Like private equity funds,
hedge funds are typically organized as either limited partnerships or limited
liability corporations to protect investors from losses exceeding their initial
investment and to avoid double taxation of corporate earnings.
Compensation for hedge fund
managers typically is based on two components:
- A management fee of 1-2% of assets
under management
- An incentive fee of 15-20% of the
returns in excess of a pre-determined benchmark. Incentive fees are
usually constrained by features such as high-water marks, claw-back
provisions and other features.
The high fees earned by
hedge fund managers has been widely criticized, particularly when the returns
generated include some exposure to beta. Beta can be obtained very cheaply
through passive investments such as index funds. However, to the extent that
the hedge fund returns offer diversification the fees may simply represent a
sort of insurance premium that investors are willing to pay in exchange
for risk reduction.
The investments made by
hedge funds are often illiquid, and as such many funds require a lock-up period
before investments can be withdrawn. In addition, most funds allow cash inflows
and outflows only at specific times (usually quarterly.)
