A hedge fund is less a product than a bundle of permissions. It may borrow heavily, sell short, hold investors' money for years and take a share of the profits. The law grants those permissions only to funds that stay away from the general public.
A hedge fund is a privately offered pool of investor money. Its manager has wide freedom to borrow, sell short and trade derivatives. Most hedge funds take one of two legal forms:
- Limited partnership: The manager, or a company it controls, is the general partner and makes every investment decision. Investors are limited partners.
- Limited liability company (LLC): Investors are members, and the manager is the managing member. Members get the same limited liability.
Sold as private placements. Registering fund interests under the Securities Act of 1933 would require a prospectus and Securities and Exchange Commission (SEC) review. Instead, the fund sells through a Regulation D private placement under Rule 506. Its buyers are generally accredited investors. Rule 506 offers two paths:
Common mistakes
- Counting accredited investors, not owners: The 3(c)(1) cap counts beneficial owners of any kind. Accredited status comes from the Regulation D sale. A fund of funds holding 10% or more counts as all its investors, not one.
- Swapping the dollar tests: Accredited means net worth over $1,000,000 excluding the home. Qualified client means $1,400,000 managed or net worth over $2,700,000. Qualified purchaser means $5,000,000 in investments, so a choice reading "$5,000,000 net worth" mixes up the measure.
- Ignoring the high-water mark: After a loss, measure the performance fee from the mark, not the latest starting value. In Example 1, that error produces $18,000 instead of $3,600.
Bottom line
- Hedge funds are usually limited partnerships or LLCs sold through Regulation D Rule 506 private placements, generally to accredited investors.
- An accredited individual has net worth over $1,000,000 excluding the home, income over $200,000 ($300,000 joint), or a Series 7, 65 or 82 in good standing.
- Section 3(c)(1) funds have no more than 100 beneficial owners and make no public offering.
- Section 3(c)(7) funds sell only to qualified purchasers: $5 million in investments for individuals, $25 million for discretionary investors.
Exam shortcut
Before computing anything, name the gate the stem is testing: A count of owners means 3(c)(1) and 100. A pile of investments means 3(c)(7) and $5 million. A performance fee means qualified client. The way interests are sold means Regulation D and accredited investors. If a fee stem shows a loss and then a gain, write down the high-water mark first. The wrong answer measures from the latest starting value.
The full lesson (about 4,664 words, 31 min read) adds 2 worked examples, all 5 common mistakes, a self-check, free in the app.
Learning objectives
- C25
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