Hedge Fund Accounting

Do not act on any of this information without contacting an attorney, accountant or tax professional.

Choose an Area of Interest:

I'm Starting a Hedge Fund, How Should I Handle My Accounting?

How To Choose A CPA Firm For Your Audit, Tax and/or Back-Office Accounting

Selected Accounting Definitions & Issues

Tax Allocations and Issues

I'm Starting a Hedge Fund, How Should I Handle My Accounting?

When a new hedge fund is created, the fund must keep detailed accounting records. The accounting records for the fund will be compiled mainly from your brokerage statements. Determination of fees(incentive and management) and other expenses will depend on your partnership agreement. Along with determining the profit and loss in your partnership, special attention should be paid to the nature and characteristics of the limited partners in the fund.

You will also want to get audited, your limited partners will demand it and some marketing agents may not work with you if you're not.

How Should A Fund Proceed With Accounting Functions?

Accounting functions can be outsourced to back-office accounting operations firms and CPA firms or the fund can hire an in-house accountant.

An advantage in hiring an in-house accountant, for obvious reasons, is the timeliness of performance data. In-house accountants can also help you with the analysis of your portfolio, and identifying exposure in certain areas. An in-house accountant with an audit and tax background can also ease the burden of the audit and tax duties that a CPA firm provides by preparing a significant portion of the work that a CPA firm would normally do. It is important to hire an individual with a background in investment partnerships, As a former auditor, I have worked on several funds where the accountant erroneously prepared the accounting records or missed some compliance issues because of lack of knowledge of the industry.

Another and cost saving method to handle your accounting functions is to outsource it to firm that exclusively provide this service. There are some firms that can be found on the internet that provide this service

How To Choose A CPA Firm For Your Audit, Tax and/or Back-Office Accounting

A good CPA firm will have knowledgeable staff at all levels. When seeking services, always ask how many professionals are dedicated to the hedge fund practice. Find out how many professionals are in audit and  how many are in tax. If a firm only has two or three professionals dedicated in any of these areas, then they probably aren't committed in the area of hedge funds. Try and meet with the seniors involved in the hedge fund practice area, this group will be the most involved in completing your work. Make sure to ask complex questions about your hedge fund's accounting and tax issues to this group, also test their product knowledge. Meeting with partners is fine, but remember, when one reaches the level of partner they are only interested in the sale and some firms may say anything to get your business. That's why I suggest meeting with the other staff levels, they usually have to pick up the mess. Also ask to see each department's work area.

The firm should also have several hedge fund clients that can be used as references. Most firms will provide a list of their clients, ask if you can contact these clients. Make sure the clients you contact are utilizing the same services that you are seeking. Some firms may do a good job at auditing, but they provide poor tax support.

Selected Accounting Issues


The heart of hedge fund accounting is the partnership allocations. The allocations are then broken into sections called break periods.

Break periods will always occur when a partner withdraws fully or partially, contributes more capital or a new partner is admitted. The break period will usually end on the last day of a given month (dictated by the partnership agreement). The partnership then needs to be valued on that date and the new capital activity and percentages will become effective on the following day (the first of the month). Basically, anything that affects the partnership percentages is going to result in a break period.

Let's use an example to show a typical break period and the allocation of the performance for the break period:

Phil is the general partner of Hedge Fund Homepage Partners, L.P., he has decided to start this partnership. Paul and Gene have also joined in as limited partners. On 1/1/97 they start the partnership, Phil contributes $100,000, Paul contributes $500,000, Gene contributes 200,000. The partnership begins trading and has net income from 1/1/97  -  3/31/97 of  $50,000, on 4/1/97 they add a new partner, Linda, she contributes $250,000. This has now resulted in a 3/31/97 break, with new partnership percentages taking effect on 4/1/97.

On the date of the break period, the revenue and expenses are all accounted for, the securities are marked to market and a valuation of the partnership is determined.  The net income is $50,000. For example:

Partner name 1/1/97 % 3/31/97 3/31/97 4/1/97 4/1/97 4/1/97
  Capital   Performance Capital Additions Capital


Phil 100,000 12.50


106,250   106,250 9.66
Paul 500,000 62.50 31,250 531,250   531,250 48.30
Gene 200,000 25.00 12,500 212,500   212,500 19.32
Linda         250,000 250,000 22.72
Total 800,000 100.00 50,000 850,000 250,000 1,100,000 100.00


The above schedule is a simple example of what is called book allocations. When a limited partner invests in a hedge fund, it is important to make sure that the investment partnership is audited by a reputable accounting firm. Book allocations must adhere to the partnership agreement. There are other items that will be part of book allocations, such as, management fees and performance fees, it is important for an independent auditor to make sure that the hedge fund manager is adhering to the limited partnership agreement. A hedge fund manager may interpret the agreement incorrectly, resulting in either an overcharge or undercharge to the limited partners. So, if you are investing in a limited partnership you should make to sure to read the partnership agreement, find out what the management fee is (usually 1% a year) and how the performance fee is determined(usually 20% of net income)*

*Performance fees may have benchmarks and hurdles


The percentage and method of calculation depends on your partnership agreement. the typical fee structure is as follows:

  • 1.00%/year charged quarterly

The fee is usually charged on 1/1, 4/1, 7/1, 10/1. The partnerships net asset value is determined on the specified date and is charged to the partnership. the are instances where some funds do not charge all the limited partners this fee. Some funds may have relatives or others who they do not wish to charge. If a fund does not charge this fee to everyone, a break period will result on the dates that the management fee is charged. Over a length of time, certain inequities may result to those who are charged due to the dilution of their partnership percentages. There will also need to be a separate allocation of the management fee whenever charged.


Carefully track your realized gains and losses on a break period basis. It is important for the fund to track gains and losses on a TRADE DATE basis. Most good prime brokers offer trade date monthly realized gains and losses reports on a monthly and YTD basis. For audit and tax purposes, hold on to all your brokerage reports and schedules prepared by your accountants. For tax purposes, keep track of gains and losses that are considered short-term and long-term on a monthly and break period basis. Having the accounting firms recreate this for you can increase your audit and tax fees.


This fee is usually 20% of the net profits of the partnership. Calculation of the fee is determined by the partnership agreement. The fee is a reallocation on the book and tax allocations on the income of the limited partners to the general partner. Incentive fees may have hurdles, benchmarks, complicated scenarios, etc. There are also certain SEC rules regarding the incentive fees and Registered Investment Advisors.


Depending on how the partnership agreement is structured, when a partner fully withdraws from a hedge fund, the hedge fund manager will usually pay the limited partner that is leaving 90-95% of the amount due to him/her within 10-15 days of the break period. The remaining 5-10% will be paid pending a verification of capital amounts on the date the partner decides to leave. This 5-10% is usually paid a certain amount of interest until paid to the withdrawing limited partner. Please read your partnership agreement (offering memorandum) to see if this applies to you.


Some partnership agreements provide for loss-carryforwards. This protects the limited partner from being charged an incentive fee on an "up" year when total cumulative return is a loss. For example, if a limited partner enters into a partnership on 1/1/96 and has a net loss of $60,000 for the year, the general partner will not be entitled to an incentive fee. If in 1997 the limited partner has a net appreciation for the year of $50,000 the general partner will still not be able to charge an incentive fee, even though there was a net gain for the year. In addition, the general partner must make up another $10,000 loss in 1998. This is a loss carry-forward, the general partner cannot charge an incentive fee till the limited partners are made whole. Each limited partner must be tracked individually. Please read your partnership agreement to see if this pertains to you. A high water mark is similar except that the manager must recoup lost profits on the limited partner's interest.


Hedge funds frequently trade in what are called "Hot Issues". Hot issues are basically IPOs. When a partnership trades in Hot Issues, only certain investors are allowed to participate, there are certain  rules that will restrict certain partners. Hot Issue activity such as profit and loss, interest income and expense, dividends, etc. must be separated from regular trading activity. A separate brokerage account must also be maintained for Hot Issues. If you trade hot issues and you're a hedge fund, your prime broker will ask you for an "opinion letter", at least they're required to. This letter is usually prepared by your attorney.

When preparing book or tax allocations, one must create a separate allocation of performance for those who can participate in Hot Issues.


For purposes of counting investors, a 3(c) 1 fund must carefully consider capital contributions made by registered investment companies, 3(c) 1 funds and 3(c) 7 funds. If any of these entities hold more than 10% of the funds capital, the fund will have to count the investors in the contributing fund as well for purposes of the 99 partner limit. Fund managers operating a 3(c) 1 fund that wishes to accept large contributions from these entities should consider starting a 3(c)7 fund or converting their fund to a 3(c)7. When your accountant prepares your allocations, a check should be performed at each break period for limited partners exceeding 10% of the fund's assets.


Legal, accounting fees and other fee associated with starting the fund can be charged through the fund.


The fund will normally incur accounting and legal fees throughout it's life. Fees that are directly related to the fund should be expense through the fund. Audit and accounting fees should be accrued on a monthly basis, rather than when paid. If your anticipated audit and tax fees are $24,000/yr. You should expense $2,000 a month for accounting and audit expenses.


These characters of income should be recorded when earned and not when received. Interest should be accrued on a monthly basis based on interest rates or coupon dates. Dividends should be recorded on ex-date rather than pay-date.


By and large the most complicated area. There are several federal and state tax issues that a hedge fund must consider when starting a hedge fund, management company or/and affiliate management company of a hedge fund. Below you will find some some information on tax allocations.

Tax allocations are created to determine the amounts to be reported on the K-1s. The tax allocations are the area that some of the hedge fund software manufacturers try to facilitate.

For tax purposes your accountants will create a tax allocation of your partnership. The tax allocations are derived from the book allocations. The difference between the book allocations and tax allocations are outlined below:

  • For book allocation purposes, performance need not be broken out by character of income, for tax purposes all the components that make up the partnership's performance must be broken out(i.e.; Interest, dividends, realized long term, realized short tem, etc.). Unrealized is not taxed.
  • The performance must be broken out by period, by character.
  • For book allocations a general partner can take 20% of the total performance and reallocate that amount to his/her account. For tax purposes, the accountant must hit every component of income for the 20% performance fee.
    • This means that the GP must take 20% of interest income, 20% of dividends, 20% of realized short term, etc.
  • What results at the end of the tax allocation is every partners share of each component of income for the tax year net of any performance fee to be reported on the K-1s

There are a couple of methods that accountants use to account for realized gains for tax purposes (layering, aggregate, etc.).

In addition to determining what the character of income for each partner is for tax purposes, the accountant will review the partnerships trading activity to determine if there are any tax adjustments to made. Certain tax laws require these adjustments. Contact a CPA firm for information on these adjustments.