What You Need for a Successful Fund Launch
An investment manager wishing to start a hedge fund will need a proven strategy, relevant experience, and substantial business know-how to create a successful alternative investment management firm. In order to secure investments from sophisticated investors, the prospective hedge fund manager will also need to engage a capable team of service providers to help facilitate a successful launch. This article is designed to provide an overview of the process for would-be managers interested in starting a hedge fund.
Starting A Hedge Fund — An Overview
Starting a hedge fund demands a concentrated effort on the part of the manager, sponsor, and key personnel that will form the core operating team for the fund and adviser (the management company). The hedge fund launch process can run smoothly when launch responsibilities are organized and executed in a coordinated fashion. However, many sponsors will encounter challenges through the process because they are unprepared or disorganized and lack effective guidance.
In general, the process to start a hedge fund includes:
- refining the investment program and and compiling investment results
- determining the appropriate hedge fund structure based on the nature of the strategy and expected investors
- crafting an effective marketing strategy and pitch
- addressing critical business functions in operations, trading, marketing, finance and compliance
- forging important service partner relationships
- securing applicable regulatory licenses or exemptions
- developing robust offering and governance documentation
- designing compelling marketing communication materials
- forming management and fund entities
- opening bank and brokerage accounts
- implementing the fund’s strategy in live trading
Please read on for a summary of the typical challenges in starting a hedge fund and the keys to putting together a successful hedge fund launch.
Starting A Hedge Fund — Common Challenges
The greatest challenge in launching a hedge fund will typically be securing investor commitments sufficient to scale a professional investment management business (see our discussion further below on capital raising). However, other challenges can arise related to compliance with state and federal laws, marketing restrictions, license requirements, and a host of other potential hurdles.
Depending on where the hedge fund manager’s place of business is located, where investor solicitation activities will occur, and applicable state (and federal) rules, the fund’s management company may be required to register as an “investment adviser” even prior to the fund’s launch. Only a handful of jurisdictions are “friendly” to startup hedge fund managers and do not require registration until the fund’s adviser accumulates a significant number of clients or level of assets under management. However, in the past few years, many states and the SEC have adopted “private fund advisers” exemptions to allow investment advisers whose only clients are private funds (and not separate managed accounts) to avoid registration.
Registered investment advisers will be subject to a review and approval process by the securities division of their home state or by the SEC. Depending on the state, this process can take anywhere from several weeks to several months. Managers with a significant criminal record, substantial past industry misconduct, or an otherwise questionable personal record may be disqualified from state or SEC registration.
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Developing an Attractive Hedge Fund Structure
Emerging hedge fund managers that intend to raise capital from sophisticated investors must go to market with an offering that is consistent with current market expectations and norms. Hedge fund structures have evolved substantially over the past few decades and institutional investors continue to lean on hedge fund managers to develop structures that provide a balance between the interests of the manager/ sponsor and the investors.
Trends in fund governance and structural mechanisms change frequently in response to evolving market dynamics, changes in applicable laws, and other factors. As such, offering a hedge fund structure that is in-line with current market imperatives can be a significant advantage when raising “smart money.”
Fund Structure — Domestic vs. Offshore
Domestic hedge fund structures will be attractive to U.S. taxable investors, while U.S. tax-exempt investors will prefer to invest through an offshore hedge fund structure. Non-U.S. investors may prefer an offshore hedge fund structure to avoid entanglement with U.S. tax authorities. However, many non-U.S. investors will actually incur less withholding tax by investing directly into a U.S. partnership.
Master-feeder hedge fund structures, that utilize both a domestic fund and offshore fund components, allow the manager to target diverse capital sources while allowing for the efficient management of the investment portfolio at the master-level.
Fund Structure — Fees & Liquidity
A fund’s liquidity characteristics, the terms that define when an investor can access invested capital, will be of primary concern to prospective investors. Hedge funds that employ investment strategies focused on liquid markets and exchange-traded products will generally find a warmer reception from investors if the fund provides favorable withdrawal terms, with opportunities for liquidity at regular intervals.
Funds that invest in illiquid assets or otherwise employ an investment strategy that requires a fixed lead-time for effective implementation, will have an easier time convincing prospective investors that a lock-up period, “gate” mechanism, or other withdrawal restriction is necessary for the overall success of the fund.
Hedge fund managers have received intense pressure in recent years to reduce fees. While the 2% management fee and 20% performance (incentive) allocation are vestiges of the past for most managers, hedge fund managers can still raise capital on terms that permit the manager to cover expenses, earn a living, and participate in the success of the fund’s investment program.
A successful hedge fund launch will typically offer discounted “founder” fee terms to anchor investors and other early investors. This is frequently done through “side letter agreements.” Raising “full fee” capital is a mark of success for the emerging hedge fund manager because investors will negotiate fiercely for discounts from whatever the manager considers full fees.
For the emerging hedge fund manager, raising capital is the greatest challenge of all. With enormous competition for investor dollars between traditional and alternative investments alike, it is difficult to engineer a fund offering that stands out against the crowd of available investment opportunities.
Despite the challenges, hedge funds that can present investors with a compelling investment proposition can amass significant investor assets.
Hedge fund managers that are successful at capital raising will have:
- a well-developed understanding of their fund’s value proposition and target market
- a coherent offering from an investment strategy, structural, and operational perspective
- an organized marketing plan
Hedge funds that attract institutional capital will have implemented operational risk controls that assist to demonstrate the robustness of the investment manager’s business (beyond a pure trading operation). In this regard, thoughtful operational risk controls can be designed to limit catastrophic business risk, the specter of which tends to keep institutional investors away from investments with emerging managers.
What is an Institutional Quality Hedge Fund?
The ultimate challenge for an emerging hedge fund manager is to present an offering that attracts investment capital from institutional investors. The term “institutional quality” is used for hedge funds that have the mix of characteristics that institutional investors require before making an allocation. These characteristics include:
- a well-developed investment management infrastructure
- a robust compliance function
- an emphasis on transparency
- excellent service providers (especially an experienced third-party fund administrator)
- a thoughtful risk management program
Institutional investors are increasingly interested in investments with hedge fund managers that have developed institutional quality processes and procedures throughout their operations (and a history operating with such processes). In this respect, prospective and early-stage hedge fund managers should note well that good returns are generally not enough, on their own, to attract institutional assets.
While there is no one element that will secure an institutional investment, emerging hedge fund managers can begin to develop the infrastructure necessary to support institutional investment early on in the fund’s life cycle. Doing so requires a thoughtful approach with support from competent counsel.
Starting a Hedge Fund — Service Providers and Independence
Launching a hedge fund, and gainfully operating the fund, requires the assistance of a number of key service providers. These service providers should be independent to avoid conflicts of interest and assure investors that adequate checks and balances exist. Important hedge fund service providers include:
- an independent third-party fund administrator
- an independent certified public accountant for audit and tax services
- a broker (prime broker or otherwise)
- a custodian or custodians
- a capable attorney
Each of the foregoing providers plays a critical role in the process to start a hedge fund and successfully operate the fund in a manner that ensures compliance and safekeeping of funds and securities.
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If you’re ready to begin the process to start a hedge fund, please give us a call or schedule a complimentary consultation to answer any questions that you may have and to learn more about the timeline and costs to launch your fund.Let's Connect