Your Step-By-Step Hedge Fund Guide

Many involved in the securities or asset management industry have thought about opening their own hedge fund or private investment vehicle. They have managed money or traded securities successfully for others and think they have what it takes to unleash the entrepreneurial fund management tiger within themselves. Sound familiar?

Making the leap, often from a working as an employee of a financial institution in some capacity to being your own boss and the master of your own financial domain, is an exciting yet daunting task. Every year, hundreds try, and they experience varying degrees of success and failure. Taking the right measures up front and staying true to your plan could be the difference between making it and not in the highly competitive world of private fund management.

Step 1: Developing A Trading Strategy

If you are thinking of starting your own fund, step one is developing an edge or a trading strategy that you have tested and are ready to roll out under your own brand.

Sometimes this is a theoretical model based on research, but more often than not, the new manager has already taken the next step from trading theory to enacting the strategy with real dollars – most likely his or her own money in a personal trading account. If the trading theory works with real money, the first step has been made toward a new fund launch: you have a trading model to employ. In many ways this is the easiest of all of the steps needed to not only launch a fund, but also to be successful.

Step 2: Finding Investors and Raising Capital

The next daunting task is how to find investors and raise funds. Many trading-oriented emerging managers find that partnering with others who can provide the capital introductions and ultimately fund assets, is not only a luxury but a requirement. Managers without internal methods of raising capital often reach out to broker-dealer firms, known as placement agents, which specialize in raising fund assets, typically for an up-front fee (similar to a sales load).

Step 3: Engaging Accounting and Legal Service

The first two steps mentioned above are the key initial ingredients for success – but they are only the beginning. Prospective managers will need to contract several service providers who can help them get to the operational starting line.

Investors have become more sophisticated and diligent following the high-profile hedge fund frauds of the late 2000s, and the trader’s track record has become critical for raising assets. Prospective managers should strongly consider engaging a reputable CPA – preferably one who is known in the industry – to audit the emerging manager’s track record. Not only will this provide an important level of assurance to investors regarding the trader’s strategy and prior performance, but it will also enable the new fund to establish a professional relationship with a CPA firm that can provide audit and tax services annually after launch.

You will also need to work with an attorney to create offering documents and promotional materials for prospective investors. Engaging both legal and accounting firms during this stage can make the go-to market process smoother. An accounting firm with hedge fund expertise can provide a unique level of assistance to the manager and his attorney concerning tax and manager fee disclosures and methodologies, as well as help to determine the most operationally and tax efficient structure for the fund and its manager.

Step 4: Choosing the Right Structure and Tax Elections

Choosing the right organisational structure and related tax elections of the fund and its management entities is critical. Many factors such as trading strategies and use of leverage, asset class, fund fee structure, investor liquidity, fund domicile and US tax status of prospective/target investors are just as important as the trading strategy itself. An inefficient operational structure or tax structure will not only eat away at the investor’s and manager’s after-tax returns and compensation, but could discourage prospective investors from signing up to begin with. Remember, hedge fund investors of today are savvier than they used to be!

Once these basic structuring decisions have been evaluated and agreed-upon with counsel and the CPA firm, you can begin to focus on the next steps, which will include engaging additional service providers: broker or prime broker, bank, fund administrator, internal or outsourced compliance team, and possibly an outside placement agent.

Step 5: Establishing Brokerage and Banking Relationships

Often emerging managers have a prior relationship with a broker and prime broker, but regardless of any such ties, managers must take extra efforts to select the brokerage firm that is best able to execute the manager’s trading strategy and accommodate the various asset classes in the strategy.

Use of multiple brokers has become more common over the years for these reasons as well as providing a safeguard in the event of a major financial crisis like we experienced in 2008. Not keeping all your portfolio eggs in one basket, or at least being able to easily switch between firms in a time of crisis can be the difference between keeping the lights on and closing down due to an asset freeze or worse.

Using multiple executing or clearing brokers would most likely require the manager to also engage in a prime broker relationship to augment and facilitate the trading efforts between the various custodial and executing brokers.

It’s important to remember that just because you have engaged a broker and prime broker does not mean you can forego a traditional banking relationship. Like any operating business, the fund operator will to need establish a banking relationship for the structure’s management company needs. The fund itself will have banking needs to facilitate investor capital activity transactions and to pay for its operating expenses. Many brokerages can provide this introduction through a banking affiliate.

Step 6: Engaging a Fund Administrator

The single largest ongoing operating expense of a fund is typically the fund administrator. It is also likely to be the most critical service provider relationship to keep your fund running smoothly and keep your investors happy.

A fund administrator handles the day-to-day fund-level accounting, is involved with processing investor capital activity, calculates manager fees, maintains the official books and records, reports interim results directly to investors and liaises with the audit team at each year-end. In many cases, the fund administrator will also provide financial statement preparation services in connection with the audit.

Many investors require use of a third-party administrator, which in turn has many benefits for the fund. Outsourcing this function is often more cost effective and eliminates the need for a manager to invest in staff and technology to build this infrastructure internally.

Step 7: Addressing Compliance Requirements

Finally, you will need to address compliance with various federal and state registration requirements. There are many organisations that offer outsourced services in this area, which is almost always more efficient to outsource than to develop internally – at least until the fund achieves a sufficient history and operating base of capital to support it internally.

Step 8: Getting Started!

By now you’ve realized that starting a fund is not as simple as it seems. Yes, it’s true that many of the processes mentioned above can be and often are outsourced for both start-ups and even mature funds. However, raising capital, finding the right service providers, establishing the appropriate structures and overall getting your fund ready to launch take time and resources.

Above all it’s important to remember that a manager can outsource the processes but not the responsibilities. As the fund manager, you will be inherently responsible for managing, supervising, reviewing and approving the work of your service providers throughout the life cycle of the fund.

Ready to get started? Let the steps above be your starting point, and lean on your service providers for help. With proper planning and the right team behind you, you will have a much higher chance of success.