Hedge Fund Formation: Steps to Start and Structure Your Fund

Starting a hedge fund requires careful planning, legal compliance, and strategic decision-making. Unlike traditional investment vehicles, hedge funds operate with fewer restrictions, allowing fund managers to use complex strategies to generate returns. However, this flexibility comes with regulatory obligations and structural considerations that must be addressed before launching the fund.

A well-structured hedge fund ensures operational efficiency, tax advantages, and investor confidence. From selecting the right legal structure to securing initial capital and hiring key service providers, each step plays a role in the fund’s success.

Regulatory Registration

Compliance with financial regulations is essential to avoid legal complications. In the United States, hedge fund managers must register with the Securities and Exchange Commission (SEC) if they manage over $110 million in assets under the Investment Advisers Act of 1940. Those managing between $25 million and $110 million typically register at the state level. Managers with less than $150 million in private fund assets may qualify for the private fund adviser exemption but must still file Form ADV with the SEC.

Funds trading futures, options on futures, or swaps must comply with Commodity Futures Trading Commission (CFTC) and National Futures Association (NFA) regulations. Managers engaging in these activities may need to register as Commodity Pool Operators (CPOs) or Commodity Trading Advisors (CTAs) unless they qualify for exemptions like CFTC Rule 4.13(a)(3), which limits leverage and investor types. Funds must also adhere to the Bank Secrecy Act and Anti-Money Laundering regulations, requiring policies to detect and report suspicious financial activities.

State regulations vary, with some imposing additional registration or reporting requirements. California and Texas, for example, have stricter oversight for investment advisers. Hedge funds operating internationally must consider regulations such as the European Union’s Alternative Investment Fund Managers Directive (AIFMD), which imposes reporting and transparency obligations on funds marketing to EU investors.

Fund Structures

The legal structure of a hedge fund determines tax treatment, investor eligibility, and regulatory obligations. The choice depends on the fund’s target investors, geographic location, and investment strategy. Common structures include the domestic partnership model, offshore structure, and master-feeder setup.

Domestic Partnership Model

A domestic hedge fund is typically structured as a limited partnership (LP) or limited liability company (LLC) in the United States. The fund serves as the LP, while the fund manager acts as the general partner (GP) or managing member in an LLC. Investors contribute capital as limited partners, benefiting from pass-through taxation, which avoids double taxation at both the corporate and investor levels.

Delaware is a preferred jurisdiction due to its well-established legal framework. Hedge funds structured as LPs typically charge a management fee (e.g., 2% of assets under management) and a performance fee (e.g., 20% of profits).

One drawback is that U.S. taxable investors receive a Schedule K-1, which reports their share of the fund’s income, gains, and losses. This can create tax complexities, especially if the fund generates income from multiple states, requiring investors to file state tax returns in those jurisdictions. Foreign investors may face withholding tax issues under Internal Revenue Code Section 1446, which imposes a withholding tax on effectively connected income from U.S. sources.

Offshore Structure

An offshore hedge fund is typically established in jurisdictions such as the Cayman Islands, British Virgin Islands, or Bermuda. These locations offer tax neutrality, meaning the fund itself does not pay corporate income tax, allowing investors to defer taxation until they realize gains. This structure is attractive to non-U.S. investors and U.S. tax-exempt entities, such as pension funds and endowments, which seek to avoid Unrelated Business Taxable Income (UBTI).

Offshore funds are usually structured as corporations rather than partnerships to prevent U.S. investors from receiving direct pass-through income, which could trigger U.S. tax liabilities. These funds often elect to be treated as Passive Foreign Investment Companies (PFICs), which subjects U.S. investors to special tax rules, including the potential for higher tax rates on gains and interest charges on deferred income.

The Cayman Islands requires registration with the Cayman Islands Monetary Authority (CIMA) under the Mutual Funds Act, which mandates annual audits and regulatory filings. Offshore funds marketing to European investors must comply with AIFMD, which imposes reporting and disclosure requirements.

Master-Feeder Setup

A master-feeder structure allows hedge funds to attract both U.S. and non-U.S. investors while maintaining a single investment portfolio. A master fund holds the pooled assets and executes trades, while two feeder funds—one domestic and one offshore—channel investor capital into the master fund.

The domestic feeder is structured as a limited partnership or LLC for U.S. taxable investors, ensuring pass-through taxation. The offshore feeder, typically a corporation, accommodates non-U.S. investors and U.S. tax-exempt entities, shielding them from direct U.S. tax exposure.

The offshore feeder avoids generating UBTI for tax-exempt investors, while the master fund’s income is allocated proportionally to each feeder. U.S. investors in the offshore feeder may face PFIC tax treatment, which can result in higher tax liabilities. Transfer pricing rules require that transactions between the master and feeder funds be conducted at arm’s length to prevent tax avoidance.

Offering Memorandum

An offering memorandum serves as the primary disclosure document for prospective investors, outlining the hedge fund’s strategy, risks, terms, and operational details. Hedge funds rely on private placements under exemptions such as Regulation D of the Securities Act of 1933, which requires detailed disclosures but avoids the stringent registration process of public offerings.

A well-prepared offering memorandum details the fund’s investment approach, including asset classes, risk management policies, and expected liquidity terms. It specifies redemption policies, lock-up periods, and potential restrictions on withdrawals. Hedge funds often impose “gates” or suspension clauses, allowing managers to limit redemptions during periods of market stress.

Fee structures are outlined, detailing management and performance fees, as well as any additional expenses. Some funds implement hurdle rates, ensuring performance fees are only charged if returns surpass a predetermined benchmark. High-water marks prevent managers from collecting performance fees until losses from prior periods are recovered.

Legal and regulatory considerations are addressed, including investor eligibility requirements and tax implications. The memorandum includes representations and warranties that investors must acknowledge, affirming their understanding of the risks involved.

Capital Acquisition

Raising capital requires a strategic approach, as institutional and high-net-worth investors scrutinize fund managers before committing assets. A strong track record, either from prior fund management or proprietary trading, is often the most compelling factor in attracting early investors. Without verifiable performance data, managers may struggle to secure commitments.

Networking plays a role in capital acquisition. Family offices, endowments, and pension funds often allocate capital to emerging managers, but only after extensive due diligence. Attending industry conferences, joining capital introduction platforms, and leveraging prime brokerage relationships can open doors to potential investors.

A cornerstone investor—typically contributing a substantial percentage of initial assets—can provide credibility. Some managers seed their own capital to demonstrate alignment with investor interests. Funds often use early-stage fee concessions, such as reduced management fees or founder share classes, to incentivize initial commitments.

Hiring Service Providers

Building a hedge fund requires assembling a team of specialized service providers to ensure compliance, operational efficiency, and investor confidence. These third-party firms handle legal structuring, financial reporting, and administrative functions.

Legal Counsel

Legal counsel assists with structuring the fund, drafting offering documents, and ensuring compliance with securities laws. They help navigate regulatory filings such as Form ADV and blue sky laws.

Auditors

Hedge funds must engage independent auditors to conduct annual financial statement audits, which are often required by institutional investors and regulatory bodies. Auditors verify financial records, ensuring compliance with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).

Fund Administrators

Fund administrators handle back-office operations, including net asset value (NAV) calculations, investor reporting, and subscription and redemption processing. They also assist with anti-money laundering compliance, conducting due diligence on investors.

Tax Considerations

Tax structuring impacts a hedge fund’s profitability and investor returns. U.S.-based hedge funds structured as limited partnerships benefit from pass-through taxation. Offshore funds structured as corporations avoid direct U.S. taxation but may trigger PFIC rules for U.S. investors.

Hedge fund managers must also consider the tax implications of carried interest, which represents their share of fund profits. Under current U.S. tax law, carried interest is taxed as long-term capital gains if the holding period exceeds three years.