Quick Answer
Hedge funds avoid 1940 Act registration through the 100-beneficial-owner or qualified-purchaser private-fund exemptions, layered on top of a Regulation D private placement. They offer limited liquidity, lock-ups, "2 and 20" fees, and wide-ranging strategies. Investors get a Schedule K-1, not a 1099, and may owe tax on phantom income.
Hedge funds operate outside the regulatory framework that governs mutual funds. This section walks through how that exemption structure works, what makes hedge funds behave differently from registered investment companies day to day, and how fund of funds change the calculus for smaller investors.
How Do Hedge Funds Avoid Registering With the SEC?
Most hedge funds combine two separate layers of exemption: one that keeps the fund itself from having to register as an investment company, and one that keeps the offering of its interests from having to register as a public securities offering.
Layer 1: keeps the fund from registering as an investment company. These two exemptions from the Investment Company Act of 1940 are based on who owns the fund, not on the securities offering:
| Exemption | Beneficial-Owner Cap | Ownership Requirement | Key Restriction |
|---|---|---|---|
| 100-beneficial-owner exemption | No more than 100 beneficial owners | No accredited-investor requirement in the exemption itself | Cannot make or propose a public offering |
| Qualified-purchaser exemption | No owner cap under this exemption | Owned exclusively by qualified purchasers ($5M+ in investments for individuals, $25M+ for institutions on a discretionary basis) | Cannot make or propose a public offering |
Layer 2: keeps the offering itself exempt from Securities Act registration. Most hedge funds sell their interests as a Regulation D private placement, and it is Regulation D, not the 1940 Act exemption, that imposes an accredited-investor standard on purchasers:
| Private-Placement Exemption | Investor Limit | Investor Qualification |
|---|---|---|
| Accredited-plus-sophisticated exemption | Unlimited accredited investors, plus up to 35 financially sophisticated non-accredited investors | No general solicitation or advertising |
| Accredited-only, general-solicitation exemption | Accredited investors only | Issuer must take reasonable steps to verify accredited status; general solicitation is permitted |
- Registered hedge funds: A small number of hedge funds voluntarily register under the 1940 Act and file with the SEC, making shares available to a wider investor base
- Unlike mutual funds, hedge funds are not required to calculate daily net asset value (NAV), limit leverage, or deliver a prospectus
Exam Tip: Gotchas
- The 100-beneficial-owner exemption caps the fund at 100 beneficial owners, NOT 100 investors. Beneficial ownership is counted at the entity level; a fund of funds investing in the hedge fund may count as a single beneficial owner, but look-through rules can apply.
- Don't confuse the two layers. The 1940 Act exemption controls whether the FUND must register as an investment company, based on who owns it. Regulation D controls whether the OFFERING must register as a public securities offering, based on who is being sold to. The accredited-investor requirement comes from Regulation D, not from the 100-owner exemption itself.
- The qualified-purchaser exemption has no fixed owner cap in the exemption itself, unlike the 100-owner accredited-investor exemption. Qualified purchaser is also a much higher bar than accredited investor.
Blind Pools and Blank Check Companies
- A blind pool raises capital without disclosing specific investments; investors trust the manager's strategy and judgment
- A blank check company, also called a Special Purpose Acquisition Company (SPAC), has no business operations and raises funds solely to acquire or merge with another entity, typically within 24 months
What Makes Hedge Funds Different From Mutual Funds?
Hedge funds differ from registered investment companies in several ways:
Liquidity and Lock-Up Provisions
- Limited or no liquidity: Hedge fund shares are not traded on exchanges; redemptions are typically restricted to specific windows (quarterly or annually)
- Lock-up provisions: Investors must commit capital for a minimum period (commonly 1-2 years) during which withdrawals are prohibited or subject to early redemption penalties
- Contrast with mutual funds: mutual fund shares can be redeemed at NAV on any business day
Exam Tip: Gotchas
- Hedge funds have NO daily redemption. Unlike mutual funds, which must redeem shares at NAV on any business day, hedge fund investors may be locked in for 1-2 years with redemptions only at quarterly or annual windows.
Fee Structure: "2 and 20"
The typical hedge fund fee structure is known as "2 and 20":
| Fee Component | Amount | Based On |
|---|---|---|
| Management fee | 2% annually | Assets under management (AUM) |
| Performance/incentive fee | 20% of profits | Gains above a benchmark (high-water mark) |
- The high-water mark ensures performance fees are only charged on new profits. The manager must recover any prior losses before earning incentive fees
- Total fees are significantly higher than mutual fund expense ratios (typically 0.5%-1.5%)
Think of it this way: If a hedge fund starts at $100, drops to $80, then climbs back to $100, the manager earns zero performance fees on that recovery. The "high-water mark" is $100, and the manager only collects the 20% incentive fee on gains above $100.
Limited Transparency
- Hedge funds are not subject to the same disclosure requirements as registered investment companies
- Investors receive limited information about specific portfolio holdings, leverage levels, and counterparty exposures
- No requirement for standardized prospectus delivery
Investment Strategies
Hedge funds employ a wide array of strategies unavailable to or restricted for registered investment companies:
| Strategy | Description |
|---|---|
| Long/short equity | Simultaneously buying undervalued and shorting overvalued securities |
| Global macro | Bets on broad economic trends using currencies, interest rates, commodities |
| Event-driven | Targets mergers, acquisitions, bankruptcies, restructurings |
| Market-neutral | Offsetting long and short positions to eliminate market risk |
| Distressed debt | Purchasing debt of companies in or near bankruptcy |
- Heavy use of leverage, short selling, and derivatives (strategies that are restricted or prohibited for mutual funds)
- Some hedge funds invest in tangible/real assets (real estate, commodities, precious metals) alongside financial instruments
What Is a Fund of Funds?
A fund of funds is a pooled investment that allocates capital across multiple hedge funds rather than investing directly in securities.
Advantages
- Diversification across multiple managers, strategies, and asset classes
- Lower investment minimums than direct hedge fund investment (may start around $25,000 vs. $1 million+)
- Professional manager selection: the FOF manager performs due diligence on underlying hedge funds
- May be registered under the 1940 Act, making it accessible to non-accredited investors
Disadvantages
- Double layer of fees: The fund of funds charges its own management and performance fees ON TOP of the fees charged by each underlying hedge fund
- Diluted returns: The additional fee layer reduces net returns to investors
- Less control: Investors cannot choose which specific hedge funds receive their capital
Exam Tip: Gotchas
- Fund of funds charge fees ON TOP of the underlying hedge fund fees. The primary disadvantage of a fund of funds structure is this "double fee" layer and its impact on investor returns.
- A fund of funds may be registered under the 1940 Act, making it accessible to non-accredited investors, but the underlying hedge funds typically are not registered.
How Are Hedge Fund Distributions Taxed?
Hedge fund tax reporting differs fundamentally from mutual fund tax reporting:
| Feature | Hedge Funds | Mutual Funds |
|---|---|---|
| Tax form | Schedule K-1 (partnership) | Form 1099-DIV / 1099-B |
| Income character | Passed through (retains character) | Distributed as dividends or capital gains |
| Phantom income | Yes: taxed on allocated gains even if not received in cash | No: only taxed on actual distributions |
- Income retains its character as passed through: short-term capital gains, long-term capital gains, interest, and dividends are each reported separately on the K-1
- Phantom income: Investors may owe taxes on gains that were reinvested by the fund rather than distributed as cash
- Registered hedge funds that distribute income follow standard investment company distribution rules
Think of it this way: Suppose the hedge fund makes $1 million in trading profits but reinvests all of it. As a partner, your share of that $1 million shows up on your K-1, and you owe taxes on it even though you never received a check. That is phantom income.
Exam Tip: Gotchas
- Hedge fund investors receive Schedule K-1s, not 1099s. This is because hedge funds are structured as partnerships, not investment companies.
- Phantom income means you can owe taxes on money you never received. The fund allocates gains on paper even if profits were reinvested rather than distributed as cash.
What Should You Check on Exam Day?
- Hedge funds combine two exemption layers: a 1940 Act exemption (100-beneficial-owner or qualified-purchaser) so the fund itself does not register as an investment company, plus a Regulation D private placement so the offering does not register under the Securities Act; a small number instead register voluntarily.
- Match the 1940 Act exemption to its owner cap: 100 beneficial owners for the general exemption, no owner cap for the qualified-purchaser exemption (which instead requires exclusively qualified-purchaser ownership). Neither exemption permits a public offering. The accredited-investor requirement comes from Regulation D, a separate layer, not from the 100-owner exemption itself.
- No daily NAV, no leverage limit, no prospectus delivery requirement, and typically no exchange trading; redemptions happen only at scheduled windows, often after a 1-2 year lock-up.
- "2 and 20" means a 2% management fee on assets plus a 20% performance fee on profits above the high-water mark; the manager recovers prior losses before earning new incentive fees.
- A fund of funds diversifies across managers but layers its own fees on top of each underlying fund's fees, and it may be 1940 Act-registered even when the underlying hedge funds are not.
- Hedge fund investors get a Schedule K-1, not a 1099, and can owe tax on phantom income: allocated gains the fund reinvested rather than distributed in cash.