Whenever the job title “hedge fund manager” drops, the first words that pop into most individuals’ minds are probably SMART, RICH, AND VERY RICH. I mean, they’re not wrong; some of the wealthiest people in NYC today are hedge fund managers who’re worth millions and, at times, billions, like George Soros of Soros.
But what exactly do these “hedge fund” outfits do, and how do they make people a fortune in a slump? And can anyone start one? Below, you’ll find a detailed guide on how to start a hedge fund, as well as extra tips that’ll help you get off on the right foot.
But first, let’s nail the basics.
Also Read: What Is Money Market Hedge?
- What is A Hedge Fund?
- How To Start a Hedge Fund
- Common Challenges Involved with Starting a Hedge Fund
What is A Hedge Fund?
A hedge fund, an alternate investment vehicle, is a limited partnership where investors (institutional investors or accredited investors) pool funds together (usually tens of millions of dollars), and a fund manager will deploy the funds in an array of assets using sophisticated investment techniques that align with the fund’s strategy.
Unlike most other funds, Hedge funds can also use leverage, hold long/short positions in derivatives, and take short positions. Also worth noting, they’re less regulated by the Securities and Exchange Commission (SEC) compared to other funds.
How To Start a Hedge Fund
Without further ado, I’d like to skip to the most exciting section of the guide and take a detailed look at how you can start a hedge fund today. We intend to go over everything here, from how you should set your fee structure and raise capital to the different challenges you ought to expect to encounter while starting a hedge fund.
Pick a Name
The first thing you’ll need to do when starting a hedge fund is to craft a creative yet memorable name. A posh part of New York or London would be a great place to start: think Thames River Capital, Cheyne Capital, or even Pershing Square Capital.
Also, feel free to go for something a little bit more aggressive, like Centaurus, Citadel Capital, or Tiger Capital. Among leading hedge funds, it’s common practice to squeeze as many pointless words into a hedge fund’s title as possible. Remember, however, that a sign isn’t a sign of quality.
Set your Fee Structure
This is where the real fun starts. The main reason hedge funds are so lucrative is their standard fee structure and investment agreement, which is “two and 20.” Typically, this implies that if you start a hedge fund and are the manager, you get up to 2 percent of your clients’ money upfront before you even do anything.
Moving forward, you then get to keep up to 20 percent of any appreciation on the fund’s value. For many hedge funds, that means a phenomenal annual income in the hundreds of millions of dollars. Here is a great example.
Say your new hedge fund raises $1 billion from investors and attains a 30 percent appreciation in value over the next year. In that case, the fund makes $78.8 million.
Develop An Attractive Hedge Fund Structure
Every emerging fund manager who intends to raise capital from institutional investors ought to go into the market with a hedge fund offering consistent with the current market norms and expectations. Hedge fund structures have significantly evolved over the past decade, which has compelled institutional investors to lean on hedge fund managers to craft a hedge fund structure that provides the perfect balance between the interests of the investors and the fund manager/sponsor.
Trends in structural mechanisms and governance also change frequently in response to changes in applicable laws, evolving market dynamics, and more. With that in mind, a hedge fund structure that aligns with current market imperatives will be advantageous when it’s time to raise and pool investors’ money.
With all that in mind, there are two main points a fund manager will have to think about when crafting a hedge fund structure.
A hedge fund’s liquidity characteristics will be of primary concern to any prospective investors. That’s especially true when it comes to terms that define when investors can access their invested capital.
Hedge funds focusing on exchange-traded products and liquid markets will generally find a warm reception from investors. A hedge fund manager can take this further and provide favorable withdrawal terms with liquidity opportunities at regular intervals.
On the other hand, hedge funds investing in illiquid financial sectors or employ investment strategies that require fixed lead-times for practical implementations will have to convince investors that the “gate” mechanism, lock-up period, and any other withdrawal restrictions are needed for the overall success of the hedge fund.
Domestic or Offshore
A domestic hedge fund structure often attracts American taxable investors, whereas U.S. tax-exempt investors prefer offshore hedge fund structures. Also, non-American hedge fund investors usually prefer offshore structures to avoid entangling themselves with U.S. regulatory bodies. Others believe they’ll incur less withholding tax if they invest directly with U.S.-based accredited investors.
You’re advised to utilize offshore and domestic hedge fund components if you’d like to target diverse seed money sources. These kinds of hedge funds are also known as master-feeder hedge fund structures.
Pick a Proper Business Structure For Your Hedge Fund
Next, you’ll need to pick a legal structure for your hedge fund and register it with the Secretary of State in every state you intend to operate your business. If you’re in doubt about the proper business structure you should pick, feel free to consult with a professional.
The five most common legal structures you’ll usually find with hedge funds include S Corporation, C Corporation, Limited Liability Company (LLC), Partnerships (including limited partnerships), and Sole Proprietorship.
Like most other large hedge funds, you may want to legally register your business in a tax haven to avoid both the Internal Revenue Service (IRS) and the Securities and Exchange Commission while simultaneously skirting regulatory hurdles. Bermuda and the Caymans’ sunny climes are particularly popular among fund managers.
Now comes the most exciting step.
Also Read: Bull and Bear Markets: Understanding the Trends That Dominate Financial Markets
Raise Some Money
Needless to say, on your quest to start a hedge fund, this will be the trickiest bit. You’ll generally need above $50 million to have any sort of credibility among high-net-worth individuals. It definitely helps if you have private rich, or wealthy, trusting friends. If you have your own funds, it will help as well.
In the U.S., Hedge funds have historically been prohibited from publicly advertising on the internet. Thanks to new rules, however, they’re now permitted to engage in all forms of communication with prospective investors, which has been a game changer in the realm of hedge fund marketing practices.
Good relations with Wall Street banks will also come in handy. In return, these “business acquaintances” can arrange introductions for hedge fund managers to investors.
Also worth noting, it’s extremely wise to only accept funding from well-off people. The last thing you want to go through is your clients pestering you daily because they liquidated their personal assets, and their entire net worth is now tied up in your fund.
Get Business Insurance For Your Hedge Fund
Business insurance policies you ought to consider getting for your hedge fund include workers’ compensation insurance, professional indemnity insurance, Directors and Officers (D&O) Liability Insurance, Commercial Property Insurance, and General Liability Insurance.
That list includes everything: insurance covers that’ll protect your hedge fund from third-party claims and those that’ll protect your business from natural disasters or anything that breaks in and steals things.
Before committing to any specific covers, I’d recommend finding a reputable insurance agent, telling them all about your business and needs, and seeing what policies they recommend that cover your specific needs.
Service Providers and Independence
Key service providers are a critical part of any hedge fund landscape as they assist in smoothly running operations within the hedge fund. What’s more? These service providers ought to be independent to avoid conflicts of interest and assure prospective investors that sufficient checks and balances exist.
Important service providers that every hedge fund will need include a capable attorney, a custodian or custodians, a broker (prime broker or otherwise), an independent certified public accountant for audit & tax services, hedge fund marketers, and independent 3rd party fund administrators.
Together, these groups of experts will make investment decisions and perform an assortment of essential services for hedge funds, such as providing advice on fund terms & securities laws, facilitating securities lending, custody & valuation of assets, and even assisting with investor subscription and fundraising processes.
What’s more? Selecting the appropriate service providers will also be one of the first steps you’ll need to get out of the way when starting a hedge fund. This, in turn, allows hedge fund managers to concentrate more efficiently on their “hedge fund strategy,” which helps provide the institutional quality hedge fund infrastructure that early investors seek before committing their investment capital to new vehicles.
Even more critical, fund managers will not only seek to have these service providers at launch, but they’ll also be required to continually review their relationships with said individuals to ensure they’re getting the best value for their money and every service provided is up to standard.
Hire Your Employees
In addition to service providers, your hedge fund will also need four kinds of employees to get started: managers, back office staff, analysts, and traders. Managers are responsible for the hedge fund’s overall operation and will make strategic decisions about the right kinds of investments that should be made.
Back office staff will handle the business’ financial operations, including preparing financial reports and reconciling accounts. Analysts will study all financial statements and conduct in-depth research to find investment opportunities.
The traders, as their name insinuates, are responsible for buying and selling securities. Only hire people who can start trading and make quick decisions in line with the quickly adjusting market conditions.
You’re Ready To Launch
Congratulations! Your investment company is ready for inception. If you follow this guide’s steps to the letter, setting off on the right foot shouldn’t be a hassle. Make sure your hedge fund’s logo, website, and social media accounts are fully set up before launching.
Common Challenges Involved with Starting a Hedge Fund
Arguably the biggest challenge in launching a hedge fund will be securing sufficient potential investors’ commitments to scale a professional investment management firm. That said, other challenges can still arise related to compliance with federal and state laws, license requirements, marketing restrictions, and a whole lot of other hurdles.
Depending on the location where prospective investors’ solicitation activities will take place, where the hedge fund manager has chosen as the business’ location, and any applicable federal (and state) rules, the fund’s management firm may have to register as an “investment advisory company” even prior to the launch of the hedge fund.
Only a few jurisdictions are ‘law-friendly’ to new hedge funds and will not demand registration until after the fund’s investment advisor has accumulated a significant level of assets or a number of clients under management.
Better yet, over the last couple of years, the SEC and many states in America have been adopting “private fund advisors” exemptions in an effort to allow some investment advisors to avoid registration. This only applies to any investment advisor whose clients are private funds and not separate managed accounts.
What’s more? Every registered investment advisor will be subject to reviews and approval processes by the SEC or the securities division of their home state. Depending on the state in question, the process will typically take between a few weeks and several months.
Hedge fund managers with substantial past industry misconduct cases, a significant criminal record, or an otherwise questionable personal record might be disqualified by the SEC or state for registration.
So yeah, there you have it. All an investment manager looking to start a hedge fund needs is a relevant track record, a viable strategy, and substantial business know-how to create a successful alternative investment management firm.
Before raising capital from sophisticated investors and high-net-worth individuals, the hedge fund manager will also need to work with a capable team of key service providers to help facilitate a successful launch.