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Studying for a test? Prepare with these 5 lessons on Investment vehicles, insurance, and retirement.
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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.