Hedge fund structure and fees | Finance & Capital Markets | Khan Academy

Let's see if we can understand
the structure of a hedge fund a little bit, and also how the
management and the performance fees work out. So most hedge funds,
the funds themselves are set up as
limited partnerships. So this is the hedge
fund that Pete set up, we'll call Pete Capital Fund 1. He's maybe in the future going
to start Fund 2, and Fund 3, and all of the rest. And he's able to
raise $100 million. 10% of that $100 million,
or $10 million of it, is coming from him. Or I guess to be
more exact, it's coming from Pete Capital
Management, LLC, limited liability company,
which he starts off as the general
partner of this fund. And it might be a
little bit confusing, but this is one company.

This is another
company over here. This company is going to manage
the assets of that company. And in return, it will be
able to get management fees. And it will be able to
get the performance fees. And we'll talk about
that in a second. And probably, Pete owns
this entire company. But he might have a couple
of employees, probably four or five. Now, the way it works
with a limited partnership is they don't call it
necessarily shares, but it's essentially
the same thing. Someone who, out of
this $100 million contributed $30
million, would get 30% in the limited partner interest.

Someone who contributed
10% would get $10 million in limited partner interests. So let's just say that he does
really good over the next year. That he's able to, on a gross
basis, before we take out his management fee
or anything else, grow the fund by $20 million. So roughly on a
gross basis, 20%. But this is net of the
trading fees and all the stuff that he has to pay, the broker
and all of that type of thing. To understand what goes to
Pete Capital Management, that Pete can use to pay himself
and his handful of employees, first to guess the
management fee. And the management fee will be
on the average net asset value. And I'm going to do it a little
bit back-of-the-envelope right over here. It's normally done
on a monthly basis. But I want to go into
all of the accounting. But if he did this
fairly linearly, or if you does this
fairly consistently, the average net asset
value over the year would be about $110 million. So average would be
approximately $110 million. And so he'll get
about 2% of that.

We're assuming he gets a 2%
management and 20% performance fee, or 20% carried interest,
it's sometimes called. So if the average net asset
value is $110 million, you multiply that times 2%. And then that means that he's
going to get $2.2 million in management fees. And this is for his salary,
his employee's salary, to pay the rent,
to I don't know, get some fancy computers,
whatever it might be. This is kind of viewed as the
cost just to manage the fund. So we need to subtract that from
the total amount in the fund, because that's going to
the management company. So instead of $120 million
over here we're going to have, what is that? $117 million 0.8,
$117.8 million. And then we'll have to
calculate how much she gets in a performance fee.

So in this situation, net
of his management fee, we have a $17.8 million gain. So let me write that over here. We have $17.8
million in profits. The way that we've
set up the performance fee, or the carried interest,
is it Pete gets 20% of it. Or more particular,
the general partner, the Pete Capital
Management, LLC, the partner that is controlling,
that as managing this fund, will get 20%. So let's multiply
that times 20%. And what does that give us? That gives us $3.56 million.

So $3.56 million will also go
to Pete Capital Management. So not bad. In this year he made a
little– almost $6 million. And that's probably
going to go to him and probably four
or five employees. So it can, if someone
performs well, it can be a very
profitable business. And just to make it clear
how the mechanics work here is that these funds tend
to be open end funds, like open end mutual funds. Well not like them,
they have to be private. They could only take money
from accredited investors. They can't market themselves. They don't have to
register with the SEC. But when I say that they can
be open-ended it means that at any point– well
not at any point, usually this is restricted–
at certain points in time the
investors are allowed to redeem, or kind
of add investments, to what's going on in the fund. So let's say after the end of
the year, so instead of $117.8, we're going to have to
subtract $3.56 from that for Pete Capital Management.

So what's left in the
fund is going to be– and he could leave it
in there to reinvest, but that would just
increase his share. But let's say Pete Capital
Management takes it out. So we'll be left
with– let's see we have 117.8 minus
it gives us 114.24. So over here, what's left
of the fund is 114.24. And let's say this
period, investors are allowed to redeem
their interest. And let's say this
guy right over here, this guy with the 30% interest,
he says, you know what? That was a pretty good year. I want to take 10%
of my interest out. So instead of having
a 30% interest, he wants to have a 10% interest. So what happens is,
so instead of a 30% this is now 20% interest. He'll take 10% out. So he'll take 10% of 114.24. So he's going to take
out– that's essentially going to be– we just have
to move the decimal places one over. So he's going to take
out $11.424 million. That's this guy right over here. He's going to take
out $11.424 million.

And then the fund will
decrease by that amount. So he can, at these specific
periods, people can redeem. Usually it's at the
end of the month, at the end of the quarter,
or the end of the year. So then the fund
will be left with, what's 114– let me take
the calculator out again. The fund will now be left
with 114.24 minus 11.424 which is going to be 102.816. And at the same
time, other people might say, hey, that was
a pretty good return. I'm going to now
contribute to the fund. So either way,
it's not like it's a closed-end fund where
just at the beginning, people can commit their capital
and they can't take it out until the end of the fund,
or they can't add more. During the life of most hedge
funds, at specific periods, people are allowed to
redeem their funds. Or they're allowed
to add more funds..

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