Clients often come to us wanting to start an investment fund knowing what they want to invest in, but they may not know the correct terminology. For instance, they may say they want to start a “real estate hedge fund” (which is a real thing), when in truth, they want to start a real estate fund (which is something completely different).

Read on to learn more about the different types of investment funds and see which matches your investment strategy.

Hedge funds

Hedge funds invest in publicly traded securities, such as stocks, bonds, or options. Hedge funds may invest on margin, meaning that they borrow money from a broker to buy securities, with the securities serving as collateral for the loan.

Hedge funds offer redemption privileges for investors (after a lock-up period, generally one year), which is possible because of the liquid nature of the assets they hold. The hedge fund manager is entitled to a management fee and a performance fee. The management fee is a percentage of the fund’s assets under management (usually 1% to 2%) and is assessed monthly, quarterly, or annually. The performance fee is a percentage of the fund’s realized and unrealized gains (i.e., the amount that the fund’s portfolio exceeds its cost basis in the securities it holds). The performance fee is usually 20% of the fund’s gains, although this can be higher if the management fee is lower or the fund manager has a stellar track record. The performance fee is usually calculated and paid quarterly or annually.

Because the value of a hedge fund’s securities vary daily, the fund manager’s performance fee is subject to a “high water mark.” A high water mark is the highest level of the fund’s performance for which a performance fee has been paid; if the fund’s value slips below that level at the next performance fee calculation date, then no performance fee is paid at that time. Once the fund’s performance exceeds the prior level at which a performance fee has been earned, then a subsequent performance fee will be earned.

Hedge funds sometimes also have “hurdle rates”, which are a minimum return that fund investors must achieve before the fund manager is entitled to a performance fee.

Hedge funds are limited to 100 investors, unless the investors are qualified purchasers ($25 million in investments; $5 million in certain circumstances).

Commodity funds

Commodity funds invest in futures traded on the commodities exchange, such as gold, crude oil, stock indices, and currencies. Commodity funds are similar structurally to hedge funds in that they offer liquidity to fund investors and charge management fees and performance fees. See this article for more information on the distinctions between hedge funds and commodity funds.

Commodity funds do not have a limit on the number of investors.

Private equity funds

The term “private equity fund” is a generic term for a fund that invests in securities, but is not a hedge fund. A buyout fund is a type of private equity fund. A buyout fund raises money from investors to acquire one or more companies.

Another type of private equity fund is a sector-specific fund, for instance, a fund that invests in healthcare technology companies. A fund of this sort would take either a minority or majority ownership interest (i.e., less than entire ownership) in companies that match the fund’s investment parameters.

Private equity funds generally seek to purchase interests in companies with the purpose of selling the company, either to a strategic buyer, to a financial buyer (i.e., another private equity fund), or take the company public via an initial public offering.

If the private equity fund’s portfolio companies pay dividends to the fund, those can either be distributed to the fund’s investors or retained by the fund to finance other investments during the fund’s investment period (more on this below).

The general partner of a private equity fund is paid a carried interest, that is, a percentage of the fund’s realized gains upon selling its investments. The carried interest is only paid once the fund’s investors have received their capital back. Most funds also include a preferred return, which is an additional amount that has to be paid to the fund’s investors before the general partner is paid its carried interest.

The investment manager of the fund is also paid a percentage of each investor’s deployed capital as a management fee.

Larger private equity funds raise capital in tranches through capital commitments. For instance, an investor might commit to investing $25 million in the fund, but would only invest $5 million upfront. The other $20 million would be called by the fund as needed to finance investments and expenses of the fund.

Funds that raise capital through capital commitments have a commitment period during which they the fund can call capital commitments for investments. Beyond the commitment period, the fund can only call upon commitments to pay fund expenses.

Private equity funds also have an investment period, which is the period during which the fund can make investments. This usually (but not always) corresponds to the commitment period, if there is one.

Private equity funds do not permit redemptions during the life of the fund. As a result, investors’ capital is committed during the life of the fund.

Private equity funds are also limited to 100 investors unless the investors are qualified purchasers.

Private equity funds come in many flavors, and as a result, their documentation is often bespoke.

Venture capital funds

Venture capital funds are much like private equity funds in terms of structuring. As with private equity funds, the general partner is entitled to a carried interest, and the investment manager is paid a management fee based upon deployed capital.

That being said, there are three main differences between private equity funds and venture capital funds. First, a venture capital fund often achieves liquidity in its investments by selling them during or after the company goes public via an initial public offering. Second, smaller venture capital funds (up to $10 million) can have up to 250 investors, significantly more than the 100 investors permitted in private equity funds. Third, venture capital funds must invest at least 80% of their assets in securities issued directly by operating companies.

Larger venture capital funds are limited to 100 investors unless the investors are qualified purchasers.

Real estate funds
Real estate funds invest directly in real estate or in real estate-related assets, such as mortgage loans. They may also engage directly in real estate lending.

The most successful real estate funds limit their investments to predefined verticals in a defined geographic area, for instance, retail shopping centers in San Antonio with a 5% or greater cap rate.

Real estate funds are structured similarly to private equity funds in that the general partner is entitled to a carried interest once investors’ invested capital plus any preferred return is paid (usually upon sale or refinancing of the fund’s properties). The general partner also shares in operating income paid by the fund’s investments.

Depending on the nature of the fund’s investments, it may be possible to have an unlimited number of investors in the fund, as opposed to the 100 investor limit in other types of funds. However, investment adviser registration may be necessary in some cases if there are more than 100 investors.
Hybrid funds
Hybrid funds combine two or more of the above models. For instance, a hedge fund may invest in privately offered securities, which would normally be the domain of a private equity fund or venture capital fund. In such a scenario, liquidity would be a consideration, since the portion of the portfolio allocated to private investments would be illiquid, which could therefore prevent the fund from redeeming the interests of its investors. There are certain workarounds for this, however.

Another type of hybrid fund is a hedge fund and commodity fund. These funds invest both in publicly traded securities and futures or currencies. In this scenario, the investment manager is usually required to register as a commodity pool operator and may need to register as an investment adviser as well. See this article for additional information on commodity funds.

Whitley LLP Attorneys at Law has helped many fund sponsors form many different types of funds. We make it easy to start your fund. Please contact us today to see how we can help you get your fund off to a successful start.