LOS q: Explain the typical structure of a hedge fund, including the fee structure and the rationale for high water marks.

Q1. In the structure of a hedge fund, which of the following is least accurate concerning a lock-up period? A lock-up period:

A)   establishes a minimum investment period for each investment.

B)   establishes a cap on new investment.

C)   establishes exit windows.

Q2. With respect to the operations of a hedge fund, a high water mark is designed to:

A)   prevent a manager from being paid twice for the same gains of the fund.

B)   prevent a manager from allowing the fund to become so large that it cannot be managed efficiently and/or use its selected style effectively.

C)   put a cap on the assets-under-management fee.

Q3. Which of the following would be among the most common compensation of the manager of a hedge fund?

A)   An assets-under-management fee of 20% and an incentive fee of 1.5% of the dollar return over the initial investment.

B)   An assets-under-management fee of 1.5% and an incentive fee of 20% of the dollar return over the initial investment.

C)   An assets-under-management fee of 1.5% and a lock-up fee of 20%.

LOS q: Explain the typical structure of a hedge fund, including the fee structure and the rationale for high water marks. fficeffice" />

Q1. In the structure of a hedge fund, which of the following is least accurate concerning a lock-up period? A lock-up period:

A)   establishes a minimum investment period for each investment.

B)   establishes a cap on new investment.

C)   establishes exit windows.

Correct answer is B)

A lock-up period is a common provision in hedge funds. Lock-up periods limit withdrawals by requiring a minimum investment period, e.g., 1-3 years, and designating exit windows. The rationale is to prevent sudden withdrawals that could force the manager to have to unwind positions.

Q2. With respect to the operations of a hedge fund, a high water mark is designed to:

A)   prevent a manager from being paid twice for the same gains of the fund.

B)   prevent a manager from allowing the fund to become so large that it cannot be managed efficiently and/or use its selected style effectively.

C)   put a cap on the assets-under-management fee.

Correct answer is A)

The high-water mark provision is designed to prevent payment to a manger twice for the same gains. If a fund goes from $100 to $ffice:smarttags" />120 in value and the manager earns an incentive fee for the $20 gain, and then the fund’s value goes down to $110 and back to $120, the manager will not earn a fee for the gain from $110 back to $120. $120 was a “high water mark.”

Q3. Which of the following would be among the most common compensation of the manager of a hedge fund?

A)   An assets-under-management fee of 20% and an incentive fee of 1.5% of the dollar return over the initial investment.

B)   An assets-under-management fee of 1.5% and an incentive fee of 20% of the dollar return over the initial investment.

C)   An assets-under-management fee of 1.5% and a lock-up fee of 20%.

Correct answer is B)

The most common compensation structure of a hedge fund consists of an assets-under-management fee, or AUM fee, of about 1%-2% and an incentive fee of 20% of “profits”. The definition of profit should be spelled out in the terms of the investment. It could be dollar return over the initial investment, for example, or the dollar return above the initial investment increased by some hurdle rate.

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