Hedge fund structure and fees Understanding how hedge funds are structured and how the managers get paid
Hedge fund structure and fees
- let's see if we can understand the structure of a hedge fund (a little bit) and also how the management
- and the performance fees work out.
- so most hedge funds, the funds themselves, are set up as limited partnerships.
- so this is the hedge fund that Pete set up.
- we'll call it the Pete Capital Fund 1, maybe in the future, we're going to start Fund 2 and 3 and all the rest.
- and he's able to raise $100 million
- 10% of that $100 million, or 10 million of it, is coming from him
- - or to be more exact, coming from Pete Capital Management, LLC (limited liability company)
- which he starts off as the general partner of this fund.
- and this might be a little bit confusing, but this one company, this is another company over here.
- this company is going to manage the assets of that company.
- and in return, it will be able to get management fees and it will able to get a performance fee
- that we will talk about in a couple of seconds.
- and probably Pete owns this entire company,
- but he might have a couple of employees, probably four or five.
- now the way it works with a limited partnership is that they dont call it necessarily shares, but it's
- essentially the same thing.
- someone who, out of this $100 million, contributed $30 million
- would get 30% in limited partner interest,
- someone who contributed 10% would get $10 million in limited partner interest
- so let's just say that he does really good over the next year, that he's able to,
- on a gross basis - before we take out his management fee or anything else -
- grow the fund by $20 million,
- so roughly on a gross basis, 20%
- so this is net of trading fees, all the stuff he has to pay the broker, and all of that type of thing.
- to understand, kind of what goes to Pete Capital Management,
- that Pete can use to pay himself and his handful of employees,
- first he gets the management fee,
- and the management fee will be on the average net asset value
- and i'm going to do it a little "back of the envelope" right over here,
- it's normally done on a monthly basis, but i dont want to go into all of that accounting
- but if he did this fairly linearly, consistently,
- the average net asset value over the year would be $110 million
- and so he'll get about 2% of that,
- we're assuming he gets the 2% management fee,
- and 20% performance fee (carried interest as sometimes called)
- so if the average net asset value = $110 million
- you multiply that times 2%
- and that means that
- he's going to get $2.2 million in management fees
- this is for his salary, his employee's salaries, to pay the rent, to get some fancy computers
- whatever it might be
- this is kind of viewed as the cost to just manage the fund.
- so we need to subtract that from the total amount to the fund,
- because that's going to management companies
- so instead of $120 million over here, we're going to have
- what is that, $117.8 million
- and then we'll have to calculate how much he's going to get in performance fee
- so in this situation, net of his management fee,
- we have a $117.8 million gain.
- (in profit)
- the way that we set up the performance fee, or the carried interest, is that
- Pete gets 20% of it,
- or more particular, the general partner, the Pete Capital Management, LLC,
- the partner that is controlling, managing, this fund will get 20%
- so lets multiply that by 20%,
- and what does that give us,
- that gives us 3.56 million
- will also go to Pete Capital Management.
- so not bad, this year, he made
- a little over $6 million
- so that's going to him and his four or five employees,
- so if someone performs well, it can be a very profitable business.
- and just to make it clear how the mechanics works here,
- these funds tend to be open-end funds, like open-end mutual funds,
- well not like them, they have to be private,
- they can only take money from credited investors, they cant market themselves,
- they dont have to register with the SEC
- when i say that they are open-ended, it means that
- at any point, well not at any point, usually there are restrictions.
- at certain points in time, the investors are allowed to redeem or kind of add investments to what's going
- on in the fund.
- so let's say at the end of the year, so instead of $117.8, we're going to have to subtract 3.56 from that
- Pete's Capital Management.
- so what's left of the fund is going to be, and he could leave it in there to reinvest but that would just
- increase his share.
- but let's say, Pete's Capital Management takes it out, so we would be left with .. let's see, we have
- 117.8 - 3.56, right?
- gives us $114.24
- and let's see this period, investors are allowed to redeem their interest.
- and this guy right over here, this guy with the 30% interest, he says you know what, that was a pretty
- good year. I want to take 10% of my interest out... so instead of having a 30% interest, he wants to
- have a 10% interest.
- so what happens is... so instead of a 30% interest, this is now a 20% interest. he'll take 10% out
- so he'll 10% of a 114.24, so he's going to take out... that's essentially going to be,
- you just have to move the decimal place, one place over.
- so he's going to take out 11.424 million, that's this guy over here.
- he's going to take out 11.424 million, and then the fund will
- decrease by that amount.
- so he can, at these specific periods, people can redeem, usually at the end of the month, at the end of
- the quarter, or at the end of the year.
- so the fund will be left with... let me take the calculator out again,
- the fund will no be left with
- 114.24 - 11.424
- which is going to be 102.816.
- and at the same time, other poeple might say hey! that was a pretty good return, i'm going to now, contribute
- to the fund.
- so either way, it's not like a closed-end fund, where just at the beginning, people can commit their capital,
- and they cant take it out until the end of the fund and they cant add more
- during the life of most hedge funds, at specific periods
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