Management company

In modern hedge fund structures, the management company operates as one part of a multi-entity framework. This framework includes separate fund general partner entities, with both components typically owned directly by the fund's founders or key personnel. The management company usually operates as a limited partnership and serves as the public face of the organization.

This entity handles several critical functions. It manages employment matters, secures office facilities, and maintains technological infrastructure. The management company also acquires research services, holds proprietary intellectual property, and establishes investment management agreements with the funds. In return for these services, it receives management fees Management fee Management fee refers to a recurring fee, typically calculated as a percentage of assets under management, that hedge funds charge investors to cover operational and administrative expenses regardless of fund performance. .

Hedge fund management businesses operate as closely held private enterprises. This structure results in limited transparency regarding their internal terms and structural features. However, the industry has evolved significantly over the past two decades.

The industry has moved from viewing portfolio managers as the sole value drivers toward recognizing the importance of sustainable business franchises. This shift reflects growing investor sophistication and the recognition that successful investment management businesses create substantial goodwill and franchise value for their owners.

The management company serves as the operational center of the hedge fund business. It handles all day-to-day operations that keep the fund running smoothly. These operations include hiring and managing employees, maintaining physical office space and technological systems, conducting research and analysis, and developing proprietary trading systems and investment methodologies.

The management company also manages client relationships and communications with investors. It ensures regulatory compliance and handles required reporting to government agencies and investors. While fund general partners have the legal authority to make investment decisions, they operate as special purpose entities. These general partner entities do not have employees, sign leases, purchase research subscriptions, or conduct other operating activities.

Management companies generate income through several different streams. They typically receive asset-based management fees, which are calculated as a percentage of the total assets under management. These fees provide steady, predictable income regardless of investment performance.

The companies also receive performance-related compensation that is structured as fees rather than profit allocations. Additionally, they may earn various other fee-based income streams. These include administrative fees for handling operational tasks and, particularly for credit or private equity strategies, transaction-related fees. Transaction fees can include deal fees for arranging investments, due diligenceThe comprehensive investigation and evaluation process conducted before making an investment or business decision. fees for evaluating potential investments, and director compensation for serving on portfolio companyCompanies in which a fund has made an investment, typically through equity or debt securities. boards.

Fund general partners receive their compensation differently. By contrast, they receive performance-based compensation that is structured as profit allocations rather than fees.

Management companies are commonly organized as limited partnerships because this structure offers significant tax advantages. Distributions made to limited partners from such entities generally are not subject to Medicare taxes, provided these distributions exceed their guaranteed payments or draws. The current top Medicare tax rate stands at 3.8 percent, making this tax savings substantial.

However, limited partnerships require a general partner with management authority and unlimited liability. To address this requirement while protecting key individuals, founders typically establish a limited liability company to serve as the general partner. This arrangement provides liability protection for the key people while maintaining the tax benefits.

The simplest organizational approach would involve key persons owning interests in a single LLC. This structure would allow all business economics to flow into one entity under a single operating agreement. However, this structure typically proves less tax-efficient and concentrates liability unnecessarily under current tax law.

The alternative is a pyramid structure, where the management company owns fund general partners as subsidiaries. This pyramid structure is typically reserved for specific situations. These situations include cases involving institutional ownership or strategic acquisitions where tax optimization is less critical than other business considerations.

The separation of revenue streamsThe separation of hedge fund manager revenue between management fees paid to the management company and performance-based compensation allocated to the general partner, providing tax advantages compared to having all revenue flow through a single entity. in multi-headed structures provides significant tax benefits. These benefits are particularly valuable for management companies located in high-tax jurisdictions. For firms operating in New York City, this structure can reduce exposure to the city's 4 percent Unincorporated Business TaxLocal business tax imposed by New York City on unincorporated businesses operating within the city..

This tax applies to business income sourced to the city from noncorporate businesses that receive fee income. However, the tax generally excludes passive entities that do not receive such fee income. By separating different types of income into different entities, firms can minimize their overall tax burden.

Management company compensation frameworks reflect the philosophical approach of the founders toward rewarding performance and building long-term value. The approach to compensation varies significantly across firms, but most follow some common patterns.

Non-investment staff typically receive guaranteed minimum profit participation with eligibility for additional profits at the founders' discretion. This approach ensures basic compensation while providing upside potential based on firm performance.

Firm economics are generally structured around two primary components. The first component involves profit sharing arrangements that provide participation in annual firm profits or returns from specific funds or strategies. The second component includes equity interests that provide rights to proceeds from any future sale of the business.

The most senior investment professionals are often, but not always, partners of the firm. Other than a modest base draw for partners or salary for employees of between $250,000 and $500,000, their compensation can follow different approaches.

Some firms use highly systematic approaches that essentially follow an individual performance model. Under this model, investment professionals and their teams receive shares of the profits they generate after accounting for direct costs and overhead allocation. This approach directly ties compensation to individual contribution.

Alternatively, compensation may be determined more holistically. This approach considers not only individual profit and loss generation but also broader contributions to the investment team and overall business success. Factors might include mentoring junior staff, business development activities, or strategic planning contributions.

Multi-headed structures require more extensive documentation and operational management compared to simpler alternatives. Each entity requires separate governing agreements and independent books and records. When desired, each entity also requires separate audit processes.

Additionally, the business's cash flows and economics cannot be consolidated easily across multiple entities. This separation means that tracking performance and managing day-to-day operations becomes more complex. This increased complexity results in higher administrative costs and operational burden for the firm.

When successful, the investment management business creates substantial goodwill and franchise value for its owners. The management company structure determines how these economics are shared among the firm's principals and how governance decisions are made.

Key elements that define these structures include several important components. These include economics (how profits and losses are shared), governance (how decisions are made), vesting (how ownership rights are earned over time), and non-compete provisions (restrictions on departing employees). They also include key person provisions (what happens if critical people leave), succession planning (how leadership transitions occur), and processes for admitting new partners.

For multi-strategy or multi-product managers, additional complexity arises in allocating costs and revenues across different strategies, products, and teams. Different investment strategies may have vastly different cost structures, risk profiles, and profitability.

Many firms implement internal "transfer pricingAccounting methodologies used to allocate costs and revenues between different divisions or entities within the same organization to ensure fair distribution of shared resources and determine appropriate compensation." methodologies to address this challenge. These methodologies ensure fair allocation of shared resources like research, technology, and administrative support across different business lines. They also help determine appropriate compensation across teams that may have different performance characteristics.

The management company's structure significantly impacts several key business capabilities. These include the firm's ability to retain talent, raise capital from investors, and eventually transition leadership. The structure also affects the firm's ability to monetize value through a sale to a larger firm or through a public offering.