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Course: Finance and capital markets > Unit 7
Lesson 4: Hedge fundsHedge fund structure and fees
Understanding how hedge funds are structured and how the managers get paid. Created by Sal Khan.
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If you're that good at investing, isn't it more efficient to use your own money rather than using other people's money and paying back most of it?(4 votes)
There are a lot of conflicts of interest in the hedge fund industry. You usually get a small percentage by just managing the money, regardless of return. When you have billions under management, that small 1-2% management fee can make you very rich.
Also, if it's other people's money it allows you to take more risk. Investors want a high return and you can risk it all because it's other people's money. If you lose it, you just shut the fund down. But if you take a lot of risk and get a huge return, you become a star in the industry with more people investing money that you can collect fees on.(20 votes)
Why is the NAV 110 Million dollars? Does is stand for 120 Millions - Pete Capital Management 10%?(4 votes)
Sal says that hedge funds usually do accounting on a monthly basis, and $120m is the NAV after a year. So $110m is an average NAV in any given month of that year, if we suppose that the fund's assets grew linearly.(5 votes)
Why do you need certain specifications in order to invest in a hedge fund if the fund manager ends up doing the decision one would need the deeper knowledge for?(2 votes)
Because it is very easy to trick people who are not sophisticated with their money.(3 votes)
- Can somebody correct me if I'm wrong? I was under the impression that the 20% is charged on alpha, the return that the fund achieves beyond the benchmark return. Otherwise, if the market was just good for everyone that year, the hedge fund manager would just get a huge cut regardless of their contribution as everybody would be performing well.
I thought say the fund achieved a return of 15% this year, and the benchmark designated, say S&P 500 had a 8% return. The hedge fund gets 20% of 7% (15% - 8%), as the extra 7% is the actual contribution the hedge fund manager put in to beat the market.(1 vote)- Every fund has its own pricing.
Rarely is the 20% on alpha, it's just on the total gain. This is because most funds claim to be "abolute return" even though that claim usually is undermined be the fact that most of the funds are normally net long.
When it is versus a benchmark, the benchmark is usually something like T-bills, which means most of the gain is still subject to 20%.
I have never seen a hedge fund that offered the S&P500 or anything similar as a benchmark for its performance calculation. Most funds would claim that is "unfair" to them because they are long/short rather than long only.
If you were a hedge fund with a S&P500 benchmark all you would do is lever up and go 150% long or more. If the market is down, you get zero, if up you make lots of money. You can't lose, and 2 years out of 3 you will win, sometimes really big. But most funds want the odds stacked even more in their favor.
In other words, it works exactly the way that surprises you: if the market is good for everyone, the hedge fund managers make lots of money regardless of their contribution. That should not be how it works, but it is exactly how it works.
You need to understand that the whole thing is a ripoff.(1 vote)
- At1:45you took Peter's management fee from the initial $100M, however you deducted the performance fee from the $120M after the funds were grown. Why is that ?(1 vote)
- Because that's the way hedge funds do it (in most cases)(1 vote)
- What is the legal status of Pete Capital Fund 1, is it a partnership or a limited liability company ? How does Pete establish the ownership of the fund ?(0 votes)
- The most common structure is to form an LLC which then becomes the general partner of the fund. The other investors are limited partners in the fund.(1 vote)
- where do management fees come out of a 100M AUM fund?
assuming 2%/20%. Do they set aside 2M cash for the year first?(0 votes)- They take the management fee out quarterly (usually) and the performance fee at the end of the year.(0 votes)
1:45Video transcript
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 Pete Capital Fund 1. He's maybe in the future going
to start Fund 2, and Fund 3, and all of 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 I guess to be
more exact, it's coming from Pete Capital
Management, LLC, limited liability company,
which he starts off as the general
partner of this fund. And it might be a
little bit confusing, but this is 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 be able to
get the performance fees. And we'll talk about
that in a second. 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 they don't 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 the limited partner interest. Someone who contributed
10% would get $10 million in limited partner interests. 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%. But this is net of the
trading fees and all the stuff that he has to pay, the broker
and all of that type of thing. To understand what goes to
Pete Capital Management, that Pete can use to pay himself
and his handful of employees, first to guess the
management fee. And the management fee will be
on the average net asset value. And I'm going to do it a little
bit back-of-the-envelope right over here. It's normally done
on a monthly basis. But I want to go into
all of the accounting. But if he did this
fairly linearly, or if you does this
fairly consistently, the average net asset
value over the year would be about $110 million. So average would be
approximately $110 million. And so he'll get
about 2% of that. We're assuming he gets a 2%
management and 20% performance fee, or 20% carried interest,
it's sometimes called. So if the average net asset
value is $110 million, you multiply that times 2%. And then that means that he's
going to get $2.2 million in management fees. And this is for his salary,
his employee's salary, to pay the rent,
to I don't know, get some fancy computers,
whatever it might be. This is kind of viewed as the
cost just to manage the fund. So we need to subtract that from
the total amount in the fund, because that's going to
the management company. So instead of $120 million
over here we're going to have, what is that? $117 million 0.8,
$117.8 million. And then we'll have to
calculate how much she gets in a performance fee. So in this situation, net
of his management fee, we have a $17.8 million gain. So let me write that over here. We have $17.8
million in profits. The way that we've
set up the performance fee, or the carried interest,
is it Pete gets 20% of it. Or more particular,
the general partner, the Pete Capital
Management, LLC, the partner that is controlling,
that as managing this fund, will get 20%. So let's multiply
that times 20%. And what does that give us? That gives us $3.56 million. So $3.56 million will also go
to Pete Capital Management. So not bad. In this year he made a
little-- almost $6 million. And that's probably
going to go to him and probably four
or five employees. So it can, if someone
performs well, it can be a very
profitable business. And just to make it clear
how the mechanics work here is that these funds tend
to be open end funds, like open end mutual funds. Well not like them,
they have to be private. They could only take money
from accredited investors. They can't market themselves. They don't have to
register with the SEC. But when I say that they can
be open-ended it means that at any point-- well
not at any point, usually this is restricted--
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 after the end of
the year, so instead of $117.8, we're going to have to
subtract $3.56 from that for Pete Capital Management. So what's left in 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 Capital
Management takes it out. So we'll be left
with-- let's see we have 117.8 minus
it gives us 114.24. So over here, what's left
of the fund is 114.24. And let's say this
period, investors are allowed to redeem
their interest. And let's say 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% this is now 20% interest. He'll take 10% out. So he'll take 10% of 114.24. So he's going to take
out-- that's essentially going to be-- we just have
to move the decimal places one over. So he's going to take
out $11.424 million. That's this guy right 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 it's at the
end of the month, at the end of the quarter,
or the end of the year. So then the fund
will be left with, what's 114-- let me take
the calculator out again. The fund will now be left
with 114.24 minus 11.424 which is going to be 102.816. And at the same
time, other people 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 it's a closed-end fund where
just at the beginning, people can commit their capital
and they can't take it out until the end of the fund,
or they can't add more. During the life of most hedge
funds, at specific periods, people are allowed to
redeem their funds. Or they're allowed
to add more funds.