In this post I will be explaining everything you need to know about launching your own hedge fund.
Most importantly, I will be sharing some secrets that will allow you to do it at a fraction of the normal cost.
This will allow you to move your money management business to a credible structure more quickly. This will give investors more confidence and make it easier to grow your AUM.
We will be looking at the following points:
- A step by step guide to what makes up a hedge fund
- The common costs of traditional hedge fund formation
- How to launch your own fund at a fraction of the cost
There are many jurisdictions around the world where your hedge fund could be based. However, the choice you make will have a big impact on the perceived credibility that it has to investors.
If you select the wrong location then you will find it incredibly difficult to convince professional clients to invest into your fund.
There are generally two distinct types of locations for launching your new fund. First there are onshore hedge funds and then there are offshore hedge funds.
Onshore locations are often heavily regulated and expensive to set up and operate. This pushes most new managers offshore.
According to research by hedgeweek, the Cayman Islands is the most popular offshore location with hedge fund managers. Around 75% of all offshore funds are based there.
For most start up managers cost will be an issue. This makes it highly likely that your first fund will be based in an offshore jurisdiction.
While it can be significantly cheaper than an onshore fund the overall costs can still be very high for new managers.
Structure Of A Hedge Fund
There are many different types of fund structure. My own experience is with open ended private placement funds structured as exempted SPC’s.
Before we discuss how to get your first fund set up it is important to explain exactly how a traditional SPC fund is structured.
To illustrate the structure of a hedge fund we can use the analogy of a private company. Just as a company has shareholders, directors and a management team so does a hedge fund.
There are two distinct type of shareholders. Profit sharing, non-voting and voting, non-profit sharing.
When an investor places their capital into a hedge fund they are actually exchanging their money for shares in that fund.
The shares they buy entitle them to a portion of the profits. They do not receive any voting rights or say in how the fund is managed or operated.
Each share has a value that is calculated on a regular basis. This is called the ‘Net Asset Valuation’ of the fund (NAV).
The NAV calculation determines whether or not the value of each share has gone up or down and whether or not the investor has made a profit.
When the investor wants to leave the fund they will redeem their shares. This means that they will sell their shares back to the fund in exchange for their original investment plus their profits.
A hedge fund will usually try and keep cash reserves on hand for such redemptions. Alternatively, the investor can also sell their shares privately to other investors.
Shares with voting rights do not have any profit share. These shareholders are responsible for appointing service providers to the fund and ensuring it runs smoothly.
Voting shares are not publicly available and are a formality for setting up and operating the hedge fund effectively.
Directors Of The Fund
Each fund usually has a board of directors. These are responsible for the effective day to day operations of the fund.
The directors are also the ones that have voting shares in the fund.
Anyone can be the director and many funds usually appoint a board of directors with a mixture of people on them.
The role of the director is to ensure that the investor’s capital is safe and being used appropriately. They are also on hand to recommend any service providers that the fund may need.
The directors meet regularly to discuss the operations of the fund and to resolve any issues that maybe be prevalent.
For an offshore fund it is important that the majority of directors be offshore themselves. This is to prevent onshore jurisdictions claiming that the fund is operating within their boundaries.
The directors are responsible for appointing all of the main service providers of the fund. These include the investment manager, the prime broker, the auditor and the administrator.
They are also responsible for ensuring the fund has access to banking facilities and legal counsel.
Hedge Fund Service Providers
For a fund to operate it needs to appoint a variety of service providers. This is the equivalent of the management team within a traditional company structure.
The most obvious provider is the investment manager. This is the company that will be responsible for generating returns on the assets of the fund.
If you are a trader or money manager looking to start your own hedge fund then it is highly likely that you will fill the investment manager role.
To do this you will need to form an investment management company to work with the fund.
The investment manager will have a clear strategy and track record that investors will be buying into.
A hedge fund also needs an appointed administrator. They are responsible for all of the back end work and admin.
For example, the administrator will be responsible for opening bank accounts, brokerage accounts and getting all of the legal documents checked and processed.
They will also be responsible for calculating the NAV and sharing the information with investors. The administrator is usually the main point of contact for the investors.
Another key service provider is the auditor. The auditor is responsible for ensuring that the stated performance of the fund is true and accurate.
Having a credible auditor is essential in order to attract serious investors that are capable of investing significant amounts of capital.
Finally, the fund also needs banking facilities and legal counsel. The lawyers are on hand to ensure the fund is operating as it legally should.
The banking allows the fund to hold its cash assets and transfer funds between brokerage accounts. A credible bank is also essential in order to attract serious investors.
Common Costs Of Hedge Fund Formation
According to Grant Thornton, in 2017, the average cost of setting up a basic fund was around $75,000 USD. The first year operational costs of that fund were a further $100,000 USD.
This puts the total first year cost at close to $200,000 USD for getting your own fund up and running.
These costs include everything that is required to attract investors and operate the fund as a standalone enterprise.
As the investment manager, your salary is not included in these costs. They cover things like administrator, auditors and legal costs instead.
All of these fees can be taken directly from the fund as a cost of doing business but they will impact on your returns.
For example, if you have $1 million in AUM and the first year cost is $200,000 then you will need to make a 20 percent return just to break even.
Of course, if all of your returns are eaten up by costs then there will be no room for any performance fee to be charged.
According to research by Investopedia the average fund needs a minimum of $15 million AUM.
This amount is required if you have any chance of covering the costs and posting an attractive performance during the initial years.
For most small managers there is a huge gap between them generating a consistently profitable return and attracting significant AUM.
These high costs often act as a hurdle that smaller managers can never overcome. You may have experienced this when trying to build your own management business.
Alternative Routes For Start-up Managers
If you are a start-up money manager with a profitable track record then there are several steps you can take before launching your own fund.
The first step is to set up a managed account investment programme. This is far more cost efficient and allows clients to retain their funds in their own trading account.
Operating a managed account programme can help you to build up trust with your clients and demonstrate your trading skills to investors.
The fee structure is generally the same which allows you to prove yourself to investors without forgoing the rewards of your trading performance.
It is important to note that managed accounts do have several flaws that you should be aware of.
Firstly, it is notoriously difficult to truly prove your performance within a managed account structure. This is because the funds are held in the name of the client and not the trader.
This means that it is difficult to ensure that only you have traded or managed that account over time.
Without this proof it is almost impossible to verify that the returns are yours and not the clients. This makes institutional investors and some professional clients uncomfortable with the structure.
Managed accounts are also difficult structures for institutional investors to enter logistically. Most managers are set up to allocate into fund based structures.
When trying to attract more institutional investors you will very often meet resistance based on the fact that you have a managed account programme rather than a fund.
Managed account programmes will be most attractive to high net worth individuals that are looking for ways to allocate their own capital.
Building your AUM inside a managed account structure will allow you to build a base of clients that you can use to launch your first fund.
Reducing The Cost Of Your Hedge Fund
Launching and operating a hedge fund structure is essential if you want to grow your AUM significantly and have credibility with institutional investors.
To help counter the large costs of fund formation a good first step is to offer investors a managed account programme.
You will get a feel for operating a money management business within a regulated environment while building a base of professional clients.
A second stepping stone for start-ups is to utilise a segregated portfolio hedge fund structure. A segregated portfolio is a separate fund within an existing hedge fund platform.
Rather than having to launch everything from scratch it allows you to tap into the existing resources and massively reduce your initial costs.
The purpose of these segregated portfolios is to allow an investment manager the ability to create a new fund for new and different investment strategies.
However, anyone can set up their own SPC and then offer individual funds on their platform.
Typically, a hedge fund administrator will operate their own hedge fund SPC. They will then offer new managers a segregated portfolio within that platform.
The segregated portfolio operates in much the same way as a normal hedge fund and is a completely separate legal entity.
If one segregated portfolio fails then the assets of the other funds remain safe and untouched.
This structure also gives new managers access to existing infrastructure, including, legal counsel, banking facilities and regulatory coverage.
This ‘hedge fund in a box’ offering is the perfect step for new managers that have only a small amount of assets under management.
Potential Cost Savings
The fees are very often a fraction of the cost of setting up your own fund from scratch. For example, the initial set up costs can be under $10,000 USD.
This includes everything from the legal documentation to the appointing of the administrator and setting up of all banking and brokerage facilities.
The first years running costs can also be significantly lower, with some managers reporting that they pay under $20,000 USD.
Once your segregated portfolio fund is up and running the annual costs can be as low as $40, 000 USD. This includes the audit of performance.
This solution offers the possibility of launching a credible fund structure while incurring only ten percent of the traditional costs.
Another interesting feature is that it is possible to spin the fund off into its own SPC later on. Thus creating your very own platform and the ability to launch multiple funds with different strategies.
If you have a profitable trading record and maybe even a few clients ready to invest these steps are worth investigating further.
I would recommend this route if your AUM is currently under $5 million and you are serious about building a money management business.
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