How to Make a Hedge Fund: Structure, Exemptions, and Filings

To start a hedge fund, you form a private investment entity (usually a limited partnership with an LLC as general partner), claim an exemption from the Investment Company Act of 1940, register or file as an investment adviser with the SEC or your state, file Form D under Regulation D to exempt the fund’s securities from public registration, make state notice filings, and put a service-provider and compliance framework in place before accepting the first dollar. The order matters, because a decision at the entity stage locks in who can invest and how the fund is taxed for years afterward.

Pick the Entity and Structure

Domestic hedge funds almost always use a limited partnership. The general partner (typically an LLC controlled by the manager) runs the portfolio, and the limited partners contribute capital. Structuring the GP as an LLC keeps the manager’s personal assets separate from the fund’s liabilities. Some funds organize the fund itself as an LLC instead of an LP, which offers similar liability protection and the same pass-through tax treatment. Institutional investors are used to the LP model, so that remains the default choice.

If the fund will take money from both U.S. taxable investors and foreign or U.S. tax-exempt investors, plan for a master-feeder structure from the outset. A domestic LP acts as the feeder for U.S. individuals and corporations. An offshore corporation, commonly formed in the Cayman Islands, acts as the feeder for foreign investors and U.S. tax-exempt entities such as pension plans. Both feeders invest into a single master fund, usually an LLC treated as a partnership, where all the trading actually occurs.¹ Each investor class then gets the tax treatment it needs without running duplicate portfolios.

Choose an Investment Company Act Exemption

A hedge fund must fit within an exemption from the Investment Company Act of 1940 to avoid registering as a public investment company. Two exemptions cover nearly every hedge fund launched in the U.S.

Section 3(c)(1) exempts a fund with no more than 100 beneficial owners that does not make a public offering. The 100-owner cap is what makes this exemption workable for a first fund with a small investor base. Contrary to a common misconception, 3(c)(1) itself does not require investors to be accredited; that requirement comes from Regulation D, which is a separate filing under the Securities Act.

Section 3(c)(7) removes the 100-investor cap but restricts the fund to “qualified purchasers,” generally individuals holding at least $5 million in investments.² Most new managers launch under 3(c)(1) and convert to 3(c)(7) later, once they can attract qualified purchasers in volume.

One boundary to be aware of even if you don’t plan to solicit them: if pension plans, 401(k) accounts, or other employee benefit plans end up holding 25 percent or more of any class of the fund’s equity, the fund’s underlying assets are treated as plan assets under ERISA, and the manager becomes an ERISA fiduciary to those plans.³ That brings a separate layer of fiduciary duties, prohibited transaction rules, and reporting. Funds that take pension money typically cap benefit plan participation below 25 percent right in the governing documents.

Draft the Offering and Governing Documents

Three documents form the core paperwork given to every investor: the private placement memorandum, the limited partnership agreement (or operating agreement), and the subscription documents. Specialized securities counsel drafts these. This is the wrong place to cut costs.

Private Placement Memorandum

The PPM is the fund’s primary disclosure document. It describes the strategy, the specific risks that go with that strategy, the fee structure, and the redemption terms. The typical fee arrangement is a 2 percent management fee on assets plus a 20 percent performance fee on profits. Most PPMs include lock-up provisions preventing withdrawals for the first year or longer so the manager can deploy capital without facing immediate redemption pressure. If a securities fraud claim ever arises, it will trace back to something in (or missing from) this document, so every material risk needs disclosure and the strategy description has to match what the manager actually intends to do.

Limited Partnership or Operating Agreement

The LPA (or the operating agreement for an LLC fund) is the binding contract between the manager and investors. It sets out profit and loss allocations, the GP’s authority and compensation, valuation policies, voting rights, and dissolution procedures. Watch the high-water mark provision: it prevents the manager from collecting performance fees on gains that only recover prior losses. If the fund drops 10 percent and then climbs back to even, no performance fee is owed on that recovery.

Subscription Documents and Side Letters

Each investor completes a subscription agreement that collects the information needed to verify accredited or qualified purchaser status, along with net worth, income, and legal representations. Complete subscription records are essential during any regulatory examination.

Large or early investors sometimes ask for side letters that modify their terms with reduced fees, better liquidity, or enhanced reporting. If the governing documents don’t authorize side letters, investors who didn’t get one can bring breach of fiduciary duty claims. A most-favored-nation clause, common in these letters, lets certain investors elect any benefit granted to another investor, which puts a practical ceiling on how generous the manager can be with any one investor.

Register as an Investment Adviser

The Investment Advisers Act of 1940 splits registration between the SEC and state regulators by assets under management.

Advisers managing $110 million or more must register with the SEC.
Advisers managing between $100 million and $110 million may choose SEC or state registration.
Below $100 million, registration is generally with the state where the adviser’s principal office sits.⁴

There is a third path that most new hedge fund managers take. An adviser managing only private funds with less than $150 million in fund assets qualifies as an exempt reporting adviser under Section 203(m) of the Advisers Act.⁵ An ERA files an abbreviated Form ADV, remains subject to SEC anti-fraud rules, and skips most of the compliance overhead required of registered advisers. When the fund crosses $150 million in assets, the manager has to transition to full SEC registration.

All advisers register or file reports electronically through the Investment Adviser Registration Depository. Form ADV Part 1 covers ownership, employees, business practices, and any disciplinary history. Form ADV Part 2 is a plain-language brochure of services, fees, and conflicts, and it must be delivered to every client before they invest. The SEC has 45 days after submission to declare the registration effective.⁶ Once registered, the adviser must file an annual updating amendment within 90 days of the end of its fiscal year.⁷ Missing that annual deadline is one of the most common deficiency findings in SEC exams.

File Form D and State Blue Sky Notices

Separate from the Investment Company Act exemption, the fund’s securities also need an exemption from the Securities Act of 1933. Nearly every hedge fund relies on Regulation D, Rule 506. Form D is filed through the SEC’s EDGAR system to give notice of the private offering.⁸ The filing is due within 15 days after the first investor is contractually committed to invest.⁹

Rule 506 has two paths:

Rule 506(b) is the traditional route. No general solicitation, no public advertising, and the fund can accept up to 35 non-accredited but sophisticated investors alongside an unlimited number of accredited investors.⁹ In practice, most hedge funds under 506(b) limit themselves to accredited investors, because accepting non-accredited investors triggers disclosure requirements that resemble a registered offering.

Rule 506(c) allows general solicitation and public advertising, but every purchaser must be a verified accredited investor. An accredited individual is generally someone with a net worth over $1 million (excluding their primary residence) or annual income over $200,000 (or $300,000 jointly) in each of the past two years with a reasonable expectation of the same this year.¹⁰ Under 506(c) the fund can’t rely on self-certification; acceptable verification includes reviewing tax returns, examining bank or brokerage statements, or obtaining written confirmation from a registered broker-dealer, investment adviser, licensed attorney, or CPA who has independently verified status.

Before filing Form D, run background checks on everyone who counts as a “covered person” under Rule 506(d), which includes directors, general partners, managing members, and anyone paid to solicit investors. The rule disqualifies the fund from using either 506 exemption if a covered person has certain events in their history: securities-related felony or misdemeanor convictions in the prior ten years, securities fraud injunctions in the prior five years, and certain final orders from federal or state financial regulators.¹¹ Finding one of these events after investors have already committed capital is not a problem with a clean fix.

Most states also require a separate blue sky notice filing for Regulation D offerings, generally submitted through the Electronic Filing Depository. Fees vary by state, from nothing in some jurisdictions to about $1,500, with most in the $300 range. Track investor residencies and file in each applicable state as new investors from new jurisdictions come in.

Hire the Service Providers the Fund Cannot Function Without

A fund administrator independently calculates the net asset value, prices the portfolio, reconciles trades, and sends periodic statements to investors. Handling NAV calculations in-house is a red flag for institutional investors and a compliance risk.

A prime broker executes trades, provides margin financing for leveraged positions, and lends securities for short selling. Most funds launch with one prime broker and add a second as assets grow, both for redundancy and to keep financing pricing competitive.

An independent auditor registered with the Public Company Accounting Oversight Board must perform an annual audit. Under the SEC’s custody rule, a fund adviser satisfies the independent verification requirement by delivering audited financial statements to all investors within 120 days of the fund’s fiscal year-end.¹² Missing that deadline is a custody rule violation, not an inconvenience.

Every SEC-registered adviser must designate a chief compliance officer responsible for administering the firm’s written compliance policies, and must review those policies at least annually.¹³ At a small fund, the CCO is often the founder or the chief operating officer. The annual review has to be documented, and the SEC asks to see it during examinations.

Set Up Ongoing Compliance and Reporting

Getting the fund open is one thing; keeping it compliant is a recurring workload.

Form PF. SEC-registered advisers to hedge funds with at least $150 million in hedge fund assets must file Form PF, which reports systemic risk data to the SEC and the Financial Stability Oversight Council. Advisers with $1.5 billion or more in hedge fund assets are classified as large hedge fund advisers and file more granular data more often.¹⁴
Form 13F. An institutional investment manager with discretion over $100 million or more in Section 13(f) securities (mainly U.S. exchange-listed equities) must file Form 13F quarterly, within 45 days of each quarter’s end.¹⁵
Annual compliance review. The CCO must produce a documented review of the adequacy and effectiveness of the compliance program at least once a year.¹³
Audited financials. Funds using the custody rule’s audit path must deliver audited statements to all investors within 120 days of fiscal year-end.¹²
CFTC registration. Funds trading commodity futures, swaps, or other commodity interests may require the manager to register as a commodity pool operator with the CFTC and file Form CPO-PQR, with reporting requirements scaled by pool size.¹⁶

Every fund also has to screen investors and counterparties against the Specially Designated Nationals list maintained by the Treasury Department’s Office of Foreign Assets Control. Transacting with a blocked person is a strict liability violation; intent is not a defense. Most funds use automated screening software at onboarding and periodically thereafter, following OFAC’s risk-based guidance that accounts for the fund’s investor base and the jurisdictions where it deploys capital.¹⁷

A separate anti-money laundering rule for investment advisers has been finalized but delayed. FinCEN postponed the effective date to January 1, 2028.¹⁸ When it takes effect, SEC-registered advisers and exempt reporting advisers will need formal AML programs, customer identification procedures, and suspicious activity reporting. Build these processes in now rather than retrofitting them later.

Understand How the Fund and the Manager Are Taxed

A hedge fund organized as a limited partnership or an LLC taxed as a partnership does not pay entity-level federal income tax. Income, gains, losses, and deductions pass through to the partners, who report them on their own returns, and the fund issues a Schedule K-1 to each partner annually. Pass-through treatment is a major reason hedge funds use partnerships rather than corporations.

The manager’s performance fee is typically structured as a carried interest allocation rather than a fee, which brings it under Section 1061 of the Internal Revenue Code. To qualify for the long-term capital gains rate of 20 percent rather than the ordinary income rate of up to 37 percent, the underlying investments must be held for more than three years.¹⁹ Gains on positions held for three years or less get recharacterized as short-term and taxed at ordinary rates, regardless of whether the position would otherwise qualify for long-term treatment under the standard one-year holding period. The Tax Cuts and Jobs Act of 2017 added this three-year rule, and it can effectively eliminate the carried interest tax benefit for higher-turnover strategies.

1
SEC.gov. Hedge Fund Basics
2
Office of the Law Revision Counsel. 15 U.S. Code 80a-3 – Definition of Investment Company
3
eCFR. 29 CFR 2510.3-101 – Plan Investments
4
eCFR. 17 CFR 275.203A-1 – Eligibility for SEC Registration
5
U.S. Securities and Exchange Commission. Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers, and Foreign Private Advisers
6
U.S. Securities and Exchange Commission. Electronic Filing for Investment Advisers on IARD
7
U.S. Securities and Exchange Commission. Form ADV General Instructions
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U.S. Securities and Exchange Commission. What Is Form D
9
U.S. Securities and Exchange Commission. Filing a Form D Notice
10
U.S. Securities and Exchange Commission. Accredited Investors
11
Federal Register. Disqualification of Felons and Other Bad Actors From Rule 506 Offerings
12
U.S. Securities and Exchange Commission. Final Rule – Custody of Funds or Securities of Clients by Investment Advisers
13
eCFR. 17 CFR 275.206(4)-7 – Compliance Procedures and Practices
14
U.S. Securities and Exchange Commission. Form PF Frequently Asked Questions
15
SEC.gov. Form 13F
16
Federal Register. Amendments to Compliance Requirements for Commodity Pool Operators on Form CPO-PQR
17
U.S. Department of the Treasury. OFAC Compliance in the Securities and Investment Sector
18
FinCEN.gov. FinCEN Issues Final Rule to Postpone Effective Date of Investment Adviser Rule to 2028
19
Office of the Law Revision Counsel. 26 U.S. Code 1061 – Partnership Interests Held in Connection With Performance of Services