Ready To Start A Hedge Fund? Not So Fast…

Written on April 30, 2015

So you’re ready to start a hedge fund; you have your logo, business cards, letterhead, domain name, email accounts and your website is up and running. Not so fast…have you done the hard work that leads you up to this point?

What is a Hedge Fund?

Hedge fund has always been a mysterious phrase. If you ask 100 people what a hedge fund is, you might get 100 different answers. A hedge fund is an investment vehicle and a business structure that pools capital from a number of investors and invests in securities and other instruments. It is administered by a professional management firm, and often structured as a limited partnership, limited liability company or similar vehicle. Hedge funds are generally distinct from mutual funds as their use of leverage is not capped by regulators and the majority of hedge funds invest in relatively liquid assets.[i]

So who “coined” the industry as we know it today as “hedge funds?” In 1949, Alfred Winslow Jones dubbed his new $100,000 investment venture a “hedged fund.” At the time, there was no such thing as a performance fee or a net asset value.[ii] He raised $100,000 (including $40,000 out of his own pocket) and set forth to try to minimize the risk in holding long-term stock positions by short selling other stocks. This investing innovation is now referred to as the classic long/short equities model. Jones also employed leverage in an effort to enhance returns.[iii]

Jones’ key insight was that a fund manager could balance their portfolio by buying stocks that were expected to go up and selling short stocks expected to decrease. The technique shielded the fund from risk associated with overall market movement, and hence became known as a “hedge fund.” [iv]

In 1952, Jones altered the structure of his investment vehicle, converting it from a general partnership to a limited partnership and adding a 20 percent incentive fee as compensation for the managing partner. As the first money manager to combine short selling, the use of leverage, shared risk through a partnership with other investors and a compensation system based on investment performance, Jones earned his place in investing history as the father of the hedge fund. [v]

While hedge funds have existed for many decades, they have become increasingly popular in recent years, growing to be one of the world’s major investment vehicles and sources of capital.

According to Hedge Fund Research Inc., as of the first quarter of 2014 were nearly 10,000 individual funds in the marketplace with more than $2.7 trillion in assets under management. There are single strategy funds, fund of funds, registered investment advisors and investments in private operating companies, as well as other investment vehicle structures.

What Steps Should I Take?

 So, you’ve worked several years at a well-respected investment firm and now you are ready to branch out and take more of the “lions share” of the profits verses the firm. After all, your investors are benefiting from your investment advice and trust in you. So where do you start? Here are four steps that will get you started in the right direction:

1. Find a mentor

Talk to a fund manager who already has a successful fund. Converse with them, and listen and learn from their experiences as to how they started their fund. Fund managers can share with you the things they learned before they got started, after they got started and the things they are still learning.

2. Assemble your “Magnificent Four”

Find a knowledgeable and credible CPA, attorney, prime broker and your third-party administrator. Start with a CPA firm or a law firm first and get estimates as to costs as it relates to tax and audit services and for services in preparing your private place memorandum (PPM) and your operating agreement. They will also be able to help you with introductions to third-party administrators and prime-brokers through relationships they already have with other service providers within the industry.

When interviewing law firms and CPA firms always be sure to ask them their expertise in their respected fields and how much of their practice is spent on serving hedge funds.  This is an industry that is becoming more and more each day as an “under the microscope” industry. This past year was evidence of that in how now broker dealers are no longer being audited under the oversight of the American Institute of Certified Public Accountants (AICPA) but is now under the oversight of the Public Company Accounting Oversight Board (PCAOB). Therefore, this shows the importance of having a professional service firm that is very active in this industry.

If there is one thing we have seen over the years, its operating agreements that do not always cover the technical areas that need to be covered when preparing the necessary documents. The same can be said for CPA firms financial statements that we have read that do not have the footnote disclosures that are needed. You want to make sure that these two service providers are respected experts within the industry.

When interviewing prime brokers and third party administrators, they are not all created equally, so be sure you clearly understand what types of reporting packages they can each generate not only for your benefit, but also for your investors benefit as well so that it can help the fund reduce its administrative costs and audit fee which helps increase the fund’s performance. We all know how important fund performance is and “basis points (BPS).” Once you have selected your CPA, attorney, prime broker and your third-party administrator (the magnificent four) it is time to put the team to work. It would be advised to have collaboration between the parties from the very beginning so that everybody is clear on what each service provider needs from the other, and you can have a good team ready to work together for you and your investors.

3. Create an incubator fund

Some fund managers will start with an incubator fund as the ideal investment vehicle for entrepreneurial managers that are searching for a cost-effective stepping stone to launching a full-fledged hedge fund. Generally, a manager will contribute his or her own capital to the fund and manage the fund’s assets for 6 to 12 months in order to test investment strategies and create a track record. Once a successful track record has been established, the manager can reach out to prospective investors and obtain indications of interest prior to incurring the expense of launching a full-fledged fund.[vi]  This will be your primary business card when a meeting with potential investors and raising capital. Most, if not all investors, want to know what your performance has been. Having a performance examination with you when you meet with a potential investor will give you and edge and credibility. If there’s one thing we have noticed over the years its that when you get ready to start a fund nothing is more important than being able to show potential investors what your performance has been.

4. Raise your capital

Now the hard part begins, there is the capital raise. You will need to have a strategy when it comes to marketing and how you plan on raising capital. As we all know there is a plethora of funds out there to invest in so how do you make a difference amongst your peers.  One of the ways you can do that is to have a performance examination done for your fund, which was discussed in the preceding paragraph. Another way is to have a capital account of some proportion so that your investors know that you believe in your strategy and have your own money at stake. Another way could be in having some type of unique fees other than your typical 2/20.

As you can see, there is a lot that takes place behind the scenes before receiving your first investor and that initial contribution. Follow the four recommendations above before even considering starting your own hedge fund.

Warren Averett, the 27th largest CPA and accounting firm in the country, services many clients across the United States in the hedge fund industry. From funds that have been established for over 20 years with over $500 million under management, to funds that need a proactive business partner in getting their fund started, our Firm has a team that is dedicated to this practice and services this industry year round. Please let us know how we could be of service to you and your needs.

[i] Source: Wikipedia

[ii] Source: Business Insider

[iii] Source: Investopedia

[iv] Source: Business Insider

[v] Source: Investopedia

[vi] Source: Investment Law Group

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