How to Set Up a Hedge Fund: Legal and Operational Steps

Hedge funds are privately managed investment vehicles that pool capital from investors to pursue diverse investment strategies, often employing complex instruments and leverage. They aim to generate absolute returns for investors, regardless of broader market movements.

Establishing the Fund’s Legal Foundation

Establishing a hedge fund begins with legal decisions regarding its structure and domicile. The most common legal structures for hedge funds in the United States include the Limited Partnership (LP) and the Limited Liability Company (LLC). An LP typically involves a general partner who manages the fund and assumes unlimited liability, and limited partners who contribute capital and have limited liability. An LLC offers liability protection to all its members while providing flexibility in management and tax treatment similar to a partnership.

Many hedge funds also utilize a master-feeder structure when attracting both domestic and international investors. This setup involves a master fund, often offshore, that holds all investments, and multiple feeder funds (domestic and offshore) that channel investor capital into it. This structure allows for streamlined investment management and accommodates different tax considerations for various investor types. Jurisdiction choice is influenced by tax efficiency, regulatory environment, and investor familiarity. Delaware is popular for domestic entities, while offshore locations are often chosen for favorable tax regimes, especially for non-U.S. investors.

Once the legal structure and jurisdiction are determined, the drafting of governing documents becomes paramount. For an LP, the Limited Partnership Agreement (LPA) is the foundational document, while an LLC uses an Operating Agreement. These documents define the fund’s operational framework, outlining the investment strategy, governance, allocation of profits and losses, and the rights and responsibilities of both the fund manager and investors. They also specify essential terms such as management fees, performance fees, redemption policies, and any lock-up periods for investor capital.

Understanding Regulatory Compliance

Fund managers in the United States often must register as an Investment Adviser (IA) with the U.S. Securities and Exchange Commission (SEC) or state securities authorities. Registration with the SEC is generally triggered when a fund manager’s Assets Under Management (AUM) reach or exceed $150 million. Smaller funds typically register with state securities regulators.

The central document for Investment Adviser registration is Form ADV. This form requires comprehensive disclosure of the firm’s business practices, including investment strategies, client types, fee structures, and potential conflicts of interest. It also requires information about disciplinary history, Assets Under Management, and services offered. The completed form is filed electronically through the SEC’s Investment Adviser Registration Depository (IARD) system.

Beyond Investment Adviser registration, hedge funds operate under various federal securities laws. The Investment Advisers Act of 1940 governs the conduct of investment advisers, establishing fiduciary duties and anti-fraud provisions. The Dodd-Frank Wall Street Reform and Consumer Protection Act increased oversight of private funds, requiring certain hedge fund managers to file Form PF, which provides the SEC with detailed operational and exposure information. An initial compliance program is necessary to ensure adherence to these regulatory obligations. This includes anti-money laundering (AML) and know-your-customer (KYC) requirements for verifying investor identities and monitoring transactions.

Building the Operational Infrastructure

Establishing a robust operational infrastructure is fundamental for a hedge fund’s efficient functioning. An important partnership for any hedge fund is with a prime broker, who provides services for trading activities. These services include trade execution, financing for leveraged positions, custody of assets, and clearing and settlement of trades. Prime brokers also offer reporting capabilities, providing the fund manager with consolidated views of their positions and performance.

Another important service provider is the fund administrator. The administrator is responsible for independent calculation of the fund’s Net Asset Value (NAV), maintaining investor records, and processing capital calls and distributions. They also handle financial reporting, ensuring accurate and timely statements for both the fund and its investors. Engaging a reputable fund administrator provides an independent check on financials, often required by institutional investors.

Specialized legal counsel is important throughout the fund’s lifecycle, from formation to ongoing regulatory compliance. Legal professionals assist in drafting complex fund documents, advising on securities laws, and navigating the intricacies of regulatory filings. Their expertise helps ensure that the fund’s structure and operations meet all legal requirements and industry best practices.

An independent auditor verifies the fund’s financial statements. Annual financial statement audits conducted by a qualified auditing firm provide credibility and transparency to investors, confirming the accuracy of the fund’s reported performance and financial position. Compliance consultants can offer specialized assistance in developing and maintaining the fund’s compliance program, providing guidance on evolving regulatory requirements and helping to conduct mock regulatory examinations. Their support helps ensure ongoing adherence to complex rules.

Approaching Capital Raising

Raising initial capital for a hedge fund involves adherence to specific legal and structural requirements. A key document in this process is the Private Placement Memorandum (PPM), also known as an Offering Memorandum. The PPM serves as a comprehensive disclosure document, providing prospective investors with detailed information about the fund, its investment strategy, risks, fee structure, and terms of investment. It also outlines regulatory disclosures and information about the management team.

Alongside the PPM, subscription documents and investor questionnaires are important. Subscription agreements are the legal contracts that investors sign to commit their capital to the fund. Investor questionnaires are used to gather information necessary to verify that prospective investors meet the required qualifications for participation in the private offering. These documents ensure compliance with securities laws regarding investor eligibility.

U.S. securities laws, particularly Regulation D, define investor qualifications for private fund offerings. Hedge funds rely on exemptions that permit offerings only to “Accredited Investors” and “Qualified Purchasers.” An Accredited Investor generally includes individuals with a net worth exceeding $1 million (excluding their primary residence) or an annual income above certain thresholds (e.g., $200,000 for single filers, $300,000 for married couples). A Qualified Purchaser, as defined under Section 3(c)(7), refers to individuals owning $5 million or more in investments or institutions owning $25 million or more in investments. These designations are important because they define the pool of eligible investors a hedge fund can solicit.

Regulations also impose restrictions on how hedge funds can market and solicit investors. Hedge funds are generally prohibited from “general solicitation” or public advertising, meaning they cannot broadly market their offerings. Capital raising efforts often rely on private networks, direct outreach, or introductions through placement agents who can confirm the accredited or qualified status of potential investors. This ensures the offering remains within permissible private placements.