A hedge fund is simply a term used to describe an investment partnership setup by a money manager. It can take the legal form of a limited liability company or a limited partnership so that if the company goes bankrupt, the creditors can't go after the investors for more money than they've put into the hedge fund. The manager of the hedge fund, typically the person that created it, is paid a percentage of the profits he or she earns on the money investors have deposited with his company. The term was originally used because the purpose of many of the first hedge funds was to make money regardless of if the market increased or decreased because the managers could either buy stocks or short them (shorting is a way to make money when a stock falls - for more information read The Basics of Shorting Stock). Today, the term hedge fund is a generic term used for any such arrangement.
Along comes a single investor that puts $100 million into my hedge fund. He writes the company a check, I put it into our brokerage account, and invest the cash according to any guidelines that were spelled out in the operating agreement. Perhaps I use the money to buy up local restaurants. Maybe I start a new company. Either way, the point is that every day when I wake up and go to the office, my purpose is to put my investor’s capital to work at the highest rate possible (adjusted for risk, of course), because the more I make him, the more I get to take home.
For argument’s sake, image that I made an unbelievable investment the first year, doubling the company’s assets from $100 million to $200 million. Now, according to the company’s operating agreement, the first 4% belongs to the investor with anything above that being split 25% to me 75% to my investor. In this case, the $100 million gain would be reduced by $4 million for that “hurdle” rate, as it is often called on Wall Street (because you have to clear that “hurdle” as the hedge fund manager before you are ever paid a dime under an arrangement like this). The remaining $96 million is split 25% to me and 75% to my investor.
The net result is that I walk away with $24 million in compensation. My investor gets the $4 million hurdle earned and $72 million from the split to which they are entitled above that hurdle for a grand total of $76 million. The news headlines are going to say, “Hedge Fund Manager Earns $24 Million!” yet it doesn’t tell you that I earned my investors $76 million. If I were managing $10 billion, my compensation would have been $2.4 billion and I would have made my investors $7.6 billion. The newspapers would write articles about how I was earning ridiculous amounts of money, never once mentioning the massive payday I delivered to the people who entrusted me with their funds.
A Fictional Hedge Fund to Help You Understand What a Hedge Fund Is
To make the idea easy to understand, let’s take an extreme example. Imagine that I setup a company called “Global Umbrella Investments, LLC” as a Delaware corporation. The operating agreement, which is the legal document that says how the company is managed, states that I will receive 25% of any profits over 4% per year and that I can invest in anything – stocks, bonds, mutual funds, real estate, startups, art, rare stamps, collectibles, gold, wine, or anything else of value. Most hedge funds are structured as a limited partnership or limited liability company.Along comes a single investor that puts $100 million into my hedge fund. He writes the company a check, I put it into our brokerage account, and invest the cash according to any guidelines that were spelled out in the operating agreement. Perhaps I use the money to buy up local restaurants. Maybe I start a new company. Either way, the point is that every day when I wake up and go to the office, my purpose is to put my investor’s capital to work at the highest rate possible (adjusted for risk, of course), because the more I make him, the more I get to take home.
For argument’s sake, image that I made an unbelievable investment the first year, doubling the company’s assets from $100 million to $200 million. Now, according to the company’s operating agreement, the first 4% belongs to the investor with anything above that being split 25% to me 75% to my investor. In this case, the $100 million gain would be reduced by $4 million for that “hurdle” rate, as it is often called on Wall Street (because you have to clear that “hurdle” as the hedge fund manager before you are ever paid a dime under an arrangement like this). The remaining $96 million is split 25% to me and 75% to my investor.
The net result is that I walk away with $24 million in compensation. My investor gets the $4 million hurdle earned and $72 million from the split to which they are entitled above that hurdle for a grand total of $76 million. The news headlines are going to say, “Hedge Fund Manager Earns $24 Million!” yet it doesn’t tell you that I earned my investors $76 million. If I were managing $10 billion, my compensation would have been $2.4 billion and I would have made my investors $7.6 billion. The newspapers would write articles about how I was earning ridiculous amounts of money, never once mentioning the massive payday I delivered to the people who entrusted me with their funds.
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