Hedge funds can be mentioned over 1,000 times a day in blogs, newspapers, magazines and on radio stations. At the end of 2011, there were over 9,000 hedge funds in existence with 1,113 starting that year, according to Hedge Fund Research. In this article, we'll explore the reasons why these funds continue to be popular and what you should take into consideration before starting up your own hedge fund.
SEE: A Brief History Of The Hedge Fund
Why Start a Hedge Fund?
There are many reasons why starting a hedge fund is the new American dream. Here are some of the most popular:
- Almost everyone has read the news stories about the few hedge fund managers who have earned over $1 billion a year running their funds.
- Hedge funds grace the cover of mainstream media newspapers and magazines on an almost-daily basis.
- The secretive and exclusive nature of hedge funds has a draw, compared to many other areas of finance and investing, which can at times seem mundane.
With a little bit of capital it is relatively easy to start a hedge fund. However, implementing risk controls, growing assets, hiring staff and running the organization as a profitable business, while producing positive performance, is very challenging.
Between 4 and 10% of all hedge funds fail or close down each year, and countless others are half-started, abandoned or re-shaped into private investment pools for friends and family. This is not to say that starting a hedge fund is a bad idea, but it is important to realize that it is a very challenging endeavor - one that must be approached with the same long-term perspective required for running a business.
Tips for Hedge Fund Startups
If you are set on starting a hedge fund, there are dozens of factors that will determine your success. Here are seven tips or crucial areas of your new venture that you should be cognizant of and think through, before showing any potential investors or partners your business plan for your fund.
1. Competitive Advantage
Your hedge fund must have a competitive advantage over others in the market. This may be a marketing advantage, information advantage, trading advantage or resource advantage. A marketing advantage could be close career-long relationships with hundreds of high net worth investors or family offices. An example of a resource advantage would be if you work for a large asset-management firm that would like to heavily invest in launching a hedge fund.
2. Strategy Definition
Some hedge fund startups underestimate the importance of clearly defining their fund's investment strategy.
- What is your strategy, and how will you define and explain your investment process to your own team and initial investors? Developing a repeatable, defendable, profitable investment process after taking the costs of running a hedge fund into consideration can be difficult.
- Ideas which have not been tested (or have been only backtested) in the real markets don't hold very much water with investors and consultants, who see hundreds of wannabe hedge fund managers a year.
- It will help to do some hedge fund performance research if you haven't already and know which strategies are currently doing well, which are not and why this may be the case.
- Are you launching your fund at a time when your strategy is in very high demand, or has the pendulum swung the other way for the time being?
Start building a list of the other hedge funds that run the same strategy as your firm and conduct as much competitive intelligence on them as you are able to, ethically and legally.
3. Capitalization and Seed Capital
It is important that your new hedge fund be well capitalized. The amount of assets your fund will need to manage to become profitable will depend on three things:
- Team size
- Investment partners
- Unique cost structure
Some hedge fund managers claim profitability with less than $10 million in assets under management, while others claim that you must manage $110 million to $125 million in assets to be considered a serious business venture with some long-term prospects for survival. The number is probably somewhere in the middle, but everyone's business is unique and due to performance fees, you can sometimes see large profits with relatively low asset levels.
4. Marketing and Sales Plan
Like any business, nothing happens until a sale is made. It is important to develop a sales plan for raising assets before you open your doors for business. One of the first steps in doing so will be deciding where you will try to raise assets. There are many potential sources of investors, including:
- Seed-capital providers
- Family and friends
- High net-worth individuals
- Financial advisors
- Wealth-management offices and RIAs
- Single- and multi-family offices
- Fund of hedge funds
- Foundations and endowments
- Sub-advisory relationships
Small hedge fund startups typically try to develop long-term relationships with seed capital providers, family and friends and high net worth individuals (directly or through their financial advisors). Working with institutional-quality investors who might eventually invest $25 million to $100 million at a time can be difficult until you have a two-to-three year track record and well over $100 million in total assets under management.
Some simple marketing and sales activities to complete and create before launching your fund include:
- Two-page marketing piece
- 20-page PowerPoint presentation
- Professional logo
- Business cards
- Folders with logos for presentations
Many of these are Business 101-type details, but they are often overlooked or poorly executed. Anyone who can really help your business grow sees hundreds, if not thousands, of hedge fund managers a year, and it is easy for them to see which managers have invested their time and effort and which have thrown something together at the last minute. All marketing and sales materials should be produced under the direction of your chief compliance officer or compliance consultant, as there are many limitations and details that need to be approved and reviewed.
5. Risk Management
Risk management is an important piece of the puzzle when running a successful hedge fund. Your firm must come up with a concrete and competitive method for managing both business and portfolio risk or you will come off as not being serious about your business or long-term growth goals. There are many consultants and consulting firms that do nothing but advise hedge funds on portfolio and operational risk-management issues.
6. Compliance and Legal Assistance
Hiring great legal counsel should be seen as an investment. An experienced hedge fund lawyer can help you avoid pitfalls and build relationships and invite you to networking events such as private-capital introduction dinners. It will also show others in the industry that you are investing in your own business because you aim to be in the industry for the long haul.
7. Deciding on Prime Brokerage
Many startup hedge fund managers underestimate the importance of choosing a prime brokerage firm, which can act as a partner to their business. The prime broker is such an integral part of how your hedge fund will trade and operate that you should take several weeks or months to evaluate your options and weigh the costs and benefits of doing business with the various firms you meet with.
It is usually wise to choose a prime brokerage team that is very motivated to serve your needs, but not so small that they physically cannot meet all of your trading and prime brokerage requirements. While capital-introduction services can be a great thing for your prime broker to offer, know that they often require a nine- to 12-month track record at a minimum before they can do much for you beyond helping explore seed capital sources. Once your team has proven itself, a good prime broker will help make introductions if you have great performance and a solid team behind the portfolio.
The Bottom Line
Starting a hedge fund is a challenging endeavor that takes a multi-year commitment to refining your strategy, building a team, and finding both trading and marketing niches where your firm can profitably operate. While many hedge funds fail before they become large enough to be viable businesses, following the tips above will help save you time and gain some early momentum in marketing your portfolio.