When investors select hedge funds as an investment, they are making a bet on an asset class that is not governed by the most stringent regulations, even in the most developed economies. There are however, hedge fund structures in place that provide a reasonable amount of transparency into the way that these investments run. Although there is no one recipe for how a hedge fund is designed, there are some common pillars that support these investment vehicles through the different cycles of the financial markets. Some of the different types of hedge fund structures are limited partnerships, those with outsourced administration, those that use prime brokerage firms and those that focus on a certain type of investments.
Many hedge fund structures include a limited partnership, which is a business agreement comprised of at least two members. Usually, these partners are the limited partner and a general partner. The general partner usually holds the most responsibility for the success or failure of the venture, and the limited partner's liability is limited by the size of his or her investment. Institutional investors such as large investment banks that allocate money to hedge funds are considered limited partners. Also, it is not uncommon for the hedge fund firm itself to commit money to one or more of the company's hedge fund vehicles.
Certain hedge funds, especially the ones that are small to mid-size in nature, opt not to invest in internal hedge fund administration. This could be because of a lack of manpower or other resources such as space or time. As a result, the administration of a hedge fund, which includes the execution of back office tasks such as accounting and recordkeeping, could be outsourced to a third party firm. Hedge fund structures vary in terms of the exact services that an administrator will perform.
Often, hedge funds are investing with excessively large sums of money, so hedge fund structures rely on what's known as a prime brokerage firm to assist with those transactions. The prime brokerage firm also performs some back office tasks tied to documentation and recordkeeping but these parties will also often lend a hedge fund money to finance a transaction at a predetermined fee structure. Those borrowed funds will be added to a hedge fund transaction in an attempt to bolster the size of an expected return on an investment, but if the investment fails, the hedge fund still must reimburse the prime broker.
Hedge fund structures might also vary based on the investment strategy pursued by a firm. For instance, there could be a hedge fund that is focused on making energy investments, in which case specialized personnel and software will be in place to facilitate that strategy. Other hedge funds might be structured to invest in real estate or credit opportunities, which requires a different set of programs and talent to perform.