What Are Hedge Funds? And Why Do They Go Bust?

What legal and operational guardrails exist to protect money in a fund from leaving all at once?

Happy Saturday everyone!

I am hopeful that you can build your knowledge inch-by-inch, and so before diving into the main discussion, I’d like to briefly touch on some regulatory and industry updates that are shaping the private funds landscape in the United States:

1. The Financial Crimes Enforcement Network (FinCEN) is a US Treasury bureau that combats money laundering and terrorism financing by collecting and analyzing financial data. FinCEN’s new rule, taking effect in 2026, will require investment advisers of private funds to implement anti-money laundering programs and report suspicious activities. This increased oversight aims to combat illicit finance in the private funds sector.

2. Paul Atkins has been nominated as SEC Chair by President-Elect Trump. He is a former SEC commissioner (2002–2008) and CEO of Patomak Global Partners, a consulting firm advising financial and cryptocurrency companies. Known for his pro-business, deregulatory stance, Atkins is wary of post-2008 financial reforms, corporate penalties, and climate disclosure mandates. If confirmed, he is expected to ease private fund regulations.

3. The Investor Advocates Choice Network (ICAN) is pushing to change the “accredited investor” definition. Their petition to the SEC proposes replacing current financial thresholds ($200K in income or $1mm in wealth) with qualitative criteria like education or professional certifications, potentially broadening access to private investment opportunities. ICAN has escalated their efforts by filing for a writ of mandamus to force the SEC's review of these requirements.

Let me know if you have any questions.

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Alright, so this post addresses two questions: what are hedge funds? And how have they evolved?

It’s a longer post, so for those strapped on time, here’s the key takeaway: hedge funds, private equity, and venture capital funds are all private investment vehicles, but they differ significantly in how they handle capital inflows and outflows. It is not the type of investment, but the way money comes in and out that serves as the primary distinction between these funds.

Mating Turtles?

Louis Bacon, founder of the $10 billion hedge fund Moore Capital, is known for his eccentric approach to both investing and conservation. As a Long Islander, I was curious to learn more about his privately owned island out in Peconic Bay.

I dug a little bit.

“They put transmitters on mud turtles’ backs,” noted Edmund Hollander, a landscape architect who worked on a conservation project for Bacon, “to see their mating habits and make sure nothing interfered with them.”

Fascinating.

I won’t extrapolate further here, but I think the hedge fund folk are a more eccentric species of professional money manager than their venture capital or private equity counterparts, who undoubtedly have their own quirks.

The esoteric nature of the successful hedge fund manager is perhaps partly explained by the structure of hedge funds themselves: that they are open-end pooled investment vehicles, basically meaning that investors can more easily and frequently put money in and take money out.

Busting Hedge Funds and Myths

As such, the key fable I’d like to challenge is that the primary difference between hedge funds and venture capital/private equity funds lies in the types of investments they make. It’s not that one is focused on public markets and the other on private businesses. Rather, it’s the way capital flows in and out of these funds that truly distinguishes them.

This vantage point may explain why the success of hedge funds, for such a long time, has been shaped by a few key personalities at the top of the industry: the charisma and market intuitions of public markets investors like Bill Ackman or George Soros have been important reasons why investors are so willing to give them money. A clichéd inquiry then often follows: is it luck, some trade secret, or some brilliant capability to make timed bets on investments that makes these managers so good at investing?

I don’t know, and I am not the best person to answer that. But we can think about why they behave the way they do: their personalities are a product of the desire to both keep the investable capital they’ve accumulated and acquire more of it.

To reiterate, what I am proposing is that hedge fund personalities are partly driven by the ways in which investable capital comes to them, and the mechanisms in place that both prohibit and permit that capital to leave if investors want out.

There’s that scene from The Big Short in which the real-life investment manager Dr. Michael Burry, portrayed by Christian Bale, sends an email to investors (if I remember correctly) to the effect of “I am suspending your ability to take money out of the fund.”

And then an investor angrily calls him and says something like, “I want my money back!!”

And Burry says, “Sorry, nope.”

I hope that the information in these pages has so far been useful enough for you that, without any additional context, you’d immediately know that Burry was not running a venture capital or private equity fund.

Burry demonstrates that generally, and during the 2008 financial crisis in particular, the ability to suspend redemptions has been crucial during periods of stress for more liquid funds where an investor could just pull money out, even if that money took some time to get back to whence it came. His decision to freeze redemptions in his hedge fund protected his positions from being liquidated at a loss when mortgage-backed securities were plummeting in value. By suspending redemptions, he avoided forced asset sales, preserving the fund’s strategy and eventually benefiting when the market corrected.

Applicable governing provisions in the legal documents—whether gating, redemption restrictions, tax strategies, or fee structures—for a hedge fund structured as a limited partnership are fundamental to how hedge funds manage investor expectations and navigate the complexities of leveraged, high-risk investments.

True, hedge funds generally invest in assets which are more liquid, such as stocks, bonds, and other financial instruments which derive their underlying value from a stock or a bond, such as a derivative.

And true private equity or venture capital funds tend to invest in assets that are less readily salable and less susceptible to volatile price changes in the public markets because they tend to be privately-held businesses.

But if you remember, many private equity funds have a provision in their governing documents that allows them to have limited exposure to public securities if those securities are of a flavor that matches the investment strategy of the fund (so a private equity fund that invests in privately-held clothing companies may also have permission to purchase Abercrombie stock).

Hedge funds can do the same, in the sense that they sometimes acquire chunks of privately-held businesses held in separate, segregated accounts within the fund structure in the form of what is often called a “side pocket.”

Such hybrid strategies are becoming more common and have blurred the line between PE/VC funds and hedge funds.

These foregoing points are to further draw into suspicion: is it really the type of investment that differentiates these funds?

Liquidity and Runs on the Fund

Have you ever thought why precisely hedge funds go bust? I can’t recall a venture capital or private equity fund being in the news because it was shutting its doors. That investors frantically pulled their money out, in the fashion of a traditional run-on-the-bank. But in 2008, there were plenty of hedge funds that did close down operations.

Hedge funds typically operate as open-ended investment vehicles, allowing investors to contribute capital on an ongoing basis. This structure provides flexibility for both the fund and its investors, as new money can be invested at various points throughout the fund’s life. In contrast, private equity funds usually have a specific fundraising period, after which the fund is closed to new investors. This “closed-end” structure aligns with the longer-term investment strategy of private equity funds, which often have a longer lifespan.

The way capital is committed also differs between these fund types. Venture capital and private equity investors typically commit to a certain amount of capital upfront, but this capital is not immediately invested. Instead, the fund manager “calls” or “draws down” the required investment amount from investors as investment opportunities arise. This capital call structure allows the fund to maintain a fixed pool of committed capital for making investments over time.

Hedge fund investors, on the other hand, generally invest their entire committed amount upfront. Broadly, hedge funds can raise capital at any time due to their open-ended structure, while private equity firms can only fundraise every few years. Their compensation structure also differs—hedge fund managers receive performance fees annually, whereas private equity managers typically earn carried interest only upon the sale of investments.

Perhaps the most significant difference between hedge funds and private equity funds lies in how they handle capital outflows. Hedge funds typically offer more liquidity to investors, allowing them to withdraw their investments with relative ease, often on a monthly or quarterly basis. However, it’s worth noting that some hedge funds may impose lock-up periods or “gates” that limit when and how much an investor can take out to manage liquidity risks.

Private equity and venture capital funds, by contrast, have much more restricted liquidity. Investors in private equity funds are generally required to commit their capital for an extended period, typically seven to ten years. This extended commitment period aligns with the long-term nature of private equity investments, which often involve taking controlling stakes in private companies and working to improve their value over time.

The distribution of returns also differs between these fund types. Hedge funds often distribute returns to investors on a more frequent basis, typically annually or semi-annually, based on the fund's performance. Private equity funds, however, usually only distribute returns to investors when they exit their investments, which can be several years after the initial investment.

The Evolution of Hedge Funds: From A.W. Jones to Modern Pod Shops

The hedge fund industry, as we know it today, traces its roots back to 1949 when Alfred Winslow Jones founded A.W. Jones & Co., the world’s first hedge fund. Jones introduced the concept of hedging—combining long positions in undervalued stocks with short positions to reduce market risk. This market-neutral strategy aimed to deliver returns regardless of whether the broader market was rising or falling, a revolutionary approach at the time.

Jones’s simple strategy, using leverage and hedging to minimize risk while seeking returns, marked the start of hedge funds as a new asset class. Early hedge funds operated with a single investment strategy managed by a small, specialized team. But over time, the landscape evolved.

Today, the largest hedge funds operate as multi-strategy, or multi-manager, platforms. Also known as “pod shops.”

The modern hedge fund landscape is dominated by multi-strategy firms like Citadel, Point72, and Balyasny Asset Management, which run multiple, independent teams, or “pods,” each with its own investment mandate. These pods are integrated into a shared infrastructure that provides risk management, compliance, and operational support. This multi-strategy model allows hedge funds to diversify risk and capture returns from a wider array of investment approaches.

For example:

• Citadel, founded by Ken Griffin, operates multiple pods, each focusing on different strategies such as equities, fixed income, quantitative trading, and economic research, all while benefiting from a central risk management system.

• Point72, founded by Steve Cohen, similarly utilizes a multi-strategy framework, with independent pods focused on equities, macro trading, and systematic strategies.

• Balyasny Asset Management (BAM), founded by Dmitry Balyasny, focuses on equities, macro, and other alternative investments. BAM’s robust infrastructure supports various pods, allowing different teams to thrive under unified risk management and operational guidelines.

Original chart has been slightly modified. Here’s the link: https://images.app.goo.gl/jqYoU3h2riVGTkmr8

For starters, it’s worth thinking about the pods as mini businesses within a shopping mall, where the mall ownership and management coordinates between the different businesses to ensure smooth functioning. Asset managers can attract good talent while allowing that talent to maintain some independence inside the pod to do what they are best at. Put differently, each pod operates somewhat like a standalone hedge fund. Portfolio managers are incentivized based on the alpha they generate—the returns above the market benchmark. A manager's compensation is directly tied to performance. Strong returns mean more capital allocation, while underperformance may trigger the “eject seat,” an exit of the portfolio manager from the hedge fund after sustained poor performance.

In addition to the management fee, individual pods charge performance fees—usually 15-20% of the returns they generate. Investors also face pass-through expenses for costs like trade execution, research, and data feeds. These costs are passed on directly to the investors rather than absorbed by the fund, making it important for investors to understand the true cost of their investments.

Hedge funds have come a long way, and in further discussions, we will touch on how the pod shop model is coming under scrutiny. Which may give way to another round of organizational innovation.

That was a lot, and thanks so much if you stuck around to the end. With a clearer understanding of the major fund types and their structural differences, we can now turn our focus to the challenges they face and the emerging technologies—whether financial, social, or technical—that are shaping their future.