund.

This can be beneficial for investors who are in a higher tax bracket and who might otherwise be subject to a higher tax rate on their share of the fund’s income.

Nonetheless, the specific tax treatment of hedge funds can vary depending on the country in which they are domiciled and the jurisdiction in which the investors are tax residents.

For those considering hedge fund investments, consulting with a tax professional is advised to understand the tax implications of investing in a hedge fund.

Investment Manager Locations

New York City and Connecticut are two of the most common locations for hedge funds and investment management firms.

Many hedge funds are headquartered in New York City due to the city’s financial hub and the availability of a skilled workforce.

Connecticut is also a popular location for hedge funds due to its proximity to New York City and the presence of a number of large financial institutions in the state. Connecticut also had no state income tax until 1985.

The historical association of having lower taxes than NYC and its more rustic location helped make the southwest portion of Connecticut (e.g., Westport, Stamford, Darien) a popular location for hedge funds.

In addition to these two locations, there are also many hedge funds and investment management firms located in other financial centers around the world, such as London, Singapore, and Hong Kong.

The specific location of a hedge fund or investment management firm may depend on a variety of factors, such as the type of investors the firm is targeting, the regulations in the jurisdiction, and the availability of skilled personnel.

Side Pockets

Side pockets are a mechanism used by some hedge funds to classify assets that are relatively illiquid or difficult to value.

These assets are placed in a separate, “side pocket” account within the fund, rather than being included in the fund’s main portfolio.

One reason a hedge fund might use side pockets is to allow the fund to hold onto an asset that may have temporarily decreased in value, but which the fund’s managers believe will eventually appreciate.

By placing the asset in a side pocket, the fund can avoid having to sell the asset at a loss, which would reduce the overall value of the fund.

Another reason a hedge fund might use side pockets is to manage the liquidity of the fund.

If the fund holds a large number of illiquid assets, it may be difficult for investors to withdraw their money from the fund in a timely manner.

By placing these assets in a side pocket, the fund can more easily manage the flow of cash in and out of the fund, and ensure that investors are able to receive their redemption requests in a timely manner.

It is important to note that side pockets are not used by all hedge funds, and their use can be controversial.

Some critics argue that side pockets can be used to artificially inflate the value of a fund, or to hide losses from investors.

As such, investors should carefully consider the use of side pockets when evaluating a hedge fund.

FAQs – Hedge Fund Structure

How are most hedge funds structured?

Hedge funds are investment vehicles that are typically structured as partnerships or limited liability companies (LLCs).

The general partner or manager of the hedge fund has discretion to make investment decisions on behalf of the fund and its investors, who are known as limited partners or members.

A prime broker is a financial services company that acts as a central clearinghouse for the hedge fund’s trades and provides a range of other services, such as securities lending and margin financing.

The prime broker is typically a large investment bank or brokerage firm.

An administrator is a third-party firm that provides back-office support to the hedge fund, including record-keeping, accounting, and regulatory compliance.

An auditor is a professional accounting firm that reviews the hedge fund’s financial statements to ensure that they are accurate and in compliance with relevant regulations.

The legal entity and domicile of a hedge fund depend on the specific structure that the fund has chosen and the laws of the jurisdiction in which it is established. Some common domiciles for hedge funds include the Cayman Islands, Bermuda, and the British Virgin Islands, due to their favorable tax regimes.

The taxation of hedge funds depends on the tax laws of the jurisdiction in which they are domiciled and the tax status of the investors. In some cases, hedge funds may be eligible for favorable tax treatment, such as the ability to defer or avoid tax on certain types of income.

However, the specific tax treatment of a hedge fund will depend on its individual circumstances.

What is the master-feeder hedge fund structure?

A master-feeder hedge fund structure is a way of organizing a hedge fund in which there are two separate legal entities: a “master fund” and one or more “feeder funds”.

The master fund is the main investment vehicle that holds the bulk of the assets and is where investment decisions are made.

The feeder funds are separate legal entities that are used to hold the assets of individual investors.

The investors in the feeder funds are typically not directly invested in the master fund, but rather they are exposed to the master fund’s investments.

This structure allows the hedge fund to efficiently manage the assets of a large number of investors and to accommodate different legal and regulatory requirements in different countries.

It can also make it easier for investors to invest in the hedge fund, as they can do so through the feeder fund rather than having to directly invest in the master fund.

Are private equity firms structured the same as hedge funds?

Hedge funds and private equity funds are both types of investment vehicles that are used to pool capital from investors and make investments in a variety of assets.

Hedge funds are typically structured as either limited partnerships or limited liability companies. The investors in a hedge fund are known as “limited partners” or “members”, depending on the legal structure of the fund.

The managers of the hedge fund, who make the investment decisions and manage the assets of the fund, are known as “general partners” or “managers”.

Hedge funds are typically subject to less regulation than other types of investment vehicles, and they often have more flexibility in terms of the types of investments they can make and the strategies they can use.

Private equity funds are typically structured as limited partnerships or limited liability companies, as well. Likewise, investors in a private equity fund are known as “limited partners” or “members”, and the managers of the fund are known as “general partners” or “managers” like hedge funds.

Private equity funds typically focus on making long-term investments in private companies, rather than trading securities on a shorter-term basis like hedge funds.

They are subject to more regulation than hedge funds, and they often have stricter requirements for the types of investments they can make.

Private Equity Fund Structure Explained

Conclusion – Hedge Fund Structure

A hedge fund is an investment vehicle that pools together capital from accredited investors or institutional investors and uses that capital to make a variety of investments, often with the goal of generating high returns.

Hedge funds are typically structured as partnerships, and the partners are the investors in the fund.

The general partner is responsible for making investment decisions and managing the fund, while the limited partners are the investors who provide capital to the fund and share in the profits and losses.

There are several key elements to the structure of a hedge fund:

1. Prime broker: A prime broker is a financial institution that provides a range of services to hedge funds, including clearing trades, providing financing, and facilitating the settlement of trades.
2. Administrator: An administrator is a third-party firm that is responsible for performing a variety of administrative tasks for the hedge fund, such as calculating net asset value (NAV), reconciling trade discrepancies, and preparing financial statements.
3. Auditor: An auditor is a professional who is responsible for reviewing the financial records of the hedge fund to ensure that they are accurate and in compliance with relevant laws and regulations.
4. Distributor: A distributor is a company that is responsible for marketing and selling the hedge fund’s investment products to potential investors.
5. Legal entity: A hedge fund is typically organized as a legal entity, such as a partnership or limited liability company. The legal structure of the fund can have significant implications for the fund’s operations and the liability of its investors.
6. Domicile: A hedge fund is usually domiciled in a particular jurisdiction, which can affect the fund’s legal and regulatory environment, as well as its tax treatment.
7. Taxation: The tax treatment of a hedge fund and its investors can vary depending on the fund’s domicile and the tax laws of the investors’ home countries. It is important for hedge fund managers and investors to understand the tax implications of their investments.