Hedge Fund Series I Part 2 I What entity should I use when structuring my hedge fund?
This is our second post in our series on understanding hedge funds. Today, we will be discussing the various entity structures for your hedge fund and why it is important to choose the proper entity.
Hedge funds aren’t set up as corporations due to tax concerns
Before the 1980’s, hedge funds were almost always set up as limited partnerships. A limited partnership has both general and limited partners.
The general partners participate in management and share the profits and losses. General partners are also jointly and severally liable for all debts and obligations of the partnership.
Limited partners, however, generally do not participate in management, and are only liable to the extent of their investment in the partnership.
In the traditional structure investors are limited partners (LPs), and the fund managers are general partners (GPs).
The downside to this setup is that the general partners have personal liability for company debts. It is possible to get around this by having a limited liability entity be the general partner, but there are more simple options that have better insulation from liability.
Limited Liability Companies
LLCs are a relatively new form of company. In 1977 the state of Wyoming passed a law that created LLCs for the first time. Delaware didn’t have its own LLC law since 1991. In the last few decades, LLCs have become an increasingly common structure for hedge and other pooled funds.
A Limited Liability Company (LLC) is an unincorporated entity in which one or more individuals called “members” own the company but are not personally liable for the company’s debts. Members of an LLC have great flexibility in structuring the management of their venture through the LLC’s governing document, the “operating agreement.”
There are two main reasons an LLC is a better option that a limited partnership. First the managers of the fund set up as an LLC won’t have personal liability like they would if the fund was setup as a limited partnership. Second, LLCs have a more flexible framework enabling managers a bit more freedom in how they operate their fund.
Often times the manager will setup an LLC to be the managing member of the Fund’s LLC. This adds a second layer of protection for the manager and it enables the manager to build a track record for their management company.
Limited Liability Limited Partnerships
To further complicate the choice of entity analysis, there is a relatively new entity that can be utilized for a hedge fund called a limited liability limited partnership. In an LLLP, by having the limited partnership make an election under state law, the general partners are afforded limited liability for the debts and obligations of the limited partnership that arise during the period that the LLLP election is in place.
An LLLP is pretty similar to an LLC as far as liability protection goes. But it’s a bit more complex to setup than an LLC and there are a few more administrative hassles to deal with on an on-going basis.
There’s another relatively new entity option called Series LLCs. They’re basically one LLC with subsidiary LLCs built in. But the law around Series LLCs is still pretty sparse, and it’s probably worth sticking with something more traditional for the time being. Check out our Series LLC series for more information on this entity type.
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