A hedge fund structure typically consists of two separate legal entities working together: a fund vehicle that holds all investor capital and portfolio assets, and an investment manager that makes trading decisions and runs day-to-day operations. This split delivers three things at once — pass-through taxation for investors, limited liability for the people putting up the money, and a clean wall between the assets and the firm managing them. When the fund accepts capital from foreign or tax-exempt investors, additional entities get layered on top, but the two-entity core stays the same.
The Two-Entity Model
The fund vehicle is where the money and the investments actually live. Investors wire capital into it, and it owns the stocks, bonds, derivatives, and cash that make up the portfolio. Most U.S. hedge funds form this vehicle as a Delaware limited partnership, though some use an LLC instead. Delaware dominates because its partnership statute is flexible and well-developed; over 60 percent of U.S. hedge funds are registered there even when the people running them work somewhere else.
The investment manager is a separate company. It employs the portfolio managers, analysts, and traders, and it operates the fund under an investment management agreement that spells out what it can and cannot do with the fund’s capital. The manager doesn’t own the fund’s assets. It usually also acts as the general partner of the fund’s limited partnership, which is the role that carries authority over investment decisions.
Keeping the manager as its own entity matters for liability. If a trade goes badly or the fund faces a lawsuit, the fund vehicle’s assets are exposed, but the manager’s corporate assets sit behind a separate legal wall. General partners of a limited partnership technically carry unlimited liability, so managers neutralize that by structuring the general partner itself as an LLC or corporation holding minimal assets.
How the Manager Gets Paid
The two-entity design shapes how the manager earns its money. Fees flow from the fund vehicle to the investment manager under the management agreement, and they come in two pieces. The traditional model is “2 and 20” — 2 percent of assets under management annually, plus 20 percent of profits. Fee pressure has pushed industry averages closer to 1.5 percent and 19 percent, and the exact numbers vary by fund size, strategy, and negotiating leverage.
Management Fee
The management fee is a flat annual charge based on the fund’s net asset value. It funds the manager’s overhead: salaries, office space, data subscriptions, technology. A fund with $500 million under management at a 1.5 percent management fee generates $7.5 million a year for the manager, regardless of how the portfolio performs. The fee is usually calculated monthly or quarterly and taken directly out of fund assets.
Performance Fee and the High-Water Mark
The performance fee is the manager’s cut of the profits. On a fund that earns $50 million in a year, a 20 percent performance fee is $10 million for the manager. Almost every fund attaches a high-water mark to this fee: the manager only earns performance fees on gains above the fund’s previous peak value. If the fund falls from $100 million to $80 million, no performance fee is charged until it climbs back over $100 million. That prevents the manager from being paid twice on the same gains.
Some funds also apply a hurdle rate — a minimum return the fund must clear before the performance fee kicks in. A hard hurdle applies the fee only to profits above the hurdle. A soft hurdle applies it to all profits once the hurdle is met. The difference can move the fee number substantially in either direction.
Performance compensation is often structured as a profit allocation, known as carried interest, rather than a fee payment. Structured that way, it can qualify for long-term capital gains rates instead of ordinary income rates, provided the holding-period requirements of IRC Section 1061 are met.1Internal Revenue Service. Section 1061 Reporting Guidance FAQs
Why the Fund Is a Limited Partnership
The limited partnership form exists mostly for tax reasons. Under federal tax law, a partnership itself is not subject to income tax; the partners are liable individually.2Office of the Law Revision Counsel. 26 U.S. Code 701 – Partners, Not Partnership, Subject to Tax Profits and losses pass through the fund vehicle directly onto each investor’s tax return, and each investor pays tax at their own rate. This sidesteps the double taxation that hits regular corporations, where the entity is taxed on profits and shareholders are taxed again when dividends arrive.
Investors sit in the limited partner slot. Their liability is capped at the capital they’ve contributed — they can lose what they put in, but the fund’s creditors can’t reach their personal assets. The investment manager, in its role as general partner, controls operations and, on paper, carries the unlimited liability that comes with that job. As mentioned, that liability is walled off by making the general partner itself an LLC or corporation with almost nothing in it.
Who Is Allowed to Invest
Hedge funds aren’t open to the public. They rely on exemptions from the Investment Company Act of 1940 to avoid the heavy regulation that applies to mutual funds. Two exemptions do most of the work, and each defines a different pool of eligible investors.
Section 3(c)(1)
Section 3(c)(1) exempts a fund whose securities are held by no more than 100 beneficial owners, as long as it does not make a public offering.3Office of the Law Revision Counsel. 15 U.S. Code 80a-3 – Definition of Investment Company The statute itself doesn’t require those 100 investors to be accredited, but most 3(c)(1) funds sell interests under Rule 506(b) of Regulation D, which bars general solicitation and generally limits participation to accredited investors.4U.S. Securities and Exchange Commission. Private Placements – Rule 506(b)
An individual qualifies as accredited by meeting one of two financial thresholds: net worth over $1 million excluding a primary residence, or income over $200,000 individually (or $300,000 with a spouse) in each of the prior two years with a reasonable expectation of the same going forward.5U.S. Securities and Exchange Commission. Accredited Investors The SEC also recognizes certain professional certifications and knowledgeable employees of private funds.
Section 3(c)(7)
Funds that want more than 100 investors use Section 3(c)(7), which requires every investor to be a qualified purchaser.3Office of the Law Revision Counsel. 15 U.S. Code 80a-3 – Definition of Investment Company The bar is much higher: a natural person needs at least $5 million in investments.6Office of the Law Revision Counsel. 15 USC 80a-2 – Definitions, Applicability, Rulemaking Considerations Section 3(c)(7) doesn’t contain its own numerical cap. The practical ceiling of roughly 2,000 investors comes from Section 12(g) of the Securities Exchange Act of 1934, which triggers public reporting requirements above that level.
The Offering Itself
Because they can’t advertise, hedge funds raise capital through private placements. The fund prepares a private placement memorandum describing strategy, risks, fees, and terms. After selling securities, the fund files a Form D notice with the SEC — a brief disclosure, not a registration statement.7U.S. Securities and Exchange Commission. Filing a Form D Notice
Adding Feeder Funds for Offshore and Tax-Exempt Investors
A domestic limited partnership works cleanly for U.S. taxable investors, but it creates serious tax problems for two other groups: U.S. tax-exempt entities like pension funds and endowments, and non-U.S. investors. Funds that want capital from all three groups solve the problem with a master-feeder structure.
Tax-exempt organizations generally don’t pay tax on investment income. But when a fund uses leverage, as most hedge funds do, a share of the income becomes unrelated business taxable income under IRC Section 514, and the tax-exempt investor owes tax on it.8Office of the Law Revision Counsel. 26 USC 514 – Unrelated Debt-Financed Income Non-U.S. investors have a parallel problem: their share of income from a U.S. partnership running a trade or business becomes effectively connected income subject to U.S. tax.9Office of the Law Revision Counsel. 26 U.S. Code 864 – Definitions and Special Rules
The master-feeder structure fixes both. Two or more feeder funds channel all capital into a single master fund, typically formed in an offshore jurisdiction like the Cayman Islands. The master fund does all the trading and holds all the assets. A U.S. limited partnership feeder handles domestic taxable investors so they get the pass-through treatment they want. An offshore corporate feeder handles tax-exempt and non-U.S. investors, acting as a blocker: because it is a corporation rather than a partnership, income stops at the corporate level and doesn’t flow through to the investors behind it. The blocker itself may owe entity-level tax, but for these investor types that’s much better than the alternative. Profits and losses are allocated from the master fund to each feeder based on proportional investment, and fees are generally charged at the feeder level.
Liquidity Limits Built Into the Structure
Hedge funds are not liquid investments. Unlike a mutual fund, where shares can be sold any business day at closing price, hedge funds impose real restrictions on when and how investors can pull capital out. Those restrictions exist because many strategies hold positions that can’t be sold quickly at a fair price, and forced selling to meet redemptions damages the investors who stay.
Lock-Ups and Redemption Windows
Most funds impose an initial lock-up during which a new investor cannot redeem at all. Lock-ups typically run one to two years, longer for less liquid strategies. After the lock-up expires, redemptions are permitted only during set windows, usually quarterly or annually, and typically require 30 to 90 days’ advance notice.
Gates and Side Pockets
Even after lock-ups and notice periods, funds keep additional tools for managing large outflows. A gate caps total withdrawals on any single redemption date, often at 10 to 25 percent of fund assets. Requests above the gate are cut proportionally, and the remainder waits for the next window.
Side pockets address a different situation. When the fund holds something that can’t be fairly valued on a regular schedule — a private company stake, distressed debt that has stopped trading, litigation proceeds — the manager can segregate that position. Investors can’t redeem the side-pocketed portion until the asset is sold or otherwise resolved, and its value is excluded from the fund’s regular net asset value calculation so it doesn’t distort pricing for new or exiting investors.
Outside Firms That Keep the Structure Honest
A hedge fund doesn’t operate alone. Several independent firms perform functions that prevent the manager from being both the person making investment decisions and the person keeping score.
Fund Administrator
The administrator independently maintains the fund’s books. Its core job is calculating net asset value: pricing securities, tracking subscriptions and redemptions, and computing management and performance fees. It also handles investor reporting, processes capital activity, and runs anti-money-laundering checks. Using an outside administrator means the manager isn’t self-reporting its own performance numbers.
Custodian and Prime Broker
The custodian holds the fund’s cash and securities and is responsible for safekeeping. Many funds use their prime broker as the custodian, which creates overlap. The prime broker provides trade execution, clearing, settlement, and margin financing and securities lending. Leverage is central to many strategies, and it usually comes from the prime broker. The prime broker also consolidates trading activity into a single reporting framework used by the manager and the administrator.
Independent Auditor
SEC-registered advisers that manage pooled vehicles like hedge funds must deliver audited financial statements to every investor within 120 days of the fund’s fiscal year end.10eCFR. 17 CFR 275.206(4)-2 – Custody of Funds or Securities of Clients by Investment Advisers The audit is done by a public accountant registered with the PCAOB and is the primary check on reported performance and asset values. Funds of funds get 180 days. If a fund shuts down, an audit must be completed and distributed promptly after liquidation.
Regulatory Registration and Reporting
Hedge funds are often described as unregulated, but most managers face substantial federal oversight. The level depends mainly on how much money the manager oversees.
A manager that advises only private funds and manages less than $150 million in private fund assets qualifies for the private fund adviser exemption and does not fully register with the SEC.11eCFR. 17 CFR 275.203(m)-1 – Private Fund Adviser Exemption These managers still file as exempt reporting advisers, submitting portions of Form ADV through the IARD system and updating annually. Once a manager crosses $150 million, full SEC registration is required, which brings disclosure obligations, a compliance program, and periodic examinations.
Registered advisers with $150 million or more in private fund assets must also file Form PF with the SEC, reporting on the funds they manage, their strategies, leverage, and counterparty exposure.12U.S. Securities and Exchange Commission. Form PF Most file annually. Large hedge fund advisers face more frequent reporting and current-event triggers for events like extraordinary losses or major margin increases. Form PF was designed to give regulators visibility into systemic risk across the private fund industry.