Hedge Fund Business Models

ital, other parties must bear part of the loss, because the fund investors are
treated like equity investors in a corporation. They cannot be required to
invest more money beyond their committed amount.
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When hedge funds lose more than 100 percent of their capital, the loss
is shared by the secured and unsecured creditors. The secured creditors
have the benefit of collateral, which may greatly reduce the chance of loss
due to the bankruptcy of a hedge fund customer. The losses in excess of
paid-in capital are generally shared by the unsecured creditors and the se-
cured creditors (to the extent that their security is insufficient).
Liability of a C Corporation
Figure 5.1 shows the way losses are shared in a C corporation. The area of
the boxes represents the relative size of the assets, liabilities, and equity
(also called capital in a hedge fund).
If the assets decline in value, the loss is borne by the equity holders.
Just as debt holders do not participate in the rise in asset values, they also
don't participate in the losses, as long as there is sufficient equity in the
company (see Figure 5.2).
If the losses continue, the debt holders may be exposed to risk that
they will not be completely repaid. Figure 5.3 shows how a loss may ex-
ceed the equity and result in losses for the debt holders, as well. In Figure
5.3, losses have exceeded the value of the paid in capital. Liability holders
share in the loss because the equity holders cannot be required to infuse ad-
ditional capital and (except in circumstances involving fraud by the equity
FIGURE 5.1
Starting Levels for Asset Values
Hedge Fund Business Models
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