According to the book "Wall Street Words: An A to Z Guide to Investment Terms for Today's Investor," hedge funds have the potential for extraordinary gains, but at a risk that's greater than average. They accomplish this by allowing the fund manager "to use a variety of investment techniques usually prohibited in other types of funds. These techniques include borrowing money, selling short and using options," according to the book. Many hedge funds issue two classes of shares: participating, non-voting or investment shares that allow shareholders to share in gains but give them no vote; and non-participating, voting or management shares that offer voting rights but no participation in the funds' gains or losses.
High Risk, High Return
A hedge fund manager actively manages the investments in a hedge fund and uses high-risk strategies to outperform the market indexes. For this reason, only people who have high net worths -- known as accredited investors -- and institutional investors are allowed to invest in these risky, high-return funds. Federal securities law defines an accredited investor as "a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year."
Paying the Manager
Many times the manager and other members of the fund's management team hold non-participating, voting or Class A Shares. These shares allow the holders to vote but not to participate in the profits of the fund paid out in dividends, distributions or upon liquidation of the hedge fund. Instead the managers are paid based on a percentage of the assets under management and on the fund's gains. For example, if the hedge fund manages $50 million in assets, the manager might receive a management fee of 1 to 4 percent of the $50 million. In addition, the manager can earn 20 percent of the fund's gains. If that fund returns 10 percent or $5 million, the manager earns $1 million.
Non-Participating and Participating Shares
Non-participating, voting shares enable the manager or managers to direct the hedge fund without interference from investors who own participating, non-voting shares or investment shares. The participating, non-voting or Class B shares allow the shareholders to participate in the profits of the fund paid out in dividends or other declared distributions -- and to share evenly in the net assets of the fund and company connected to the Class B Shares when the fund is liquidated.
Voting Equals Directing
These participating, non-voting shares, also called investment shares, do not provide the holders any say in the details of how the fund is run by the managers or non-participating, voting shareholders. Problems can arise if the investors -- who have participating, non-voting shares -- grow unhappy with the performance or management of the fund, because they have no way to redirect the company or to vote out the management. These non-voting investors can remove their assets, but that's neither quick nor easy. In 2013, a Securities and Exchange Commission report told Congress that hedge fund investors could access 7 percent of their capital in one day, 24 percent in a month, and 59 percent in six months. Twenty-six percent would take more than a year to get back.
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- Bloomberg.com: SEC Says Largest U.S. Hedge Funds’ Debt Tops $1 Trillion
- U.S. Securities and Exchange Commission: Accredited Investors
- BarclayHedge: Setting Up a Hedge Fund - Part 2
- Wall Street Words: An A to Z Guide to Investment Terms for Today's Investor; David Logan Scott
- streetofwalls.com: How Do Hedge Funds Make Money?
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