About Hedge Funds
A domestic hedge fund is an unregistered investment company that is formed in the United States and is open to US investors. Most hedge funds are structured as limited partnerships. A general partner serves as investment adviser with overall responsibility management and operations. The general partner typically receives an advisory fee (1-2% of net assets) performance fee (annual or quarterly), which is a percentage (usually 20%) of the fund's net capital appreciation. Unlike registered funds, the general partner may not be registered with the SEC. Because hedge funds are unregistered, they can use securities and strategies that are either prohibited or restricted in registered funds. Short sales, arbitrage and other kinds of hedging are commonly used in greater proportions than in regulated funds. For this reason, hedge funds are often referred as "alternative" or "non-traditional" investments.
Hedge funds maintain their exemption from securities and mutual fund registration by limiting the number of investors and requiring that they be experienced investors with significantly high net worth. Hedge funds are organized as "3(c)(1)" or "3(c)(7)" funds, referring to exemptions from mutual fund registration. Funds organized as 3(c)(1) funds are limited to 99 "accredited investors." Section 3(c)(7) funds may have up to 499 "qualified" investors, but the net worth requirement is higher. Both types of funds must take care to avoid a "look-through" in certain circumstances to the underlying investors if an entity owns more than 10% of the fund. This is important because the look-through may cause a fund to exceed the number of permitted investors. Also, if a look-through is required all participants must be qualified to invest. Entities must be already in existence and investing before they invest in a hedge fund. Hedge fund operators must also keep in mind that funds can be "integrated" for mutual fund registration purposes if they have identical investment objectives, so that the SEC could consider two 3(c)(1) funds with 60 investors each to be one fund that is actually required to register. 3(c)(1) and 3(c)(7) funds can't be aggregated.
Offshore hedge funds are unregistered pooled investment funds domiciled outside the US (i.e., "offshore") and open only to non-US investors or, occasionally, US tax-exempt "accredited" investors. Offshore hedge funds are usually structured as corporations. Like domestic hedge funds, they are not subject to portfolio management restrictions that may apply to registered funds. Generally, the number of investors is not restricted. Many offshore hedge funds are formed in international tax havens such as Bermuda or the Cayman Islands, which offer privacy as well as tax advantages. It is important to keep in mind that the domicile of a hedge fund is not an indication of its quality.
When a new hedge fund is created, the fund must keep detailed accounting records. The accounting records for the fund will be compiled mainly from your brokerage statements. Determination of fees (incentive and management) and other expenses will depend on your partnership agreement. Along with determining the profit and loss in your partnership, special attention should be paid to the nature and characteristics of the limited partners in the fund.
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