7.5 Hedge Funds and Other Alternatives

Accredited Investor Standard

Most hedge funds, private equity, and venture funds are sold in private placements under Regulation D, which limits them largely to accredited investors. Know the individual thresholds cold.

The SEC's 2020 amendments added the license pathway and the "spousal equivalent" language to the joint-income test — both are testable updates. Entities qualify with over $5 million in assets, if all equity owners are accredited, or by being a bank, insurer, or registered investment company.

Why the gate exists: Regulation D offerings skip the full SEC registration and prospectus that protect retail buyers, so the rule restricts them to investors presumed able to evaluate the risk and absorb a total loss. Note the primary-residence exclusion in the net-worth test — a person with a $900,000 portfolio and a $2 million paid-off house does not qualify on net worth, because the home is excluded. The exam likes to slip the residence into the math to see if you remember to exclude it.

Keep accredited-investor status separate from the higher qualified purchaser ($5 million in investments) standard used for the largest private funds.

Hedge Funds

A hedge fund is a privately offered pool that pursues absolute returns using leverage, short selling, and derivatives — tools mutual funds are largely restricted from using.

"2 and 20" Fees

The classic hedge-fund fee is "2 and 20": a 2% annual management fee on assets under management, plus a 20% performance (incentive) fee on profits. A high-water mark ensures the manager earns the performance fee only on net new gains — if the fund loses money, it must climb back above the prior peak before the 20% applies again.

Common Strategies

• Long/short equity — buy undervalued names, short overvalued ones.
• Global macro — position around macroeconomic and rate trends.
• Event-driven — trade mergers, spin-offs, and bankruptcies (merger arbitrage).
• Arbitrage — exploit pricing gaps between related securities.

Risks: opacity (limited disclosure), lock-ups, leverage that magnifies losses, and heavy manager (key-person) risk. Because a hedge fund need not register as an investment company, it is exempt from the diversification, leverage, and disclosure limits that govern mutual funds under the Investment Company Act — that freedom is the source of both its return potential and its danger. A registered rep recommending one must explain that performance fees, leverage, and lock-ups can all work against an investor in a down year.

Note how the fees compound the risk picture. In a flat year the 2% management fee is still charged on assets, so the investor can lose money to fees even with zero performance fee — a frequent exam point that the 2% is paid regardless of returns while the 20% is only paid on gains above the high-water mark.

Private Equity

Private equity (PE) invests in companies that are not publicly traded.

PE traits the exam tests: long holding periods (7–10 years), capital calls (committed money is drawn down over time, not invested all at once), the J-curve (early negative returns from fees before gains arrive), and illiquidity until an exit event (IPO or sale).

Venture Capital

Venture capital (VC) funds high-growth, early-stage companies through staged rounds — seed, then Series A, then Series B/C/D, then late stage (pre-IPO). The pattern is many failures offset by a few outsized winners that can return 10x–100x. Expect a high failure rate, no public market for the shares, and a 5–10 year horizon.

Putting the Risks Side by Side

Due-diligence rule: Because these vehicles are lightly regulated and disclose little, the registered rep must independently understand the strategy, fee drag, lock-ups, and worst-case loss before recommending one to even an accredited client.