Despite the economic downturn in 2008, the requirements for launching a hedge fund can be made simple by hiring the right service providers. Having a legitimate operational platform is key for a startup to grow to an institutional sized fund and the manager should choose an administrator who can provide just that. Additionally, having a creditable hedge fund attorney to provide the necessary legal documents, an established prime broker, and a reputable auditor are key components to successfully launching a hedge fund.
When launching a US fund, there are four elements to consider: regulation, investor transparency, operations, and distribution. The service providers you hire will navigate you through each of these core areas in order to work towards the future success of an established fund.
Prior to 2008, investors required minimal information from managers. An investor looked for returns (real or fake) that correlated positively with their overall portfolio, as well as making sure they obtained a set of legal documents, a prime broker, and some marketing visibility. Today investors require a thorough understanding of, not only what generated fund returns, but also how they originated and whether they will continue. A manager must be able to articulate and document its entire investment process. This process is composed of the following simple elements:
• Idea generation- How does the manager select from its investment universe?
• Research – What is the manager’s research process?
• Investment selection – How does the manager decide which ideas are selected and which ones are not?
• Portfolio construction – How does the manager construct their portfolio to achieve the advertised results? Sizing, hedges, and covariance between investments all need to be explained.
• Risk management – How does the manager protect the portfolio from the unforeseen and what monitoring and action plan do they have in place?
Investors may wish to see a manager’s “track record,” and prefer at least two years of operating capital to finance the management company. Managers need to evidently prove that they are able to cover operating and personnel expenses, as well as seeing some success within the fund. A typical fee structure will provide a 3-4% revenue stream which translates into $300,000-$400,000 for each $10M of outside AuM. Given the cost of running a business, managers need at least $50M of AuM before having a sustainable business. In order to meet investor demands, managers need to obtain adequate capitalization, develop robust operations, and prove a verifiable, repeatable investment process.
In the US, it is the manager’s responsibility to ensure compliance with regulation (created by the SEC, FINRA, CFTC, IRS, etc.), which is why hiring an experienced hedge fund attorney is critical. Failure to comply can result in fines, loss of business, and/or jail. Mistakes are easily made, but the consequences are harsh.
It is important to know that federal and state requirements depend on facts and circumstances including asset class, fund size, manager location, and location of investors. For instance, a fund launched in Texas or California may have different regulations to abide by than a fund launched in New York. By hiring a reputable hedge fund attorney, a manager should be fully informed of all applicable regulations and ensure that these regulations are followed.
Robust operations can mean different things to different people. In all cases, it requires a process that ensures the validity and integrity of the fund’s financial information. A prime broker or administrator is in the best position to advise on how the operations should be set up. However, in all cases, the operational control environment must ensure that managers have accurate and timely information and have safeguards in place to prevent misstatements or misappropriations. Most new managers accomplish this by hiring a qualified CFO combined with outsourcing the daily operations to the prime broker or administrator. Carefully weighing these decisions upfront can make the difference between operational failure and success.
The last factor to consider for the fund’s success is distribution. After developing a strategy, a manager will want to raise assets and will need to consider the various avenues which include using a prime broker’s capital introduction team, hiring a third party marketer, finding seed capital or going to High-Net-Worth individuals and family office money. There is no right choice and no choice is mutually exclusive, however the key is meeting due diligence requirements, otherwise, regardless of the returns, your fund will never get the allocation.
Taking the Leap
Understanding the hedge fund start up process in the US and the central priorities in a manager’s analysis prior to launch are crucial components to starting a hedge fund. While it may seem like less funds are forming, there are more success stories developing because the industry has become more mature. Once described procedures are in place and reputable professionals are hired to assist with starting a hedge fund, the process will not only be seamless, but also rewarding.