3.1 Fund structures and service providers

Lesson 1.2 described hedge funds as open-ended: investors can come in and go out on a regular schedule, commonly monthly or quarterly, rather than committing money for a fund's fixed life. That one difference shapes how the fund is built and who works on it. Every dealing day, someone has to value the fund, work out how many shares each investor holds, and pay out anyone who is leaving.

If you work in fund administration, investor relations or on an allocator's team, you will deal with the legal entities, share classes and service providers described here almost every day. This lesson uses the course's fictional manager, Kessling Harbor Capital, and its flagship fund, the Kessling Harbor Equity Long/Short Fund. Structures vary between managers and jurisdictions, so treat the examples as common patterns rather than rules.

The manager and the fund

As in private equity (PE101 2.1), there is an important difference between the investment manager and the fund.

• The investment manager (also called the adviser) is the firm that employs the portfolio managers, analysts and operations staff and makes the trading decisions. It is paid a management fee and, usually, a performance fee (lesson 3.3). In the US, many hedge fund advisers must register with the SEC.
• The fund is a separate legal entity that owns the portfolio. Investors buy an interest in the fund, not in the manager. If Kessling Harbor Capital went out of business, the fund's assets would still belong to the fund and its investors.

Someone also has to oversee the fund entity itself. Depending on its legal form, that is either a general partner (GP), commonly an affiliate of the manager, for a limited partnership, or a board of directors for a fund set up as a company. Offshore fund boards commonly include one or more independent directors, who are not employees of the manager and are meant to look after investors' interests on matters such as conflicts, suspensions and valuation.

The main differences from a private equity fund come from the open-ended design:

Onshore and offshore funds

Investors come from different places and pay tax in different ways. A single structure rarely suits them all, so managers commonly run more than one fund vehicle.

• An onshore fund is set up in the manager's home country. For a US manager, it is commonly a US limited partnership, used mainly by US taxable investors such as wealthy individuals and family offices. The partnership's income generally flows through to its partners for tax purposes.
• An offshore fund is set up in an offshore financial center and is commonly a company (sometimes another corporate-style vehicle). It is used mainly by non-US investors and US tax-exempt investors such as pensions, endowments and foundations. Broadly, a company can shield these investors from US tax filings or tax treatments that would be unwelcome if they invested through a US partnership.

The tax reasons are technical and depend on each investor's position, so this course keeps them general. The practical point is that investors are sorted into the vehicle that suits them, and the manager ends up with two or more funds pursuing the same strategy.

Master-feeder structures

Running two separate portfolios for the same strategy would be inefficient. Every trade would have to be split between the funds, and the two could drift apart in performance. The common solution is a master-feeder structure:

• The onshore and offshore funds become feeder funds. They take in investors' money and invest almost all of it in a single master fund.
• The master fund holds the portfolio. It trades, borrows from the prime broker and holds the positions.

For Kessling Harbor, it might look like this:

Gains and losses in the master are shared between the feeders in proportion to their investment. Each feeder then has its own investors, its own NAV (net asset value: assets minus liabilities) and its own financial statements. For operations teams this means one strategy can involve three or more sets of books that have to reconcile to each other.

Share classes and series

Within a fund, investors do not all have to be on identical terms. A fund can issue several share classes (or, in a partnership, classes of interest), each investing in the same portfolio but with different features, such as:

• Fees: a founders' class with a lower fee for early investors, or a class for large investors with a discount.
• Currency: a euro class alongside the US dollar class, sometimes with the currency risk hedged.
• Liquidity: a class with a lock-up (lesson 4.1) in exchange for a lower fee.

Each class has its own NAV per share, because fees and currency effects differ. Some funds also issue a new series of shares each time investors subscribe, to track performance fees fairly for people who joined at different times; lesson 3.3 touches on this under equalization.

The terms of the fund and its classes are set out in the offering memorandum (the fund's main disclosure document) and the fund's constitutional documents, such as the limited partnership agreement or articles. As in private equity, large investors sometimes negotiate extra terms in a side letter.

Service providers

A hedge fund relies on outside firms for much of its infrastructure. The main ones:

Some structures also have a depositary or other oversight provider, depending on the jurisdiction, and funds commonly use tax advisers and technology vendors.

Why an independent administrator matters

The administrator sits at the center of the investor's relationship with the fund. It takes the prices of the fund's positions (from market data, the prime broker and, for hard-to-price assets, agreed valuation sources), calculates the NAV, and works out each investor's share. When an investor subscribes or redeems, the administrator checks the paperwork and the cash and records the change.

When the administrator is an independent firm, the people who report the fund's value and track who owns it are separate from the people who manage the money. That matters to investors for three reasons:

• Checks on valuation. The administrator gets prices and position reports independently and reconciles them with the prime broker, rather than simply accepting the manager's numbers.
• Control of investor money. Subscriptions and redemptions pass through a process the manager does not run alone, which makes it harder for money to be misdirected.
• Reliable records. Investors can confirm their holdings with a party other than the manager.

This separation is a core part of operational due diligence (lesson 4.3). Allocators commonly treat the lack of an independent administrator as a serious warning sign. It is not a guarantee, though: the administrator still depends on inputs from the manager for some valuations, and the terms of its engagement define exactly what it checks.

Key terms

• Investment manager (adviser): The firm that makes the fund's investment decisions and is paid fees for doing so.
• Onshore fund: A fund set up in the manager's home country, for a US manager commonly a limited partnership for US taxable investors.
• Offshore fund: A fund set up in an offshore jurisdiction, commonly a company, used by non-US and US tax-exempt investors.
• Master-feeder structure: A structure in which feeder funds invest in a master fund that holds the single portfolio.
• Share class: A category of fund shares with its own terms, such as fees or currency, and its own NAV per share.
• Offering memorandum: The fund's main disclosure document, setting out its strategy, terms and risks.
• Independent director: A fund board member who is not employed by the manager.
• Prime broker: The firm that provides financing, securities lending, custody and clearing to the fund.
• Administrator: The firm that calculates NAV, keeps investor records and processes subscriptions and redemptions.

Key takeaways

• The investment manager runs the money, but the fund is a separate legal entity that owns the portfolio, overseen by a GP or a board.
• Managers commonly run an onshore fund for US taxable investors and an offshore fund for non-US and US tax-exempt investors.
• In a master-feeder structure, the feeders invest in one master fund that holds the portfolio, so the strategy is run only once.
• Share classes let investors in the same portfolio have different fee, currency or liquidity terms.
• An independent administrator separates the reporting of value and ownership from the management of the money, which is a key protection for investors.