A “hedge fund” is a small partnership or a limited liability corporation (LLC) essentially designed to minimize risk while anticipating sure profits. If you tend to be a low-risk investor, read about what a hedge fund does to your advantage.
Imagine you are an investment beginner but you feel a little bit confused about esoteric financial terms, such as “hedge funds.” This article hopes to explain in the best possible layman’s terms what a hedge fund is, and what the managers and the investors around it do.
A hedge fund is formed as a small, private partnership – a limited partnership or a limited liability company (LLC). Unlike other managers and investors of other corporations, the parties that are involved in a hedge fund are not subjected to some of the regulations with regards on how the funds are implemented and appropriated, since a hedge fund is not sold to the general public. Therefore, hedge funds are also not open for retail investors, and instead these structures are limited to select investors with a high income or net worth.
Minimizing risk and guaranteeing returns
Hedge funds are created to minimize investment risk while seeking absolute returns in more modest terms, you still can make money regardless of whether the markets are on the uptrend or on the downtrend. And that kind of structure of the hedge fund is made for such purpose – to earn considerable profit regardless of the current market climate. Most hedge funds can invest in anything – stocks, bonds, currencies, mutual funds, real estate, etc. You can use your money as well if you want to buy a restaurant or build a new company, or invest in anything else of value like art, rare collectibles (like stamps or old coins), wine, gold, etc.
Most managers of hedge funds are also the ones who establish them. A hedge fund manager takes a percentage of the profits he/she has made on the money that the investors entrust him/her with.
Since a hedge fund is formed as a limited partnership or LLC only, it also saves the investors from run-ins with the creditors in case the organization goes bankrupt. It’s because the creditors can’t charge the investors for more money other than the money they’ve invested in the hedge fund.
Hedge Fund Quotes
“You can’t have bank holding companies acting as hedge funds. You can’t have them taking a million-dollar pension plan for Joe Schmo the bus driver and treat it with the same risk appetite that you treat George Soros’ pocket money. It’s fundamentally ridiculous.” – Shia LaBeouf
“I’ve nothing against Goldman Sachs. But Goldman Sachs isn’t an investment bank. Goldman Sachs is a hedge fund. It’s bigger than any hedge fund. It’s more leveraged, to the power of three or five, than any hedge fund.” – Nouriel Roubini
“Hedge funds, private equity, and venture capital funds have played an important role in providing liquidity to our financial system and improving the efficiency of capital markets. But as their role has grown, so have the risks they pose.” – Jack Reed
The “2 and 20” formula
Most hedge funds that are currently in operation follow the “2 and 20” formula – meaning that a hedge fund investment manager receives an annual management fee of 2% (just like a salary for services performed) as well as 20% of the profits annually, in case there’s an increase in the fund’s net asset value during the operating year.
Even if the company is not making a lot of money (or even otherwise losing a lot of it), fund managers are still guaranteed with the 2% performance fee for their services. Obviously, with the company’s dismal performance investors might look for “greener pastures,” so to speak, and leave the company soon enough. So it’s really the responsibility of the fund managers to maximize the company’s profits.
Some performance fees include hurdle rates, which are used as a determining factor of a hedge fund’s performance in case it exceeds its fixed rate or percentage which has been proposed by the company.
For example, you create an LLC company or a limited partnership where you are also its manager. Then you have a legal document that states that you will receive 25% from the profits in case they exceed over the rate of 5% annually, and your investor will get the remaining 75% of the profits. Then, an investor agrees to put $10 million into your company, and that $10 million eventually doubles into $20 million. So that $10 million profit will be trimmed by the hurdle rate of 5%, and the profit will now stand at $9.5 million.
This is made so as to ensure that you (as manager) have to clear that hurdle rate first before you’ll be rewarded with the 25% share of the profits. The $500,000 that’s taken off from the profits through the hurdle rate will go to your investor, plus the 75% share of the profits. So you (as manager) will walk away with $2.5 million and your investor will get $8 million. ($7.5 million plus the $500,000 from the hurdle rates).
We hope that this article has helped you understand the basics of the hedge fund. If you are a conservative business person who is not too keen on taking high risks in investing, then the hedge fund is ideal for you.