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How to Start a Hedge Fund:
A Guide for Managers
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Table of Contents:
Introduction
Fundraising
Key Service Providers
Hedge Fund Support Structure (graphic)
Other Service Providers
Introduction
Starting a hedge fund is an exciting and rigorous undertaking. It requires most of the same skills as starting a new business, but with the added task of managing money as well. While the operational challenges are difficult, the personal fulfillment can be limitless.
Develop and articulate your strategy
The hedge fund world is very competitive; therefore, you should define your strategy, be able to consistently execute that strategy and be able to articulate that strategy to investors. Building on these cornerstones will provide you with a better foundation for success.
Develop and create a working business plan
Before you commence operations you should devise a business plan. After all, a hedge fund business is still a business. The goal of the business plan is to get an understanding of the path to profitability and the annual operating cost of running the fund. The plan should incorporate projected revenues and expenses with particular detail spent to predicting the costs including expenses such as: Administration, Legal, Marketing (more on this topic within Fundraising), Compliance, Operations and Technology. The plan should also incorporate your expected time allocations around different processes related to the fund, particularly research, marketing and operations. Understanding how much time you need to focus on each part of the business is a key to working efficiency. The business plan should also provide a formal calendar or timeline detailing all the "to dos" required to launch your hedge fund business.
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Fundraising
After finalizing the business plan, you should research and formulate a plan for fundraising. Ultimately, this is how the fund will generate revenue so having a good understanding of potential sources of capital will be important. Some hedge funds are lucky enough to open with an established fund base, but in many cases managers elect to use his or her own capital, or seek investments from friends and family members to start. Putting your own capital into the hedge fund, along with gathering initial investments from friends and family is a good way to start to generate a track record, especially if you cannot provide performance data from your previous firm.
Additional capital for the fund can come from different sources. Each one of the sources is different in style and degree of capital deployed.
Friends and family tend to be the first sources of capital. They are generally the easiest to convince and usually require the least amount of effort. However, the allocations tend to be smaller.
High net worth investors tend to make quicker decisions on investments and usually have a longer time horizon when investing. They are more sophisticated than family and friends and demand less attention from you. Investments can be in the millions to hundred of millions.
Seed investors or incubators invest in the early stages of a hedge fund’s life and may require additional economic incentive through equity partnership in the fund. They can provide guidance and further contacts in the investor space including assistance with fundraising for a fee.
Family offices, which vary in size and sophistication, are another large potential source of capital. They too have pre-investment criteria, but may be more flexible and quicker to act than a Fund of Hedge Funds.
Fund of Hedge Funds are more sophisticated and more demanding of you. They usually have certain investment criteria you must meet before receiving an allocation. Some of the criteria can be long term track records, operational transparency, and minimum asset bases. Due diligence tends to be extensive initially and ongoing during the life of the subscription. Allocations can be larger in magnitude and provide you credibility with additional potential investors.
Institutional investors like pension funds and insurance companies may represent some of the larger money, but they usually take a long time to invest in a fund. They also have increased regulatory parameters associated with their investing and can therefore be more difficult through their demands of the funds for operational and reporting transparency.
Because of the importance of fundraising, you should take the time to develop a formal marketing plan. A marketing plan should outline which types of investors you think are most appropriate, and how you intend on approaching such investors. For example, if you wish to approach Funds of Hedge Funds you can purchase lists from a number of hedge fund industry database providers. High Net Worth investors are a vast and fragmented group, thus you may want to consider how to identify and market to High Net Worth individuals located locally.
Besides identifying the types of investors you want to target, your marketing plan should also consider the resources to support your fundraising effort. You should speak with the Capital Introduction team at your prime broker to learn about what assistance they can provide you as most prime brokers offer this service complimentary to their clients. There are countless hedge fund conferences and events that may be worth attending, though they can be expensive so you should identify which conferences you think are best suited for you and your investment strategy. You can also purchase investor lists from various database providers, which may make sense if you hire an in-house marketing person. In addition, you may wish to outsource your fundraising effort to a Third Party Marketer who has a network of hedge fund investors to contact.
The best marketing plans integrate all the components, and include a projected marketing budget to ensure you costs are kept under control. Developing an integrated marketing plan will provide you with your best chance of making your fundraising effort a success.
To summarize the various types of investors to consider for your fundraising efforts:
- Friends and Family: Smaller amounts of capital, easier to commit, low level of due diligence
- High Net Worth: Longer term in commitment, some level of due diligence
- Seed Investors: Early stage, may require equity stake or revenue share, can help with additional fundraising
- Family Offices: Can mirror High Net Worth investors or Fund of Hedge Funds
- Fund of Hedge Funds: Larger subscriptions, minimum criteria, extensive due diligence
- Institutional Investors: Slow to invest, minimum criteria, extensive due diligence
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Key Service Providers
Role of the Law Firm
Selecting the right law firm is also a crucial element. A lot of firms provide hedge fund services, and it is important to feel comfortable with the reputation, service level and expertise of the partner and associates who will handle your business. Initially the legal team will draft investor documents and organizational legal documents for your hedge fund. Some of the items will be discussed with your legal team include fund structure, management fees, lockups, and operating practices. Your legal counsel will also provide information on regulatory questions such as laws regarding “accredited investors,” ERISA rules and marketing private placements of securities, which includes hedge funds. They should also be able to provide advice about tax considerations for the fund and approval of general marketing.
To summarize, your law firm:
- creates legal documents
- advises on structure of the firm
- provides regulatory and tax advice
- approves marketing for the fund
Role of the Prime Broker
You should consider several factors when selecting your prime broker including degree of service, rates on execution and interest for debit, credit and short balances, ability to access hard to borrow securities and sophistication and reputation of trade and processing tools related to the products you intend to trade. Additionally, your prime broker should be able to support all your transactions, and custody your assets either directly or through an independent, third party custodian. A critical factor to start-up managers should be the reputation and ability of the capital introduction team to help you grow your business. As discussed previously, your prime broker is another viable source of fundraising and their attentiveness to help you build your business should be considered before making a decision.
To summarize, your prime broker should provide:
- custody and transactional support
- robust portfolio reporting
- ample stock loan capabilities including hard-to-borrow securities
- capital introductions
Role of the Fund Administrator
Fund Administrators, also called Third Party Administrators, provide the operations and accounting backbone for the hedge fund’s investors. The fund administrator provides a daily investment record, statement of performance, and an independent, third party valuation to the hedge fund. The last item is of critical importance to more sophisticated investors such as Funds of Hedge Funds and Institutional Investors. Additionally, the fund administrator provides reporting for the investors of the fund through monthly statements.
You need to follow the same approach when selecting an administrator as when selecting your legal counsel. The fund administrator should provide a high level of service and expertise, clean client reporting, smooth operations for subscriptions and withdrawals and have a credible reputation with respect to portfolio valuation. Some fund administrators provide tax reporting and advice, which may also be important to you depending on your situation.
To summarize, your fund administrator should provide:
- hedge fund record keeping
- independent, third party valuation
- performance calculation
- investor books and records
Role of the Accountant/Auditor:
The accountant provides the fund’s tax preparation and investor K-1 statements. In addition, the accountant calculates the management and performance fees and the operational costs related to running the fund. They can also advise on the hedge fund’s initial start-up and provide ongoing portfolio analysis.
Auditors certify the performance of the fund for investors, and selecting a firm that is known to have expertise in auditing hedge funds helps alleviate investor concerns. Given the recent well-publicized hedge fund fraud schemes, having a reputable, well-known auditor review your hedge fund will help demonstrate your commitment to building your business.
While not required, best practice is to hire separate firms to handle the accounting and annual audit work.
To summarize, your accountant/auditor provide:
- annual audit
- certification of performance
- K-1 Statements
- portfolio analysis
- tax preparation
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Hedge Fund Support Structure
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Other Service Providers
There are additional optional outsourcing agents that you may employ to start a hedge fund. These include:
Compliance consultants – Draft and help implement firm compliance procedures and prepare firm regulatory filings.
Human resource consultants – Provide access to healthcare and benefits for the fund’s employees.
Marketing consultants – Help design fund marketing and website. Provide coaching for manager’s presentations.
Technology consultants – Set up the office network, trading systems, risk management systems and other integrated technology solutions.
Operational consultants – Operations outsourcing, assistance in documenting the hedge fund’s operating procedures and testing to ensure such procedures are being followed.
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About VanthedgePoint
VanthedgePoint Group, Inc., is an integrated financial services holding company focused on delivering products and services to empower emerging hedge funds. VanthedgePoint Group operates three wholly owned subsidiaries: VanthedgePoint Securities LLC, a registered broker/dealer (Member FINRA/SIPC), VanthedgePoint Futures LLC (Member NFA) and VanthedgePoint Technologies LLC. VanthedgePoint Group is a privately held company with principal offices located in New York, NY. Additional information about the firm is available at www.vanthedgepoint.com.
Media contact:
Geoffrey M. Tudisco
Chief Executive Officer
VanthedgePoint Group, Inc.
(212) 514-8639
info@vanthedgepoint.com
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