How to Invest in a Hedge Fund

Hedge Fund Investors Guide

Many potential hedge fund investors come to this website for information on how to invest in a hedge fund.  While there are many headlines and resources for hedge fund managers, there are fewer resources out there for hedge fund investors.  This article will provide an overview of how to go about investing in a hedge fund.

Picking a hedge fund to invest in

Deciding to invest in hedge funds

Picking a hedge fund to invest in can be a difficult task.  First, an investor should decide why he wants to invest in a hedge fund.  Like any investment option an investment in a hedge fund involves a number of different factors including the investor’s short term and long term investment objectives, liquidity needs and risk tolerance.  While a hedge fund may have many potential benefits, those benefits should be weighed against any possible drawbacks.

Hedge Funds, Fund of Funds or Separately Managed Accounts

Next, the investor should determine how he wants to invest in hedge funds.  The investor can invest directly with a single manager or through a fund of hedge funds.  Many beginning hedge fund investors use hedge fund of funds because the managers of these vehicles have specific expertise in picking managers and maintaining a portfolio with desirable risk-reward characteristics.  Fund of funds are often a “first step” for many investors into hedge fund investing as the risk of poor performance from any single manager is theoretically minimized.

Another possibility is investing in a hedge fund through a separately managed account program.  In this structure the investor will set up a separate trading account and the manager will trade the account according to its investment program.  These structures allow the investor transparency into the underlying which is normally not available to a traditional hedge fund investors.  Most managers do not provide programs like these unless the investor invests a significant amount of assets with the manager.

Finding Managers

So where does one find these elusive hedge funds to invest in?  Many investors find hedge funds to invest in through friends and family members who have invested.  Other investors will find hedge funds through hedge fund databases.  Still other investors will be courted by hedge fund managers.  All of these are viable ways to be introduced to hedge funds.  Once introduced to a hedge fund the investor should determine whether he is eligible to invest in the fund.

Eligible to invest in a hedge fund?

Most hedge funds will require their investors to be both an accredited investor and a qualified client.  An accredited investor is, generally, an investor with a $1,000,000 net worth; an investor’s equity in a primary residence will count toward the one million dollar mark.  A qualified client is, generally, an investor with a $1,500,000 net worth.  Some hedge funds will allow investors who are not accredited investors or qualified clients.  Generally these slots are allocated to friends and family of the manager.  The investor will be able to find out the investor qualifications through the hedge fund offering documents.

Hedge Fund Documents and Investing

The hedge fund offering documents are the centerpiece of the offering process.  In addition to talking with a manager and reviewing the marketing materials, the investor should very carefully review the offering documents.  Unfortunately hedge fund offering documents are very long (usually around 100-150 pages) and are written with a lot of “legalese.”  Because of this many investors don’t even try to read the whole document. It should be noted that the offering documents are so lengthy because of the various hedge fund laws which managers must follow with regard to the offering of hedge fund interests as well as trading securities.

I recommend that investors go through each page of the offering documents and understand what each paragraph is saying.  Because the investor will be presumably making a large investment, it would seem prudent for the investor to understand all parts of the investment.  Specifically, in my opinion, the investor should focus on the following:

  • Develop an understanding the investment program, its risks and limitations
  • Fully understand the fee structure
  • Fully understand the liquidity structure (including the gate and lock-up periods)
  • Fully review and understand the manager’s background and qualifications

If an investor has any questions he should ask the manager for a detailed explanation.  If there manager cannot provide a detailed explanation the manager’s attorney should be able to describe any part of the offering documents and what the provision intends.  If necessary, seek clarification of specific provisions and receive the clarification in writing from the manager (email is fine).  If there is a provision which unpalatable, the investor may be able to enter into a side letter arrangement with the manager to remove or modify the provision with respect to the investor.

Above all, if there are questions, the investor should not hesitate to seek clarification.  Another option is to have the offering documents reviewed by a hedge fund attorney or a due diligence professional.

Hedge fund due diligence

Hedge fund due diligence is extremely important.  The recent Madoff scandal provides no better example of how a little investigation into a manager can protect an investor from a huge or complete loss.   There are many hedge fund due diligence firms which provide comprehensive review of the hedge fund and the manager.

Free due diligence resources

Many government agencies provide searchable databases to get information on hedge fund managers.

1.  IDEA (formerly EDGAR) – the SEC’s IDEA website provides a searchable list of all of the filings with the SEC.  Currently a hedge fund investor can see whether or not the hedge fund has submitted to proper Form D filings with the SEC.  (Note: if the hedge fund is new and has no investors, it will likely not have filed Form D.)

2.  Investment Advisor Search – this is another resource from the SEC which allows a potential investor to see the manager’s registration status and Form ADV filings.  If an investor invests with a manager who is registered (at either the SEC or state level), then the investor should use this resource.

3.  FINRA Broker Check – if a management company is registered as a broker-dealer then their information will be in the searchable FINRA database.  Former brokers will be listed as well.  If a manager’s bio mentions that he was a broker at one point, it is likely that this information can be cross-checked through Broker Check.

4.  NFA Basic – if a management company is registered as a Commodity Trading Advisor or a Commodity Pool Operator then the NFA’s Basic system will provide all information on the registration status of the manager.  Additionally, if the manager filed an exemption from registration (disclosed in the hedge fund offering documents), the exemption can be search as well.  Any NFA disciplinary history of the manager will be disclosed.

5.  Other good websites – NASAA (www.nasaa.org), SEC (www.sec.gov), FINRA (www.finra.org)

Checking with Service Providers

Potential hedge fund investors can also check with a hedge fund’s service providers.  The offering documents will disclose who the service providers are – the investor may want to call these providers to make sure the fund is doing business with these firms.

Investing in Hedge Funds on the Secondary Market

[Update 01-19-09] Investors can also purchase interests in a hedge fund on the secondary market.  This article on Secondary Hedge Fund Investing provides a brief explanation of the practice and discusses a new software solution which matches buyers and sellers on the secondary market.

Disclaimer

We do not make any recommendation whether or not to invest in hedge funds or any specific hedge funds.  It would be smart for first time hedge fund investors to talk about their investment goals with a fee-only financial planner who can help them understand the investment and how that investment fits within their overall financial situation.

If you have any questions on this article, please contact us.  Other related hedge fund law articles include:

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