Fund Structure, Leverage & Prime Brokerage

Understanding hedge fund strategies (previous chapter) is only half the picture. This chapter covers the actual legal and operational structure underneath — how a fund is organized, how it borrows, and who provides the infrastructure that makes it all work.

LP/GP structure — who's actually who

A hedge fund is typically structured as a limited partnership: investors are limited partners (LPs), contributing capital but not involved in day-to-day management, with liability limited to their investment. The fund manager operates as the general partner (GP), making all investment decisions and earning the "2 and 20" fee structure from Finance 101 — this is the same basic LP/GP structure used in private equity, applied to a liquid-markets strategy instead of buying whole companies.

Leverage — how borrowed money amplifies everything

Many hedge fund strategies use leverage — borrowing capital or securities to take a larger position than the fund's own capital alone would allow, amplifying both potential gains and potential losses.

Worked example: a fund has $100M of capital and uses 3x leverage, giving it $300M of actual market exposure. A 5% favorable move on that $300M position generates $15M of profit — a genuine 15% return on the fund's actual $100M capital base, not just 5%. But a 5% adverse move produces a $15M loss — also 15% of capital — and if losses continue, the fund can face a margin call: the prime broker (below) demanding additional collateral to maintain the leveraged position, forcing the fund to either post more capital or reduce the position, often at the worst possible time (into a falling, illiquid market).

Prime brokerage — the infrastructure most people never think about

A prime broker (typically a large investment bank's dedicated division) provides a hedge fund with the actual infrastructure to operate: lending securities for short positions, providing the leveraged financing described above, custody of assets, and trade execution and clearing services. This relationship is genuinely consequential — the 2008 financial crisis included real, serious stress specifically around prime brokerage relationships, when concerns about a broker's own solvency created real risk for the hedge funds relying on it for financing and custody, a structural vulnerability the industry has since worked to address through more diversified prime broker relationships.

Redemption terms — why hedge fund capital isn't as liquid as a stock

Unlike a public mutual fund (redeemable daily), hedge funds typically impose real structural constraints: a lock-up period (capital can't be withdrawn for an initial period, often a year or more), redemption notice periods (investors must request withdrawal well in advance, often 30-90 days), and gates (a fund's right to limit the total amount redeemed across all investors in a given period, preventing a rush of withdrawals from forcing fire-sale asset liquidations that would harm remaining investors). These terms exist specifically because many hedge fund strategies hold genuinely less liquid positions than a mutual fund's typical daily-tradeable stock portfolio, and a mismatch between fund liquidity and investor redemption rights is a real, well-documented source of fund failures during periods of market stress.

The connective thread

Leverage, prime brokerage, and redemption terms all exist for related reasons: hedge fund strategies often take on real risks (leverage, illiquid positions, complex derivatives) that a fund's basic legal and operational structure has to be genuinely built to withstand — understanding this structure is what separates knowing a fund's stated strategy from actually understanding its real risk.