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A Beginner’s Guide to the Different Types of Funds
So, you’re thinking about starting a hedge fund? That’s exciting, but I know it can feel overwhelming, but don’t worry—I’m here to help you navigate it. In this beginner's guide, I’ll walk you through the essentials of a hedge fund and its operation. Plus, I’ll throw in some examples like private equity funds, real estate funds, venture capital funds, and debt funds to give you a clearer picture.
I’m Bridger Pennington, and I’ve successfully launched three investment funds and co-founded Fund Launch. My mission is to help people like you understand and enter the fund world, and I’ve already assisted 20,000 individuals in starting their journey. You’ll find it all super interesting, so let’s dive in!
What Is a Hedge Fund?
A hedge fund receives investments from accredited investors, corporations, and organizations. Even more interesting is the range of assets a hedge fund can hold, from stocks and bonds to commodities, currencies, and property.
The fund manager, who may also be the General Partner (GP), also comes into the picture. They commonly employ leverage, short selling, derivatives trading, and arbitrage techniques to maximize market inefficiencies. It’s all about seizing the moments that others may miss.
Upon the return of the profits, the fund manager pays each Limited Partner (LP) investor a percentage following the distribution schedule and terms set out in the PPM.
Hedge funds offer an attractive avenue for raising investment capital, especially in today’s competitive landscape!
Diversification and Risk Management
Hedge funds provide advanced investors an excellent opportunity to diversify their portfolio from standard stocks and bonds. This diversification capability attracts investors looking to reduce portfolio risk while pursuing desirable returns.
Flexibility in Investment Strategies
The other characteristic that makes hedge funds unique is their adaptability. Fund managers can rapidly modify strategies to respond to changing market dynamics, whether long/short equity, macro, or event-based. This flexibility can be a valuable resource, especially when markets are volatile.
Potential for Higher Returns
Hedge funds focus on generating "Alpha" by using various strategies unique to the type of portfolio. In the context of investing, "Alpha" refers to returns generated over and above what is generally expected based on its level of risk. A fund manager strives to make money whether the market is going up or down. For investors looking for steady, positive returns, hedge funds are attractive!
Common Legal Structures for Hedge Funds
Hedge funds most often operate through a limited partnership (LP). Here, the fund manager is the General Partner, and investors are Limited Partners (LPs). Investors are subject to pass-through taxation in the partnership, and investor exposure is limited to the amount invested. LPs are limited in liability, but, by contrast, the GP assumes entire liability for fund obligations.
Hedge Fund Compensation - The 2 and 20 Model
Investing the time, money, and effort in launching your hedge fund is a serious endeavor with the end reward of creating yourself wealth. So, how do hedge funds make money?
Hedge funds usually operate with a fee structure called the "2 and 20" model.
Management Fee (2%)
First, there’s the management fee, typically 2%. The charge is calculated based on the fund's assets. It covers all the necessary expenses for running the fund — from salaries for the team to office costs to research fees. This is the fund’s cash flow that keeps the machine running.
Performance Fee (20%)
Then, we have the performance fee, where things get interesting. This is typically set at 20% of the profits above a certain point called the hurdle rate. The hurdle rate guarantees the LPs that they receive the first returns up to a minimum return level.
Anything over and above that amount, the hedge fund receives 20% of the profits. Essentially, it's like a bonus for the fund manager for doing a great job! The 2 & 20 fee structure ensures that the manager's interests align with those of the investors.
A basic example:
Gross investor funding: $30,000,000
Management fee 2%: $600,000
Hedge fund profit: $6,000,000
Hurdle rate 8.0%: $480,000
Profit balance: $ 5,520,000
Performance fee 20%: $1,104,000
Total Comp: $1,704,000.00
Examples of Hedge Fund Types
Real Estate Funds
The primary objective of a real estate fund is to generate returns for its investors through strategic acquisition, effective management, and timely sale of real estate properties.
A real estate funds strategy can focus on various niches such as multifamily properties, commercial buildings, medical office properties, or commercial or residential development projects.
Once properties are acquired, the fund manager oversees the portfolio, managing cash flow, budgeting for expenses, evaluating properties to boost value and returns, and handling the day-to-day financial aspects of the properties. It's important to note that the fund manager is separate from a property manager, who handles the operational aspects like rent collection, maintenance, and tenant issues.
The fund involves various fee structures that compensate the fund manager and other key employees for their services.
The primary goal of a real estate fund is to generate returns for its Limited Partners through the purchasing, management, and sale of real estate properties at the right time.
A real estate funds approach could target multiple specialty areas, including apartment buildings, office buildings, medical offices, or commercial/residential projects.
Once properties are bought, the fund manager looks after the portfolio, focusing on cash flow, budgeting for expenses, monitoring properties for potential value and returns, and handling the day-to-day operations of the assets.
However, the fund manager differs from a property manager who manages the properties day-to-day, collecting rent, maintaining the property, and managing the tenants.
The fund entails multiple fee arrangements that cover the fund manager and other core team members.
Acquisition Fees: Paid at the time of property acquisition.
Management Fees are based on the yearly revenue generated by the properties, typically ranging between 3% and 6% of the gross income.
Asset management fees are paid annually, usually between 1% and 2% of the total invested.
Disposition and distribution is the final phase involving the disposition of the properties through sale or refinancing. The proceeds from these transactions are then distributed to the investors.
Private Equity Funds
The fund takes an ownership stake in privately held enterprises. It seeks to increase the value of each company through a range of strategies, including business improvement, revenue generation, and financial engineering.
On average, the ownership position lasts 4-10 years before exiting via IPOs, sales to strategic rivals, or other private equity funds.
Private equity attracts investors such as pension funds, insurers, and endowments looking for long-term capital appreciation.
Venture Capital Funds
Venture capital funds (VC) invest in high-growth startup companies, primarily in the technology, biotechnology, or financial technology industry. VC funds seek to generate a high yield by selecting and developing companies that can scale rapidly and exit profitably via acquisition or an IPO.
Venture capital funds pool primarily institutional capital to invest in early-stage, highly growth-oriented startups. The investments made by these funds are high-risk/high-return ventures. Venture capital funds receive shares or stakes in the businesses they invest in in return for their investment. Such funds are vital to the startup world, providing capital, knowledge, and mentoring.
Debt Funds
Debt funds appeal to conservative investors as they focus on fixed-income securities and invest in various debt instruments like corporate and government bonds, treasury bills, and commercial paper. While returns are generally lower than equity funds, the stability can make them an attractive choice for those wanting to avoid market volatility.
- Lower risk compared to equity funds
- Stable and predictable returns
- Regular income from interest payments
- Emphasis on capital preservation
Direct Lending
Direct lending enables debt hedge funds to issue loans to companies directly – typically for senior secured loans on middle-market businesses. This option suits those wanting more robust returns with less volatility than fixed-income instruments.
Distressed Debt
Buying the debt of struggling businesses, usually at a deep discount. A distressed debt fund may wish to control the restructuring process or take ownership of the company when it recovers. This strategy works well when the economy is slow or interest rates start rising quickly.
Mezzanine Financing
Mezzanine financing mixes debt with equity and produces attractive returns. Another added benefit is maintaining a creditor debt position in the payout structure. This strategy appeals to investors looking for higher yields and taking on greater risk than a senior debt approach.
Corporate Bonds
These are IOUs that companies issue when they need to raise money. They might want to expand their operations, acquire another business, or cover everyday expenses. When a fund buys a corporate bond, it lends the company money. They promise to pay the fund interest regularly and return the original amount invested when the bond matures.
Sovereign Bonds
These are bonds countries issue to finance their spending. They’re generally considered safer, lower-risk investments because they have the power to tax and are good at repaying their debts. But remember that this lower risk typically comes at a lower reward than other bonds.
Mortgage Backed Securities (MBS)
Let’s move on to mortgage-backed securities, or MBS, a bundle of mortgages packaged together and auctioned off to investors. Primary sources are government-backed companies such as Fannie Mae and Freddie Mac. The consolidated mortgages generate income from interest payments.
OK, we’ve covered a lot of ground, so let me summarize.
Key Differences Between Investment Fund Types
Hedge Funds
Hedge funds are actively managed investments that use various strategies to produce Alpha returns irrespective of market conditions.
Unique characteristics:
- Use of short positions and leverage
- Flexibility in investment strategies
- Less regulated than traditional funds
Potential benefits:
- Diversification for portfolios
- Potential for higher returns
- Ability to profit in various market conditions
Private Equity Funds
Private equity funds either buy out companies or directly invest in private companies.
Unique characteristics:
- Long-term investment horizon
- Illiquid investments
- Active management of portfolio companies
Potential benefits:
- Higher returns
- Access to private market opportunities
- Expertise in company restructuring and growth
Real Estate Funds
Real estate funds purchase residential, commercial, and industrial properties.
Unique characteristics:
- Tangible asset investments
- Income generation through rent and property appreciation
- Professional property management
Potential benefits:
- Regular income
- Portfolio diversification
- Potential tax advantages
Venture Capital Funds
VC funds invest in high-growth, early-stage startup businesses. Heavily weighted towards technology.
Unique characteristics:
High-risk, high-reward investments
Focus on innovative and disruptive technologies
Active involvement in portfolio companies
Potential benefits:
Exponential returns
Access to cutting-edge technologies
Support for entrepreneurial ecosystems
Debt Funds
Debt funds purchase fixed-income assets like government bonds, corporate bonds, and other forms of stable debt.
Unique characteristics:
- Lower risk compared to equity funds
- Regular interest income
- Various subcategories based on duration and credit quality
Potential benefits:
- Stable returns
- Higher liquidity than traditional fixed deposits
- Potential tax advantages
Each fund category offers different attributes and advantages that suit various investment objectives, risk appetites, and investor preferences. Which fund to invest in depends on the potential investor's financial goals, horizon, and risk tolerance.
Why can you trust this information?
At Fund Launch©, we are experts who can quickly get you up and running a successful hedge fund! We have years of real-world experience and have developed a templated process that will save buckets of money and shortcut you to that exciting day when you roll out your fund. Over 900 fund managers have chosen Fund Launch© to hone their skills and get themselves to market fast.
To learn more, please visit us at www.fundlaunch.com and book a private consulting call today!
Here are some resources from Fund Launch© that can help you build that solid foundation and launch you to market much quicker.
Black Card Membership:
An exclusive fund incubator program that provides high-level mentorship and resources for aspiring fund managers aiming to scale their funds.
You can take advantage of these FREE fund manager training resources by visiting: https://www.fundlaunch.com/training
NOTE: If you are on a tight timeline and need to cut to the chase, you can schedule a one-on-one call here: https://www.fundlaunch.com/call
