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Hedge Fund Business Models
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Hedge Fund Business Models

CREATING LIMITED LIABILITY INVESTMENT POOLS
Investors who buy certain types of assets (notably real estate) may borrow
money that could create a situation where investors must commit addi-
tional capital or otherwise repay debt obligation. In contrast, when buying
a common stock, bond, or mutual fund, an investor can rely on losing no
more than the committed investment. Hedge fund investors would also like
to limit their exposure to their committed capital.
Need for Limited Liability
An investor in a common stock has made an equity investment in a corpo-
ration. The corporation may have issued debt in addition to stock. This
debt creates leverage because the value of the assets is greater than the
value of the equity. In the absence of default, equity holders receive all the
gains if the assets rise in value and suffer all of the losses if the assets de-
cline in value. Assets, however, sometimes decline in value by more than
the total amount of equity. If losses exceed the capital of the corporation,
lenders begin to share in the losses because equity holders cannot be re-
quired to invest more than their original paid-in investment.
This corporate structure would seem to work well as a structure for a
levered pool of investments. Structured as a corporation, a hedge fund
would be a limited liability investment that could use leverage, but the in-
vestors would never be required to make additional investments, even in
the event of default. Further, the borrowings to finance levered hedge fund
positions resemble corporate borrowings.
Indeed, the corporation is a common structure to use to organize
hedge funds located in low-tax or no-tax domiciles. In areas with substan-
tial corporate taxation, this structure often results in double taxation of in-
vestment returns. For this reason, hedge funds organized where the
investment returns are subject to corporate taxation (certainly, the United
States and Europe) use partnerships or other business structures that pass
taxable income through to investors without paying tax as a fund (see
Chapter 10). Those partnerships or other limited liability entities may
leave the hedge fund sponsors with considerable liability losses from bad
investment returns in the investment portfolios.
Who Bears the Loss in a Hedge Fund Default?
Hedge funds often invest more than their capital in assets and may have
short positions. For either reason, hedge funds may lose more than the cap-
ital invested in the fund. If a hedge fund loses more than the investors' cap-
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