Hedge funds are clearly recognisable by their legal structures. Many people think that hedge funds are completely unregulated, but it is more accurate to say that hedge funds are structured to take advantage of exemptions in regulations. Fung and Hsieh (1999) explain the justification for these exemptions is that the regulations are meant for the general public and that hedge funds are intended for well-informed, well-financed, private investors. The legal structure of hedge funds is intrinsic to their nature. Flexibility, opaqueness, and aggressive incentive compensation are fundamental to the highly speculative, information-motivated trading strategies of hedge funds. These features are in conflict with a highly regulated legal environment.
Hedge funds are almost always organised as limited partnerships or limited liability companies to provide pass-through tax treatment.
Funds don’t pay taxes on investment returns, but returns are passed through so that individual investors pay the taxes on their personal tax bills. (If the hedge fund were set up as a corporation, profits would be taxed twice.)
In the USA, hedge funds usually seek exemptions from a number of SEC regulations. The Investment Company Act of 1940 contains disclosure and registration requirements and imposes limits on the use of investment techniques, such as leverage and diversification [Lhabitant, 2002]. The Investment Company Act was designed for mutual funds, and it exempted funds with fewer than 100 investors. In 1996, it was amended so that more investors could participate, so long as each “qualified purchaser” was either an individual with at least $5 million in assets or an institutional investor with at least $25 million [President’s Working Group, 1999].
Hedge funds usually seek exemption from the registration and disclosure requirements in the Securities Act of 1933, partly to prevent revealing proprietary trading strategies to competitors and partly to reduce the costs and effort of reporting. To obtain the exemption, hedge funds must agree to private placement, which restricts a fund from public solicitation (such as advertising) and limits the offer to 35 investors who do not meet minimum wealth requirements (such as a net worth of over $1 million, an annual income of over $200,000). The easiest way for hedge funds to meet this requirement is to restrict the offering to wealthy investors.
Some hedge fund managers also seek an exemption from the Investment Advisers Act of 1940, which requires hedge fund managers to register as investment advisers. For registered managers, a fund may only charge a performance-based incentive fee (which is typically the manager’s main remuneration) if the fund is limited to high net-worth individuals. Some managers elect to register as investment advisers, because some investors may feel greater reassurance, and the additional restrictions are not especially onerous [Lhabitant, 2002].
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