What you need to do before you can launch a hedge fund

Starting a hedge fund requires you to register with the Securities and Exchange Commission (SEC), obtain a business license, set up a legal entity, and comply with securities laws that vary by the structure you choose and the amount of money you plan to manage. You cannot straightforward begin accepting investor money without these steps — doing so violates federal law and exposes you to criminal liability.

The path depends on whether you want to manage money for a small group of wealthy investors or a larger pool. A hedge fund managing under $150 million in assets may not need to register with the SEC if it stays below certain thresholds, but it will still need to register with individual states and comply with state securities laws. A fund managing $150 million or more must register with the SEC as an investment adviser.

Before you do any of this, you need a business plan that shows how you will make money, what your investment strategy is, who your target investors are, and how you will manage risk. You also need to decide on your fund structure — typically a limited partnership or limited liability company — and hire a securities lawyer to guide you through registration.

Key Takeaways

  • You must register as an investment adviser with the SEC if you manage $150 million or more, and with your state if you manage less, before you can legally accept investor money.
  • A hedge fund is usually structured as a limited partnership where you are the general partner managing the fund and investors are limited partners who contribute capital.
  • You need a Private Placement Memorandum (PPM) — a legal document that describes the fund, its risks, fees, and terms — before you can offer shares to investors.
  • Hedge funds typically charge a management fee (usually 1 to 2 percent of assets) and a performance fee (usually 20 percent of profits), and these must be disclosed in writing before investors commit money.
  • You must maintain detailed records of all trades, investor communications, and fund performance, and file annual reports with the SEC or your state depending on your registration status.

Registering with the SEC or your state

If you plan to manage $150 million or more in assets, you must register with the SEC as an investment adviser under the Investment Advisers Act of 1940. You do this by filing Form ADV, which asks for details about your business, your investment strategies, your fees, and any disciplinary history. The SEC does not approve or deny your registration — it straightforward accepts the filing and you become registered 45 days later unless the SEC asks for more information.

If you plan to manage less than $150 million, you must register with your state securities regulator instead. Each state has its own process and forms, though many use a coordinated filing system. You will still file Form ADV, but you submit it to your state rather than the SEC. Some states charge a registration fee; others do not. Your state regulator may ask questions about your background, your compliance procedures, and your investment strategy before approving your registration.

Regardless of which regulator you file with, you must disclose any criminal convictions, civil judgments, or regulatory actions against you or your employees. If you have a felony conviction or a securities-related regulatory action, you may be barred from operating a hedge fund.

Choosing your fund structure and forming a legal entity

Most hedge funds are structured as limited partnerships. You become the general partner, which means you manage the fund and have unlimited liability for the fund's debts. Investors become limited partners, which means they contribute capital but do not manage the fund and their liability is limited to what they invested. This structure is common because it gives investors confidence that you have "skin in the game" — your personal assets are at risk if the fund fails.

Some hedge funds use a limited liability company (LLC) structure instead, where you are the managing member and investors are members. This structure limits your personal liability but may be less attractive to institutional investors who expect the traditional limited partnership model.

To form either structure, you must file articles of organization or a certificate of limited partnership with your state's Secretary of State office. You will also need an Employer Identification Number (EIN) from the Internal Revenue Service, which you obtain by filing Form SS-4. Once you have an EIN, you can open a business bank account in the fund's name.

You will also need an operating agreement (for an LLC) or a partnership agreement (for a limited partnership) that spells out how the fund operates, how profits and losses are split, what happens if you want to leave, and how investor disputes are resolved. A securities lawyer should draft this document because it must comply with state law and securities regulations.

Creating a Private Placement Memorandum

Before you can offer shares or units in your hedge fund to investors, you must create a Private Placement Memorandum (PPM). This is a legal document that describes the fund, its investment strategy, the risks involved, the fees you will charge, the terms of the investment, and how investors can redeem their shares. The PPM is typically 30 to 100 pages long and covers everything an investor needs to know to make an informed decision.

The PPM must disclose your management fees, your performance fees, any side pockets (separate accounts for illiquid or troubled investments), lock-up periods (how long investors must keep their money in the fund before they can withdraw), and redemption terms (how often investors can withdraw and how much notice they must give). It must also explain what happens if the fund loses money, what conflicts of interest exist, and what your track record is.

You cannot change the PPM after investors have signed it without their written consent. If you want to change your fee structure, your investment strategy, or your redemption terms, you must amend the PPM and get all investors to sign the amendment. A securities lawyer must review your PPM before you show it to any potential investor to make sure it complies with securities laws.

Understanding hedge fund fees and compensation

Hedge funds typically charge two types of fees: a management fee and a performance fee. The management fee is usually 1 to 2 percent of the assets under management per year and covers the cost of running the fund — salaries, office space, compliance, and technology. This fee is charged whether the fund makes money or loses money.

The performance fee, also called a carried interest or incentive fee, is usually 20 percent of the fund's profits. This means if the fund makes $10 million in profit in a year, you keep $2 million and investors keep $8 million. Performance fees are only charged on profits, not on losses. Many hedge funds also use a high water mark, which means you cannot charge a performance fee on profits until the fund recovers any losses from previous years.

You must disclose your exact fee structure in the PPM before any investor commits money. Investors will negotiate fees based on how much money they are investing and your track record. Large institutional investors often negotiate lower fees than smaller investors. You cannot charge different fees to different investors without disclosing this in the PPM.

Compliance and record-keeping requirements

Once you are registered, you must maintain detailed records of all trades, all investor communications, all fund performance data, and all compliance activities. The SEC or your state regulator can examine these records at any time, and you must produce them within a reasonable timeframe. If you cannot produce records when asked, you can face fines or loss of your registration.

You must file an annual Form ADV update with the SEC or your state within 90 days of the end of your fiscal year. This form updates your business information, your fees, your investment strategies, and any disciplinary actions. You must also send each investor an annual report that shows the fund's performance, the fees charged, and any changes to the fund's terms.

You must have written policies for how you handle conflicts of interest, how you execute trades, how you value investments, and how you handle investor complaints. You must also have a chief compliance officer who oversees these policies and reports to you. If you are a small fund with only a few employees, you may be the chief compliance officer, but you still need written policies in place.

Finding and managing your first investors

You cannot advertise a hedge fund to the general public. You can only offer shares to accredited investors, which the SEC defines as individuals with a net worth of at least $1 million (not counting their primary residence) or an annual income of at least $200,000 for the past two years. Institutional investors like pension funds, endowments, and insurance companies are also accredited investors regardless of their net worth.

You can find investors through your personal network, through placement agents who specialize in raising money for hedge funds, or through investor conferences. You cannot use a general website or social media to solicit investors — you must have a pre-existing relationship or work through a licensed intermediary. Placement agents typically charge a fee of 1 to 3 percent of the money they raise.

Once an investor expresses interest, you send them the PPM and give them time to review it and ask questions. They should also consult with their own lawyer and accountant. After they sign the PPM and a subscription agreement (which confirms they are accredited and understand the risks), they wire money to the fund's bank account. You then issue them shares or units in the fund and begin managing their money according to your stated strategy.

Frequently Asked Questions

Do I need to have a track record before I start a hedge fund?

No, but investors will be much more likely to invest if you do. If you are starting your first fund, you should have at least 5 to 10 years of experience managing money, either at another hedge fund, at a bank, or at an investment firm. You will need to show investors your past performance and explain your investment strategy in detail. Many first-time fund managers start with a smaller fund and a smaller group of investors.

How much money do I need to start a hedge fund?

There is no legal minimum, but most hedge funds start with at least $5 million to $10 million in assets because the fixed costs of compliance, legal fees, and technology are high. A fund with less than $5 million may struggle to cover these costs and still charge reasonable fees. You should also invest some of your own money in the fund to show investors you believe in your strategy.

Can I run a hedge fund from home?

Yes, but you must still comply with all SEC or state registration requirements and maintain proper records. You will need find technology to protect investor data and trade information, and you will need to document your compliance procedures. As your fund grows, you may need to move to an office space, but you can start small.

What happens if I want to close my hedge fund?

You must notify all investors in writing and give them a chance to redeem their shares at the current fund value. You must then liquidate all investments, pay all debts and fees, and distribute the remaining money to investors. You must file a final Form ADV with the SEC or your state indicating that you are no longer operating. You must keep records for at least six years after closing.

Do I need insurance for my hedge fund?

Yes. You should have errors and omissions insurance (which covers mistakes you make managing money), fiduciary liability insurance (which covers breaches of duty to investors), and cyber liability insurance (which covers data breaches). These policies typically cost $10,000 to $50,000 per year depending on your fund size and your claims history.