What You Need for a Successful Fund Launch
An investment manager wishing to start a hedge fund will need the right mix of trading success, industry experience, and business know-how in order to create a successful alternative investment fund business. To attract sophisticated investors, the prospective hedge fund manager will also need to engage a capable team of service providers to start the fund off on the right footing. This article is designed to provide an overview of the process for would-be managers in starting a hedge fund.
Starting A Hedge Fund — 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 (e.g., management company). Managers and sponsors that do not effectively delegate launch responsibilities among team members and service providers will find the process to launch a hedge fund to be a challenge. This does not have to be the case.
In general, the process to start a hedge fund involves:
- developing the investment strategy and organizing the hedge fund structure
- forming entities to serve as the fund and management company
- obtaining necessary registrations with industry regulators
- forging important service partner relationships
- developing robust offering and governance documentation
- creating effective marketing communication materials
- solidifying a marketing strategy for the hedge fund business
- opening bank and brokerage accounts
- approaching prospective investors
- implementing the fund’s strategy in live trading
All of these processes can and should run smoothly with sound guidance and diligent support. However, many managers set on starting a hedge fund never get their funds off the ground because of missteps at critical points in the hedge fund startup process.
Please read on for a summary of the core challenges in starting a hedge fund business and the keys to starting a hedge fund successfully.
Common Challenges When Starting A Hedge Fund
Typically, the greatest difficulty in launching a hedge fund will be attracting investor capital in an amount that provides the would-be manager with a platform to grow a professional advisory business (please see our discussion further below on capital raising). Besides capital raising, the investment advisor registration process can also present a hurdle for advisers who are unprepared for the regulatory requirements of state or federal securities laws.
Depending on where the hedge fund manager’s place of business is located, where investor solicitation activities will occur, and applicable state rules, the fund’s management company may be required to register as an “investment adviser” at the state level, even prior to the fund’s launch. Only a handful of states 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.
For hedge fund managers that do need to register, investment adviser registration will generally require that the principal or principals of the management company – those persons that will be involved in client solicitation or investment management roles – take and pass the Series 65 examination (although certain waivers may be available). Anyone who supervises personnel that are involved with client solicitation or actual money management functions will also need to meet this exam requirement.
Registered investment advisers will be subject to a review and approval process by their home state’s securities division. Depending on the state, this process can take anywhere from several weeks to several months. Also, any would-be hedge fund manager with a significant criminal record, substantial past industry misconduct, or an otherwise questionable personal record may be disqualified from state or SEC investment adviser registration.
If you’re ready to begin the process to start a hedge fund, or you’d like to receive additional information regarding the timeline or costs to launch your fund, schedule a complimentary consultation today.
Developing an Attractive Hedge Fund Structure
Emerging hedge fund managers must be careful to create an offering that is consistent with current market trends and that will be attractive to sophisticated investors. Hedge fund structures have evolved substantially over the past few decades and the “smart money” investors continue to lean on hedge fund managers to develop structures that provide the right balance between the manager’s interests and the investors’ interests. The structural trends change constantly and it can be a significant advantage as a start-up hedge fund manager to offer a structure that is in-line with current market imperatives.
Domestic hedge fund structures will be attractive to U.S. taxable investors, while non-U.S. investors and U.S. tax-exempt investors will generally prefer to invest through an offshore hedge fund structure. Master-feeder hedge fund structures, that utilize both a domestic fund and an offshore fund, allow the manager to target diverse capital sources while allowing for the efficient management of the investment portfolio at the master-level.
Beyond a fund’s domicile, a fund’s liquidity characteristics, 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 generally 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.
Selling a hedge fund structure that is out of sync with the current market or that is unnecessarily complex can be an uphill battle.
Raising capital is the greatest challenge of all because of the enormous competition for investor dollars between traditional and alternative investments alike. 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 strong understanding of their fund’s value proposition and target market
- a coherent offering from an investment strategy and structural perspective
- an organized marketing plan
Additionally, hedge funds that are looking to attract institutional capital will have implemented operational risk controls designed to show institutional investors that the fund is “institutional quality.” Operational risk controls are designed to limit the catastrophic business risk that often makes institutional investment in an emerging fund unrealistic or impossible.
It is worth noting that U.S. securities laws generally permit a prospective hedge fund manager to “pre-market” a hedge fund by soliciting non-binding indications of interest from prospective investors. Hedge fund managers typically develop some basic, collateral marketing material (such as a “pitch book” and “tear sheet”) to facilitate the early and ongoing marketing process. Any such material should be reviewed by counsel and should include robust disclaimer language prepared by a competent hedge fund attorney. Pre-marketing and other early “soft” sales can assist a prospective fund manager in assessing the feasibility of a potential hedge fund launch and will provide valuable feedback from investors on acceptable terms and conditions for the fund’s structure.
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 finding hedge fund managers that have developed a track record of implementing “institutional quality” processes and procedures throughout their operations. 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 experienced counsel.
Starting a Hedge Fund: Service Providers and Independence
Starting a hedge fund and ultimately running the fund in a professional manner 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 to provide robust procedures and controls. These 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.
Ready to Start a Hedge Fund?
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.