A hedge fund’s structure is a set of interlocking legal entities and contracts: a limited partnership that holds the assets, a general partner that controls it, a separate management company that runs the strategy, and a network of outside service providers that keep the fund honest. Investors come in as limited partners under strict eligibility rules, sign a handful of governing documents, and accept restrictions on when they can withdraw. Layered on top are Investment Company Act exemptions, adviser registration obligations, tax-driven offshore structures, and a growing set of filing requirements. Each piece exists for a specific legal or operational reason.
The Core Entities
Most hedge funds are organized as limited partnerships. The general partner (GP) controls investment decisions and bears unlimited legal liability for the partnership’s obligations. To contain that exposure, the GP is almost always itself a limited liability company rather than an individual. The GP typically holds a small ownership stake and manages the fund’s affairs under the partnership agreement.
Investors enter as limited partners (LPs). Their liability stops at their capital commitment. If the fund takes on debt or faces a lawsuit, no one can reach an LP’s personal assets beyond what they agreed to invest. In exchange for that protection, LPs give up any say in day-to-day investment decisions. The moment a limited partner starts exercising control over fund operations, they risk losing their liability shield under most state partnership statutes.
The actual investment work happens inside a third entity: the management company. It employs the portfolio managers, analysts, and traders who execute the strategy, and it contracts with the fund through an investment advisory agreement. Keeping the management company separate from the GP provides a layer of corporate protection and allows the same firm to advise multiple funds. The GP handles the partnership’s legal obligations; the management company handles the investing. They are often owned by the same people, but they play different roles.
Large institutional investors frequently negotiate side letters — separate agreements that modify the standard partnership terms for that investor. A side letter might grant fee discounts, preferential liquidity rights, or more detailed reporting. A most-favored-nation clause is a common feature, guaranteeing the investor notice if the fund gives another LP better terms and the right to claim them.
The Three Governing Documents
Three documents form the legal backbone of any hedge fund, and an investor who skips any of them is flying blind.
The private placement memorandum (PPM) is the disclosure document. It describes the investment strategy, fee structure, risk factors, conflicts of interest, redemption procedures, tax implications, and management team. Its dual purpose is to inform investors about what they are buying and to protect the sponsor from liability by documenting that risks were disclosed upfront. Legal counsel typically drafts or reviews every PPM before distribution.
The limited partnership agreement (LPA) is the rulebook. Where the PPM discloses, the LPA governs. It sets out the GP’s authority to make investments, the mechanics for capital calls and distributions, the fee calculation methodology, the circumstances under which the GP can be removed, transfer restrictions on LP interests, default provisions if an LP fails to meet a capital call, and the process for winding down the fund. Every side letter is technically a modification of this agreement.
The subscription agreement is the contract each investor signs to commit capital. In it, the LP specifies the dollar amount of their commitment, provides tax and banking information, and makes representations that they meet the applicable eligibility thresholds, understand the risks, and have legal authority to enter the agreement. Those representations shift the burden of proving eligibility onto the investor. If someone misrepresents their status, the fund has a documented defense.
Who Can Invest, and Why Hedge Funds Escape Mutual Fund Rules
Hedge funds sell unregistered securities, so they can only accept investors who clear specific financial thresholds. Two categories matter most.
An accredited investor has annual income exceeding $200,000 individually (or $300,000 with a spouse or partner) for the prior two years with a reasonable expectation of the same in the current year, or a net worth above $1 million excluding the value of their primary residence.1U.S. Securities and Exchange Commission. Accredited Investors This is the floor for most private fund investments.
A qualified purchaser clears a much higher bar: an individual must own at least $5 million in investments. For institutional investors acting on a discretionary basis, the threshold is $25 million.2Office of the Law Revision Counsel. 15 USC 80a-2 – Definitions
Hedge funds avoid the framework that governs mutual funds by relying on one of two exemptions in the Investment Company Act of 1940. Section 3(c)(1) covers any fund whose securities are held by no more than 100 beneficial owners, provided the fund does not make a public offering. Section 3(c)(7) removes the 100-investor cap entirely but requires that every investor be a qualified purchaser.3Office of the Law Revision Counsel. 15 USC 80a-3 – Definition of Investment Company Larger funds that want to accept hundreds of investors use the 3(c)(7) route almost exclusively, which is why those funds tend to attract institutional capital rather than high-net-worth individuals.
Most hedge funds raise capital under Regulation D, which provides a safe harbor from registering the securities with the SEC. Under Rule 506(b), the fund cannot use general advertising, but the manager needs only a reasonable belief that each investor is accredited. Under Rule 506(c), the fund can advertise openly, but must take reasonable steps to verify each investor’s accredited status through documentation like tax returns or account statements.4U.S. Securities and Exchange Commission. Assessing Accredited Investors under Regulation D The vast majority of hedge funds use 506(b), because the verification burden under 506(c) is heavier and most funds raise money through private networks anyway.
Master-Feeder Structures and Fund Domicile
Hedge funds use master-feeder structures to accommodate investors with different tax situations and regulatory requirements. Multiple feeder funds collect capital from different investor groups and channel all of it into a single master fund where the actual trading happens. The manager runs one portfolio instead of several, which reduces transaction costs and ensures every investor gets the same performance.
The onshore feeder is typically a Delaware limited partnership serving U.S. taxable investors. The offshore feeder is usually incorporated in a jurisdiction like the Cayman Islands and serves foreign investors and U.S. tax-exempt entities such as pension funds and endowments. The offshore jurisdiction does not add a tax layer. It provides a neutral holding structure for international capital and, as explained below, blocks certain tax problems that would arise if those investors held partnership interests directly.
Redemption Terms and Liquidity Controls
Hedge funds are not mutual funds. You cannot sell your shares any business day. The partnership agreement defines when and how investors can withdraw capital, and the restrictions can be significant.
A lock-up period prohibits withdrawals entirely for a set time after the initial investment, typically one to two years. Hard lock-ups give the investor no option to redeem early. Soft lock-ups allow early withdrawal but impose a penalty fee, often 2% to 5% of the redeemed amount. Once the lock-up expires, redemptions generally follow a periodic schedule, quarterly being common, with advance notice requirements of 30 to 90 days.
Gate provisions limit the total amount that all investors can withdraw in a given period, usually expressed as a percentage of the fund’s net asset value. If redemption requests exceed the gate, each request gets filled pro rata, and the remaining balance carries over. Gates are the fund’s defense against a stampede. Without them, a wave of redemptions could force the manager to liquidate positions at distressed prices, hurting the investors who stayed. Of the two tools, gates tend to be more effective against sudden outflows because they remain available throughout the fund’s life, while lock-ups only protect the fund during the initial investment window.
Fees and the Mechanics That Limit Them
Hedge fund compensation follows a two-part model. The traditional benchmark has been “2 and 20,” meaning 2% of assets annually and 20% of profits. Fee pressure has pushed industry averages below that level, but established managers with strong track records can still command the full rate or higher, while newer funds often launch at lower levels to attract initial capital.
Management Fee
The management fee is calculated as an annual percentage of net asset value, typically 1% to 2%. It covers operating costs like salaries, office space, and technology. Because it is based on assets rather than performance, it provides the management company with a stable revenue stream regardless of whether the fund makes money in a given year.
Performance Fee
The performance fee, also called an incentive allocation or carried interest, gives the manager a percentage of profits, traditionally 20%. Two mechanisms prevent the manager from collecting fees they haven’t earned.
A high-water mark requires the fund to recover all prior losses before the manager earns a new performance fee. If a fund drops 15% one year and gains 10% the next, the manager collects nothing on that gain because the fund has not yet returned to its previous peak.
A hurdle rate requires the manager to exceed a minimum return before any performance fee kicks in. A hard hurdle means the manager only earns fees on the returns above the hurdle, so an 8% hurdle and a 10% return puts fees on the 2% excess. A soft hurdle means the manager earns fees on the entire return once the threshold is crossed. Same 10% return, same 8% soft hurdle, fees on the full 10%.
Clawback Provisions
A clawback clause gives LPs the right to recover performance fees paid prematurely. If the manager collects an incentive fee early based on initial gains and the fund later suffers losses, the clawback requires the GP to return enough of those fees to make investors whole up to their initial investment plus a stated share of total profit. Clawbacks are more common in private equity, but they appear in hedge fund agreements too, particularly in funds with longer investment horizons where early exits can paint an overly optimistic picture.
Tax Consequences for Different Investor Types
The master-feeder structure exists largely because of tax complexity. Different investors face different consequences from the same fund, and the wrong structure can create unexpected liabilities.
Foreign Investors and Effectively Connected Income
Foreign investors generally prefer the offshore feeder because investing directly through a U.S. partnership could expose them to U.S. tax on income “effectively connected” with a U.S. trade or business. If a fund’s activity goes beyond trading in stocks and securities, for example operating a business or lending money directly, the income can become effectively connected income (ECI), taxable at graduated U.S. rates. There is an important safe harbor: if the fund’s only U.S. activity is trading stocks, securities, or commodities through a U.S. broker, the foreign investor is generally not treated as engaged in a U.S. trade or business.5Internal Revenue Service. Effectively Connected Income (ECI) Offshore feeders are structured to keep foreign investors within that safe harbor.
Tax-Exempt Investors and UBTI
Pension funds, endowments, and other tax-exempt entities face a separate problem: unrelated business taxable income (UBTI). A tax-exempt organization that earns income from an activity unrelated to its exempt purpose can owe federal income tax on that income. The tax code provides a $1,000 deduction, meaning UBTI above that amount triggers a filing obligation on Form 990-T.6Office of the Law Revision Counsel. 26 USC 512 – Unrelated Business Taxable Income Hedge fund strategies that use leverage or generate operating business income can create UBTI for tax-exempt partners in a U.S. partnership. Investing through an offshore corporate feeder blocks most UBTI, because the offshore entity, not the tax-exempt investor, is the direct partner in the fund.
FATCA Reporting
The Foreign Account Tax Compliance Act requires foreign financial institutions to report information about accounts held by U.S. persons. Offshore hedge fund feeders fall squarely within this requirement. Non-compliant institutions face withholding on certain U.S.-source payments, which gives them strong incentive to cooperate. Participating foreign institutions must register with the IRS, obtain a Global Intermediary Identification Number, and transmit account data through the International Data Exchange Service.7Internal Revenue Service. Foreign Account Tax Compliance Act (FATCA)
Adviser Registration and Ongoing Filings
The Dodd-Frank Act eliminated the old exemption that allowed advisers with fewer than 15 clients to avoid SEC registration, which hedge fund advisers had used for decades by counting each fund as a single client.8U.S. Securities and Exchange Commission. SEC Adopts Dodd-Frank Act Amendments to Investment Advisers Act Today, investment advisers generally must register with the SEC if they manage $100 million or more in assets. Advisers managing only private fund assets below $150 million can claim an exemption from full registration but must file as exempt reporting advisers.9eCFR. 17 CFR 275.203(m)-1 – Private Fund Adviser Exemption
Registered advisers file Form ADV and deliver Part 2A (the “brochure”) to clients. The brochure describes the firm’s business, fees, disciplinary history, and conflicts of interest, and must be updated annually within 90 days of the adviser’s fiscal year end.10U.S. Securities and Exchange Commission. Form ADV – General Instructions Registration also subjects the firm to periodic SEC examinations. Every registered adviser must designate a chief compliance officer with enough seniority to enforce written policies, and those policies must be reviewed for adequacy at least once a year.11eCFR. 17 CFR 275.206(4)-7 – Compliance Procedures and Practices
Form PF
SEC-registered advisers with at least $150 million in private fund assets must file Form PF, which reports fund size, leverage, investor concentration, and risk exposure to the SEC and the Financial Stability Oversight Council. Advisers managing $1.5 billion or more in hedge fund assets qualify as “large hedge fund advisers” and file quarterly rather than annually.12U.S. Securities and Exchange Commission. Form PF – Reporting Requirements for All Filers
Form 13F
Any institutional investment manager exercising discretion over $100 million or more in publicly traded equity securities must file Form 13F quarterly, disclosing their holdings. Once the threshold is met on the last trading day of any month during a calendar year, the manager owes four consecutive filings even if assets later fall below the threshold.13U.S. Securities and Exchange Commission. Frequently Asked Questions About Form 13F
Schedules 13D and 13G
When a fund accumulates more than 5% of any class of a public company’s equity securities, it must disclose the position. Schedule 13G is the short form for investors who acquired shares in the ordinary course of business without intent to influence management. If the fund’s purpose is activist, the longer Schedule 13D is required within five business days of crossing the 5% threshold.14eCFR. 17 CFR Part 240 Subpart A – Regulation 13D-G
Anti-Money Laundering
As of January 2026, SEC-registered investment advisers and exempt reporting advisers must maintain AML and counter-terrorism financing compliance programs under FinCEN’s final rule. Covered advisers must conduct ongoing customer due diligence, build risk profiles for each investor, and report suspicious activity. The rule requires collecting information about the investor’s source of funds, domicile, citizenship, and whether they are a politically exposed person. This closes a gap that had left investment advisers as one of the last major categories of financial institution without formal AML obligations.
External Service Providers
A hedge fund’s credibility depends heavily on the independent parties surrounding it. Their absence is one of the clearest red flags in due diligence.
- The prime broker provides leverage, securities lending, and trade execution and clearing. Large funds often use multiple prime brokers to diversify counterparty risk.
- The custodian holds the fund’s securities separately from the management company’s own property. That separation is what prevents a manager from directly accessing investor assets for unauthorized purposes.
- The fund administrator calculates net asset value, processes subscriptions and redemptions, and handles investor reporting. Independent NAV calculation matters because performance figures are verified by an outside party rather than self-reported.
- The independent auditor reviews the fund’s financial statements annually to confirm compliance with standard accounting principles. The auditor’s opinion accompanies the statements sent to investors.
- Legal counsel drafts the PPM, partnership agreement, and subscription documents, advises on regulatory compliance, reviews side letters, and structures the fund’s entities to satisfy the Investment Company Act exemptions.