How to Start a Hedge Fund: A Step-by-Step Guide

A hedge fund is a specialized investment vehicle managing pooled capital from various investors. These funds employ diverse investment strategies to generate returns. Establishing a fund is a complex undertaking, requiring adherence to legal, regulatory, and operational requirements. It involves managing investor capital and executing investment mandates within financial regulations.

Establishing the Fund’s Legal and Regulatory Foundation

Selecting the legal structure is the initial step in establishing a hedge fund. Common structures in the U.S. are Limited Partnerships (LP) or Limited Liability Companies (LLC). An LP is favored for profit and loss allocation, with the general partner managing and limited partners contributing capital. An LLC offers liability protection and operational flexibility, structured for tax purposes. The chosen structure influences liability protections and tax treatment, making professional legal and tax advice important.

Hedge funds are overseen by regulatory bodies like the U.S. Securities and Exchange Commission (SEC) for federal securities laws and state securities regulators. The Commodity Futures Trading Commission (CFTC) may also have jurisdiction if the fund trades in futures or swaps. Most hedge fund managers must register as Investment Advisers with the SEC if they manage at least $150 million in assets. Advisers managing less than $100 million generally register with state authorities unless an exemption applies.

Understanding registration requirements and exemptions is important, as non-compliance can lead to penalties. The “private fund adviser” exemption under Investment Advisers Act Section 203(m) may apply to advisers managing less than $150 million in private fund assets. Advisers relying on this exemption are “exempt reporting advisers” (ERAs) and must file Form ADV, Part 1A, with the SEC. This filing provides basic firm and fund information, ensuring regulatory oversight without full registration.

The fund’s domicile, onshore (within the U.S.) or offshore (outside the U.S.), impacts tax efficiency and investor accessibility. Onshore funds are typically U.S.-based LPs for U.S. taxable investors. Offshore funds, often in jurisdictions like the Cayman Islands, are preferred by non-U.S. investors and U.S. tax-exempt entities to avoid U.S. taxation on investment income. “Master-feeder” structures combine onshore and offshore feeder funds into a single master fund, allowing for diverse investor bases and a unified investment strategy.

Developing Essential Fund Documentation

The Private Placement Memorandum (PPM) is the primary disclosure document for prospective investors. It details the fund’s investment objectives, strategies, and risks, informing potential investors before they commit capital. A PPM typically outlines the fund’s fee structure, including management and performance fees.

The Limited Partnership Agreement (LPA), or Operating Agreement for an LLC, is the foundational legal contract between the fund’s general partner (or manager) and its limited partners (or members). This document defines the rights, responsibilities, and obligations of all parties. Key provisions include terms for capital contributions, profit distributions, redemptions, governance, and fund dissolution. It also specifies voting rights, transferability of interests, and indemnification clauses, establishing a framework for the fund’s operation.

The Subscription Agreement is the contract executed by each investor to subscribe for fund interests. It outlines the investor’s commitment, including capital pledged and payment schedule. It contains representations and warranties from the investor, such as their “accredited investor” status as defined by Regulation D Rule 501. The agreement also incorporates anti-money laundering (AML) and Know Your Customer (KYC) requirements, necessitating identity and source of funds verification to comply with federal regulations.

An Investment Management Agreement (IMA) is executed between the hedge fund and its investment manager. It outlines the manager’s authority and responsibilities in managing fund assets. This agreement defines investment guidelines, trading parameters, and the manager’s compensation structure. It ensures the manager operates within predefined boundaries and clarifies fiduciary duties, providing an operational mandate for the investment team.

Initial regulatory filings, such as Form ADV, must be prepared based on the fund’s structure and the investment manager’s registration status. Form ADV, Part 1A, collects information about the adviser’s business. For registered investment advisers, Part 2A (the “brochure”) provides narrative information about services, fees, and strategies, delivered to clients. These forms are essential for legal and regulatory compliance and transparency.

Building the Operational Infrastructure

Establishing an operational infrastructure is important for a hedge fund’s efficiency and regulatory compliance. A fund administrator manages back-office operations, distinct from investment management. Responsibilities include calculating Net Asset Value (NAV), maintaining investor records, processing subscriptions and redemptions, and preparing financial statements. Outsourcing these functions allows the fund manager to focus on investment decisions.

Prime brokers provide necessary integrated services for a hedge fund’s trading activities. These include trade execution, financing (margin and securities lending), asset custody, and reporting. A prime broker facilitates trade clearing and settlement, offers leverage, and provides access to securities for short selling. The relationship is formalized through a Prime Brokerage Agreement, outlining service terms, fees, and collateral requirements.

An independent auditor verifies the fund’s financial statements. This annual audit is important for investor confidence and regulatory compliance, ensuring accurate financial reporting. The audit confirms asset valuation, fee calculation, and adherence to accounting principles. The auditor’s report is included in the fund’s annual financial statements, distributed to investors.

Specialized legal counsel is an ongoing requirement throughout a hedge fund’s lifecycle. Attorneys advise on complex regulatory matters, draft agreements, assist with compliance policies, and navigate legal disputes. Their expertise is important for interpreting evolving securities laws, ensuring compliance with federal and state regulations, and managing contractual relationships.

Beyond core providers, hedge funds engage other specialized service providers. Tax advisors guide on tax planning strategies, ensuring compliance and optimizing outcomes for the fund and investors. Compliance consultants assist in developing and implementing compliance programs, adhering to SEC rules and industry best practices. IT and technology providers are important for secure trading systems, data management, and cybersecurity protocols.

Internally, the fund must develop operational procedures and compliance policies for day-to-day activities. This includes protocols for trade execution, reconciliation, and record-keeping. A risk management framework is also important, encompassing policies for identifying, assessing, and mitigating various risks. These internal controls are important for safeguarding assets, maintaining operational integrity, and ensuring regulatory adherence.

Launching and Accepting Investments

With the legal structure, documentation, and infrastructure in place, the final phase involves launching the fund and accepting investor capital. Investor solicitation must adhere to regulatory guidelines. Under Regulation D Rule 506(b), funds generally cannot engage in “general solicitation” or public advertising, relying on pre-existing relationships to identify prospective investors. Alternatively, Rule 506(c) allows for general solicitation, but requires the fund to verify all investors are accredited, often involving rigorous documentation and due diligence.

Once prospective investors are identified, the subscription process begins. This involves distributing the Private Placement Memorandum (PPM) for full disclosure of fund terms, risks, and strategies. Concurrently, the Subscription Agreement is provided; investors must review, complete, and sign it to commit capital. This agreement typically includes investor representations confirming accredited status and understanding of investment risks.

Investors must complete Know Your Customer (KYC) and Anti-Money Laundering (AML) documentation as part of the subscription process. This includes providing identification documents and source of funds information to comply with federal regulations. The fund, often with its administrator’s assistance, reviews all submitted documents for completeness and compliance before accepting the subscription.

Upon successful review and acceptance of the Subscription Agreement, the fund initiates the capital call process. This requests investors to transfer committed capital to the fund’s designated bank account. For initial investments, this often occurs on a specified closing date, pooling all initial capital simultaneously. Subsequent capital calls may be made for additional contributions, depending on the fund’s structure and investment strategy.

Once initial capital contributions are received and cleared, the hedge fund can commence its investment activities. The fund manager executes trades according to the investment strategy and guidelines outlined in the PPM and Investment Management Agreement. The fund administrator then calculates the Net Asset Value (NAV) and maintains investor accounts, marking the fund’s operational launch.