Key Considerations for Starting a Hedge Fund

Hedge funds comprise the largest segment of the alternative asset market. With this status comes large profit potential. Many talented traders and investment professionals consider starting their own funds at some point during their careers. Launching a fund is not an easy or inexpensive undertaking, but it can be both personally and financially rewarding. Below, we will guide you on the first initial steps to take into consideration when starting your fund.

Initial Steps

In deciding to start a fund, you should develop a strategic business plan. What is your vision and what are your goals? What is your trading strategy? What makes you different and why will you succeed? You need to have clear answers to these questions and be able to articulate them to potential investors before moving forward.

Budget

At the outset, you should develop a budget. Do you have enough available resources to fund operations as well as your lifestyle, and for how long? Though the fund is normally responsible for its direct expenses, rent, salaries, and other overhead costs are typically the responsibility of the fund manager. While the asset-based management fee paid by the fund is meant to cover these expenses, early-stage capital may be insufficient to generate enough fees to cover all costs. Performance fees should not be counted on as they are not guaranteed.

Raising Capital

Another important consideration is your ability to raise capital. While your initial sources of capital will likely include friends and family, other sources such as hedge fund seeders, high net worth individuals, family offices,  endowments, pensions, insurance companies, and other institutional investors will want to see a favorable track record before they invest. Potential investors may also expect you to invest a significant amount of capital to demonstrate that you have faith in yourself and your strategy. A verified performance history will also be helpful.

Develop a clear message that you can present in a pitch book or slide deck. As you reach out to investors, expect to discuss your background and experience, your investment process and strategy, your track record, and your expected returns for the fund. Be mindful of legal issues such as limiting your marketing efforts to accredited investors.

The amount you need to raise for a profitable fund depends on your costs and fee structure. While at least $10 million in assets under management may get you started, $100 million and greater is more appropriate if you want institutional investors to take you seriously.

Legal Considerations

Once you are confident that you can raise sufficient capital, the next step is to form your legal entity. Most hedge funds in the United States operate as limited partnerships (though some are formed as limited liability companies) organized in Delaware. Your attorney will draft the limited partnership agreement for the fund. You will also need to set up a management entity and potentially another entity to act as the general partner of the fund. You may also need to register as an investment adviser and file for licenses in the state(s) where you will be operating.

Also, you will need a private placement memorandum (PPM) which outlines the terms of your fund for prospective investors including, among many other things, the fund structure (e.g. domestic, offshore, master/feeder); fee structure (management and performance); lockup terms (how long investors must keep their money in your fund); redemption rights (how much notice they need to give before a withdrawal), and the potential risks of investing.

It is highly recommended that an attorney familiar with hedge fund regulations prepare your documents. Startup legal costs can run from $25,000 to more than $100,000.

When you are just starting out, your AUM-based fees may not be enough to cover your expenses. Planning on little or no earnings and the potential for relying on savings to handle some of the startup and ongoing costs is prudent. Your goal is to have a great foundation through your strategic planning, budgeting, raising capital and your legal considerations.

If you are considering starting a fund, have questions, or would like our assistance, please contact a member of Anchin’s Emerging Manager Platform or your Anchin Relationship Partner.

Keep Reading – Key Considerations for Starting a Hedge Fund Part II