Starting a Hedge Fund – Tactics and Pitfalls

  • The key roadblock that new hedge fund managers need to recognize and then overcome is the fund is a business. Assuming they previously managed a portfolio, the manager might figure putting together a business structure is simple, and is an afterthought compared to the investing strategy.

    Managing the business adds a whole range of other costs and responsibilities, including payroll, managing service providers, investor relations, capital raising, rent, office management, and a host of others. It’s not just about running the capital side, it’s an actual business that has to operate efficiently if the fund hopes to flourish.

    Many new hedge fund managers do not anticipate how much time is involved in all of these business functions. It’s a contributing factor to hedge fund failure, which is pegged by some researchers as approximately 30% of funds not making it to 36 months in operation before folding. If a fund manager does not have staff in place to help them manage the business, then it takes away their time from focusing on generating returns. Investors will not be too understanding if a hotshot manager opens their own fund but then does not deliver because they were tied up with HR issues or outfitting the office with new furniture.

    Hedge fund managers looking to start their own shop should consider these tips:

    Create a Bulletproof Legal Structure

    Preparing the legal documentation happens early in the process and is vital to protecting you personally and professionally. As you evaluate law firms, consider how many of their clients resemble your planned fund? And ask how much they will customize standard boilerplate documents that fit your exact circumstances. These docs are long and quite complex, so you want to avoid situations where your offering documentation is not exactly aligned to your business. This might be a more cost-effective approach, but it’s a considerable risk-reward and might start you down a treacherous path. A quality law firm will listen intently to your business goals and structure and then act accordingly.

    And on the regulation side, the various regulatory bodies are looking closer and closer at hedge funds, with intense scrutiny on managers. Regulatory problems can ruin a new fund, so build the right legal structure on the front end and take the advice of qualified legal counsel every step of the way to stay in compliance.

    Pick the Right Partners and Stakeholders

    There are three critical stakeholders that are crucial for people starting a fund. There’s some overlap in what these three groups perform, and that’s a good thing as it creates some checks and balances within the lifecycle of the fund. These groups are a qualified law firm, an audit and tax partner, and the fund administrator that work together as a three-legged stool. Pick these partners based on your fund’s complexities and strategies, while judging if you can trust them to truly believe in your business and help you overcome any future pitfalls. Talk to prospective firms to see if they have experience in handholding new mangers through the process and are willing to talk about areas where you might fail in the future.

    A fund administrator should feel like an extension of your fund business. Talk to the team that you’ll be working with day-to-day to ensure you can build a good relationship and environment of mutual success. You want the administrator to offer a robust infrastructure of process and control, but it’s equally important that the people you engage with have the expertise to solve unforeseen challenges.

    Plan a Budget and Understand the Costs

    Since a new hedge fund must be run as a regular business, you have to create and stick to a reasonable budget. It should include some room for contingencies, so build in a buffer above assumed costs. Most managers do not have the luxury of attracting enough capital upfront where the management fee covers the cost of running the business. Expect to run the business at a loss for a period of time and know what you are truly comfortable with. Knowing this in advance is achievable when you have the appropriate plan in place, but can be a disaster when the loss is a surprise or continues for longer than anticipated.

    You’ll need staying power and gritty determination to see the fund through such times, and will need to lean on your investing prowess to generate returns and continue to raise money. Not everyone can start a fund with that one “big check,” so take a more grassroots approach to managing the budget and taking on capital piece by piece.

    Develop Your Messaging

    As a portfolio manager you understand that “messaging matters” when it comes to finding the right investments. Remember your company’s message has to be precise. New fund managers should concisely state what they are trying to accomplish, especially in terms of competitive differentiators and risk management.

    Establishing a marketing brand takes expertise, so consider hiring a firm that can fine tune your pitch and pitch book that allows you to be in the best possible position right “out of the gate.” Even if a manager has a successful history of generating returns they might be overconfident about their ability to raise funds. They might create an investor’s deck, but it’s not professional and they aren’t booking meetings. Developing a strong pitch and image are another part of the “business” side of a fund, and require a solid structure and for the manager to let their own personality and confidence come forward. It’s fundamentally about putting in place the right things around you (lawyers, accountants, marketing), and leverage their expertise when needed while you focus on making the key decisions.

    David Burnett is Chief Executive Officer of PartnersAdmin LLC.