A U.S. hedge fund is typically structured as a Delaware limited partnership that relies on exemptions in federal securities law to avoid registering as an investment company. A general partner, usually itself an LLC, controls investment decisions. Limited partners supply the capital and stay passive. A separate management company employs the portfolio managers and traders and collects the fees, while independent custodians, administrators, and auditors handle the money and verify the numbers. That layered design is the short answer to how hedge funds are structured, and every detail below exists to serve one of the two goals built into it: qualifying for an exemption from the Investment Company Act of 1940, and keeping the people who run the fund legally and operationally separate from the assets they manage.
The Exemptions That Shape Everything Else
Mutual funds register with the SEC under the Investment Company Act of 1940, which subjects them to strict rules on leverage, short selling, and fee structures. Hedge funds avoid all of that by qualifying for one of two exemptions that let them operate as unregistered investment vehicles. Those exemptions are the reason hedge funds look the way they do.
Section 3(c)(1) applies to any fund whose securities are owned by no more than 100 beneficial owners and that does not make a public offering.1Office of the Law Revision Counsel. 15 USC 80a-3 – Definition of Investment Company This is the exemption smaller and mid-sized funds usually rely on, and the 100-person cap is why those funds are selective about whom they take.
Section 3(c)(7) removes the 100-person cap but requires every investor to be a “qualified purchaser.” For individuals that means owning at least $5 million in investments. For institutions investing on a discretionary basis the threshold is $25 million.2Legal Information Institute. 15 USC 80a-2(a)(51) – Definition of Qualified Purchaser Larger funds that want hundreds of investors use this exemption, but every participant must clear the higher wealth bar.
Lose the exemption, and the fund would have to register as an investment company and comply with the same restrictions as a mutual fund, which would make most hedge fund strategies impossible to run. That risk is why the eligibility rules, the marketing restrictions, and the paperwork around new investors are enforced so tightly.
The Limited Partnership at the Center
The fund itself is almost always a limited partnership, usually formed in Delaware. The structure divides participants into two roles with very different rights and liabilities.
The general partner controls investment decisions and bears personal legal liability for the partnership’s obligations. In practice, the general partner is itself a limited liability company rather than an individual, which puts a layer of asset protection between fund-level liabilities and the people behind it. The general partner directs strategy, signs contracts on behalf of the fund, and has authority to hire and fire service providers.3IRS. Hedge Fund Basics
Limited partners are passive investors. They contribute capital and share in profits and losses, but they do not participate in management. Their financial exposure is generally capped at the amount they invested, so fund creditors cannot reach a limited partner’s personal assets. That protection holds only as long as the limited partner stays out of day-to-day operations. A limited partner who starts making management decisions risks being treated as a general partner and losing the liability shield.
The limited partnership agreement is the governing document. It covers profit allocation, fee calculations, voting rights, withdrawal procedures, and what happens if the fund winds down. Every material term of the fund flows through it.
Why the Manager Is a Separate Company
The general partner does not typically employ the analysts and traders who run the portfolio. That work happens inside a separate entity, the investment manager, usually organized as an LLC or corporation.3IRS. Hedge Fund Basics This entity employs the portfolio managers, research analysts, and operations staff, and it earns the management and performance fees. Keeping the manager legally separate from the fund matters for tax reasons and because it keeps the fund’s assets distinct from the manager’s own business operations.
Investment advisers with more than $100 million in assets under management generally must register with the SEC. The private fund adviser exemption lets managers who exclusively advise private funds and manage less than $150 million in private fund assets avoid SEC registration entirely.4eCFR. 17 CFR 275.203(m)-1 – Private Fund Adviser Exemption Even exempt managers still face state-level registration and must comply with federal anti-fraud rules.
Managers above the $150 million threshold who register with the SEC take on additional obligations. They file Form ADV, a public disclosure document covering fees, conflicts of interest, and disciplinary history, and they maintain books and records open to SEC inspection. Large hedge fund advisers managing $1.5 billion or more in hedge fund assets must also file Form PF, which gives regulators detail on fund-level risk exposures, leverage, and liquidity.5U.S. Securities and Exchange Commission. Form PF Frequently Asked Questions
Who Can Invest and How Funds Raise Capital
Hedge funds cannot advertise to the public the way a mutual fund can. Because they rely on exemptions from the Investment Company Act and sell securities without SEC registration, they must follow Regulation D of the Securities Act when bringing in new investors. Most funds choose one of two paths.
Under Rule 506(b), a fund can raise unlimited capital from accredited investors but cannot use general solicitation or advertising. It can also accept up to 35 non-accredited investors, though almost no hedge fund does this because it triggers additional disclosure obligations.6U.S. Securities and Exchange Commission. Private Placements – Rule 506(b) Most fundraising happens through existing relationships, placement agents, and word of mouth.
Under Rule 506(c), a fund can broadly advertise and solicit investors, but every purchaser must be a verified accredited investor. The fund must take reasonable steps to confirm each investor’s status rather than relying on self-certification.7U.S. Securities and Exchange Commission. General Solicitation – Rule 506(c) That usually means reviewing tax returns, bank statements, or written confirmation from an accountant or attorney.
To qualify as an accredited investor, an individual needs a net worth above $1 million excluding their primary residence, or annual income above $200,000 ($300,000 with a spouse or partner) in each of the prior two years with a reasonable expectation of the same going forward.8U.S. Securities and Exchange Commission. Accredited Investors Funds relying on Section 3(c)(7) go further and require every investor to be a qualified purchaser, generally $5 million or more in investments for individuals.2Legal Information Institute. 15 USC 80a-2(a)(51) – Definition of Qualified Purchaser
After the first sale of securities, the fund must file a Form D notice with the SEC within 15 days. This is a brief disclosure filing, not a registration. Most states require a separate notice filing, with fees that vary by jurisdiction.9U.S. Securities and Exchange Commission. Filing a Form D Notice
The Documents an Investor Signs
Before you invest, you receive a set of documents that lay out exactly what you are agreeing to. The Private Placement Memorandum functions like a prospectus for a private offering. It describes the investment strategy, the risks, the fee structure, the backgrounds of key personnel, and potential conflicts of interest. The PPM also discloses regulatory and legal risks. Failing to present those disclosures accurately exposes the fund to securities fraud liability, which is why the PPM tends to be long and heavily lawyered.
The limited partnership agreement is the second critical document. While the PPM describes the offering, the LPA governs the ongoing relationship between the general partner and limited partners. It covers how profits and losses are allocated, when and how you can withdraw, what happens during a liquidation, and what powers the general partner can exercise without a vote. If the PPM’s marketing language conflicts with the LPA’s legal terms, the LPA controls.
You also sign a subscription agreement, which is your formal application. It collects your personal and financial information, requires you to represent that you meet the fund’s eligibility rules, and confirms that you have received and reviewed the PPM and LPA. Broker-dealers involved in selling the fund must also file offering documents with FINRA.10FINRA. Private Placements
Master-Feeder Structures for Mixed Investor Bases
When a fund takes money from both U.S. taxable investors and foreign or tax-exempt investors, it generally cannot put everyone in the same entity without creating tax problems. The master-feeder structure solves this by creating separate entry points that all feed into a single trading vehicle.
A domestic feeder, usually a Delaware limited partnership, accepts U.S. taxable investors. An offshore feeder, often a Cayman Islands corporation, accepts foreign investors and U.S. tax-exempt entities such as pension funds and endowments. Both feeders invest into a master fund where all the trading actually happens. Pooling at the master gives the manager economies of scale and a single portfolio to run.
The offshore feeder matters most for tax-exempt investors. When a fund uses leverage or generates certain operating income, a tax-exempt investor in a domestic partnership would owe tax on Unrelated Business Taxable Income. Investing through an offshore corporation instead, the corporate entity acts as a blocker, absorbing the income at the entity level so it never flows through to the tax-exempt investor’s return. Foreign investors benefit for similar reasons, as the corporate feeder helps manage withholding tax obligations and avoids creating a taxable presence in the United States.
How the Manager Gets Paid
Hedge fund fees follow a two-part model historically described as “2 and 20,” though actual fees have drifted lower. Industry surveys show average management fees closer to 1.35% and average performance fees around 16%, with wide variation by fund size, strategy, and track record.
The management fee is charged as a percentage of total assets, typically between 1% and 2%, and is paid regardless of performance. It covers the operating costs of the management company, including compensation, technology, and office expenses. Most funds charge it quarterly.
The performance fee, also called an incentive allocation, gives the manager a share of the fund’s net profits, commonly around 20%. Two mechanisms typically limit when it applies:
- A high-water mark bars the manager from collecting a performance fee until the fund’s value exceeds its previous peak. If the fund loses 15% one year and gains 10% the next, no performance fee is owed on the gain because the fund has not recovered its prior high.
- A hurdle rate requires the fund to clear a minimum return before performance fees kick in. A fund with an 8% hurdle only pays the incentive fee on returns above that level.
The performance fee is structured as a profit allocation from the partnership rather than a fee payment. That distinction drives the tax treatment discussed below.
Expense Pass-Throughs
Beyond the stated management and performance fees, many funds pass operational costs directly to the fund rather than absorbing them inside the management company’s budget. Traditional pass-through categories include legal expenses, audit fees, administrator costs, and trading-related technology. Some large multi-strategy firms have expanded pass-throughs further to cover recruiting costs, employee compensation, compliance technology, artificial intelligence tools, and staff relocation expenses. These come directly out of fund assets, so investors bear them on top of the stated fee percentages. The PPM and LPA should disclose which categories the fund can pass through, and that section is worth reading carefully before committing capital.
Lock-Ups, Redemption Windows, and Gates
Unlike a mutual fund, where you can sell shares any business day, a hedge fund restricts when and how you can withdraw. These restrictions exist because many hedge fund strategies hold illiquid or hard-to-sell positions that cannot be converted to cash quickly without losses.
Most funds require an initial lock-up period during which no redemptions are allowed at all. Lock-ups range from several months to multiple years depending on how liquid the strategy is. A fund trading listed equities might impose a one-year lock-up, while a fund in distressed debt or private companies could lock capital for two to three years. A “hard” lock-up allows no withdrawals; a “soft” lock-up permits early redemption with a penalty fee, typically 1% to 5% of the withdrawn amount.
After the lock-up expires, redemptions are generally allowed only on specific dates, often quarterly. Most funds also require 30 to 90 days of advance written notice before a redemption date. Miss the notice deadline and the request rolls to the next window.
Funds also reserve the right to impose a redemption gate, which caps the total amount all investors can withdraw in any given period. A common threshold is 20% to 25% of the fund’s net asset value per quarter. If total requests exceed the gate, each request is reduced proportionally. You receive part of what you asked for, and the balance queues for the next date. Gates are meant to prevent a stampede of withdrawals from forcing fire-sale liquidations, but from an investor’s perspective they mean your money can be stuck longer than you planned.
The Independent Service Providers
A well-structured hedge fund separates key functions across independent parties, so no single entity controls both the trading and the accounting. That separation of duties is what prevents the kind of fraud where a manager fabricates returns because nobody else is checking the books.
- The prime broker provides leverage, trade execution, securities lending for short positions, and clearing. Most funds use at least one prime broker; larger funds spread business across two or three to manage counterparty risk.
- The custodian holds the fund’s cash and securities in segregated accounts. Because the custodian is independent of the manager, the manager can direct trades but cannot physically move assets out of the fund.
- The fund administrator independently calculates net asset value, processes subscriptions and redemptions, and prepares investor statements. Having the administrator rather than the manager calculate NAV gives investors an independent check on what their holdings are worth.
- The external auditor conducts an annual audit of the fund’s financial statements. The audited financials go to investors and provide independent verification that reported performance matches reality.
A fund that self-administers or uses an obscure auditor is a red flag. Institutional allocators pay close attention to who fills these roles.
How Investors Are Taxed
Because most domestic hedge funds are partnerships, the fund itself does not pay income tax. Income, gains, losses, and deductions flow through to investors on a Schedule K-1, which the fund issues annually. The K-1 breaks out your share of the fund’s ordinary income, short-term capital gains, long-term capital gains, dividends, interest, and deductible expenses on separate line items.11IRS. 2025 Partners Instructions for Schedule K-1 Form 1065 You report those amounts on your personal return for the year the fund’s tax year ends.
K-1s from hedge funds are notoriously late. Funds often have to wait for information from their own underlying investments before finalizing returns, so you may receive your K-1 well after the April filing deadline. Many hedge fund investors file extensions as a matter of course.
Carried Interest and the Three-Year Rule
The performance fee is typically structured as a partnership profit allocation rather than a cash payment, which means it can qualify for long-term capital gains treatment rather than ordinary income. IRC Section 1061 imposes a three-year holding period on capital gains allocated to the manager through what the statute calls an “applicable partnership interest.” If the underlying assets were held more than one year but less than three, the gains are recharacterized as short-term capital gains for the manager.12Office of the Law Revision Counsel. 26 USC 1061 – Partnership Interests Held in Connection With Performance of Services Only gains on positions held longer than three years get long-term rates for the carried interest portion.13IRS. Section 1061 Reporting Guidance FAQs The rule affects the manager’s tax bill, not the limited partners, who are taxed on their share of gains under ordinary holding period rules.
Net Investment Income Tax
If your modified adjusted gross income exceeds $200,000 (single) or $250,000 (married filing jointly), your share of the fund’s investment income is subject to an additional 3.8% Net Investment Income Tax on top of regular income and capital gains taxes. The NIIT applies to the lesser of your net investment income or the amount by which your income exceeds the threshold. Because hedge fund gains flow through on a K-1, they are included in the NIIT calculation along with your other investment income.