Operating agreement

An operating agreement serves as the main rulebook for hedge funds that are set up as limited liability companies (LLCs). This document creates the basic framework for how the fund operates, how it's managed, and how money flows in and out of the organization.

Most domestic hedge funds are actually organized as Delaware limited partnerships rather than LLCs. However, LLCs offer an alternative structure. Each type of entity—whether LLC or partnership—has its own foundational governing document that sets out the rules and procedures.

LLCs typically designate one or more managing members to run the day-to-day operations. Alternatively, they may have a managing board or hire non-member managers who don't own any equity but have broad authority to make management decisions.

Like limited partnerships, LLCs qualify as pass-through entitiesA business structure that does not pay taxes at the entity level, instead passing income and tax attributes through to its owners or investors who report them on their individual tax returns. for federal tax purposes. This means the entity itself doesn't pay corporate income tax. Instead, profits and losses flow through to the individual members, who report them on their personal tax returns.

Delaware remains the most popular state for forming domestic hedge funds because of its well-developed body of legal precedents and business-friendly courts. However, LLCs do present some disadvantages compared to limited partnerships.

Since LLCs are a relatively recent legal innovation, there is less extensive case law available to guide decision-making in complex situations. Additionally, some foreign jurisdictions classify LLCs as corporations for tax purposes rather than recognizing their pass-through characteristics. This can create complications for international investors.

An operating agreement works much like a combination of corporate bylaws and shareholder agreements. LLCs operate under contractual principles rather than rigid legal requirements set by state law. This gives fund organizers significant flexibility in designing key aspects of the business.

For example, the agreement can customize voting structures, management authority, profit-sharing arrangements, and ownership participation in ways that best serve the organization's specific needs. Management authority can be concentrated in a single person, or it can be spread among a management committee that functions like a corporate board of directors. The agreement can also give certain owners special consent rights over major business decisions.

LLCs typically designate one or more managing members to run the day-to-day operations. Alternatively, they may have a managing board or hire non-member managers who don't own any equity but have broad authority to make management decisions.

An important advantage for managing members is that they enjoy limited liability protection. This means they generally aren't personally responsible for the LLC's debts and obligations, even though they actively manage the company. This protection differs from the structure of limited partnerships, where general partners typically face personal liability. Meanwhile, investors participate as regular LLC members and also receive limited liability protection.

The operating agreement must address several essential areas. These include general company governance rules, the scope of managing member authority, management fee 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. structures, and clauses that protect members from certain liabilities and provide legal indemnificationLegal protection where one party agrees to compensate another for losses or damages arising from specified events or activities..

The agreement also covers how profits and losses are allocated among members, procedures for valuing the company, processes for admitting new members, rules for member withdrawals, and various tax-related matters.

One key flexibility of LLCs is in structuring economic arrangements. The agreement can grant each member both profit-sharing rights and ownership equity. Alternatively, it can provide senior members with full economic rights while limiting junior partners to profit participation only, without actual ownership stakes.

When members leave the organization, the agreement may subject them to buyout provisions or require them to forfeit some shares. In other cases, departing partners may continue to receive profit distributions through tail arrangementsContractual provisions allowing departing partners to continue receiving profit distributions for a specified period after they leave the organization. that extend over a specified period.

Fund sponsors typically begin operations using short operating agreements that contain only the most essential terms. These abbreviated agreements allow the fund to get started quickly while the organizers work out more detailed arrangements.

Once the fund sponsors have finalized the economic terms and operational procedures for their management entities, they usually replace these initial short agreements with comprehensive long-form agreements. Ideally, this transition occurs before the fund officially launches and begins accepting investor capital.

These long-form agreements include detailed governance provisions, member allocation arrangements, and procedures for member withdrawals. They also contain sophisticated provisions for exculpationContractual provisions that excuse or limit liability for certain actions or decisions, protecting parties from legal responsibility under specified circumstances. and indemnification, economic participation among members, restrictive covenants, and criteria for admitting future members.

Additional provisions typically address terms for departing members, penalties for engaging in competitive activities, and frameworks for employee retention and compensation. These comprehensive agreements provide the detailed operational structure needed as the fund grows and becomes more complex.

In complex organizational structures involving multiple related entities, fund general partners often operate as limited liability companies. In these arrangements, each LLC serves as the general partner for funds that are structured as partnerships.

While these fund general partners have legal authority to make investment and operational decisions in their role as general partners, they typically function as special purpose entitiesLegal entities created for specific limited purposes rather than conducting broad business operations, commonly used to isolate risks or achieve particular regulatory or tax objectives.. This means they don't have employees, lease agreements, or make research purchases. Instead, they serve primarily as legal vehicles rather than as operating businesses.