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venture capital funds, and other private equity funds are regularly con-
structed to receive flow-through tax treatment.
Hedge funds organized outside the United States are frequently or-
ganized in locations that have little or no business tax. In these loca-
tions, hedge funds are not organized to get flow-through tax treatment.
Instead, these funds are organized as corporations that do not require
investors to include the annual hedge fund income and expenses on in-
vestor tax returns.
Hedge Funds and Their Use of Leverage
Many hedge funds use leverage to carry long and short positions in excess
of their capital. Not all hedge funds use leverage, and many hedge funds
use leverage of two times or less (see Chapter 6).
Other types of investments also use leverage to carry assets in excess of
capital. Some mutual funds use leverage. Leverage is common in real estate
investments. Private equity funds may borrow money to limit the equity
needed to carry investments.
Hedge Funds Charge Incentive Fees
Hedge funds charge a variety of fees, including a substantial management
fee and an incentive fee. The management fees are similar to management
fees at mutual funds, private equity funds, and real estate funds. Incentive
fees are also typical in private equity funds, real estate funds, and (to a lim-
ited extent) mutual funds.
Hedge Funds and Lockup Commitments
Many hedge funds require investors to leave funds invested for a year or
more. This lockup provision is not typical of mutual funds, but the load
fees strongly encourage investors in mutual funds to hold their invest-
ments for several years. Private equity funds frequently have lockup pro-
visions. Venture capital funds in particular may grant the investor no
opportunity to exit before assets are liquidated. Real estate funds may
have similar restrictions.
CONTRASTING MUTUAL FUNDS WITH HEDGE FUNDS
One definition of a hedge fund is that it is a mutual fund that doesn't
have to follow any rules. This overly simple distinction may help the
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