How to Form a Hedge Fund

So you want to start a hedge fund. These alternative investments use pooled funds and a variety of strategies to achieve returns for investors. They are generally formed to identify and take advantage of specific investment opportunities, many of which come with a great deal of risk. But how do you go about setting yourself up to become a hedge fund mogul?

Getting a hedge fund up and running is a bit more challenging than forming a corporation or a limited liability company (LLC) for a private business. It involves navigating investment compliance laws, and you'll need professional legal help at some point along the way.

State Laws Vary

The laws governing the business are different for every country and state in which you do business. They may also differ—sometimes drastically—based on where your potential investors are located, how you may contact new investor leads, what you are investing in, and how many investors in total your fund attracts. 

Wherever you're doing business, these are the basics of getting a hedge fund up and running.

Key Takeaways

  • Starting a hedge fund can be time-consuming and expensive due to the many regulatory and legal hurdles you'll encounter, along with the need to raise capital from investors.
  • You can hire an experienced hedge fund attorney to handle the cumbersome paperwork involved.
  • A hedge fund incubation platform can get you started cheaper and more quickly.
  • A legal template service is a less expensive, do-it-yourself option.

How To Legally Form A Hedge Fund

The Groundwork

Before you put your hard-earned money into the venture, do some hedge fund due diligence. This is a costly and time-consuming process, so you want to make sure you've thought it through thoroughly.

First things first: Do your research and become an expert. This isn't like jumping into the stock or bond market. It's much more complicated with very nuanced steps that you'll have to take. And there are, of course, a number of risks that hedge fund managers need to understand.

Read up on hedge funds and how they operate and talk to experts in the field so you become an expert, too.

Names Are Important

You'll want to choose a name for your fund—one that best describes your investment style and your strategy. This is more difficult than it seems. You want to attract investors, and your name may help draw them to you.

Then determine how you're going to do business. Are you going to set yourself up as an LLC, a trust, or a limited liability partnership (LLP)? The LLP is generally the most popular option.

Initial Costs

Hedge funds are expensive ventures with burdensome startup costs that can reach well over the six-figure range. Startup costs for a standard equity fund can run approximately one million dollars in the first year. Start-up costs for more complex credit and systematic funds can run around two million dollars.

Most hedge fund managers will spend the majority of their money the first year on costs related to salaries and for fees for third-party services, such as lawyers and consultants. The chief operating officer (COO) will be a key hire the hedge fund will need right away. The annual salary range for a COO is $130,000 to $190,000.

Get your strategy in place and raise some startup cash before you take the legal steps.

You’ll want to secure a significant amount of capital to manage and make running a hedge fund worthwhile. Raising capital is one of the biggest challenges for hedge fund startups, as potential investors will want to see that you have a significant amount of assets under management (AUM) before entrusting you with their money.

There's no real prescribed target, but you should aim to have at least $5 million in AUM to be successful, while $20 million will make you noticeable to investors. Having $100 million will get you noticed by institutional investors. In general, hedge funds can only operate successfully with large amounts of assets under management due to the powers of leverage and economies of scale.

Raising Capital

You may find one or all of the following good sources to go to first for initial investment capital:

  • Your own savings
  • Family and friends
  • Colleagues
  • Hedge fund seeders
  • Endowments or foundations

Eventually, you'll need to attract sophisticated investors who have larger sums of money at their disposal. You'll need to convince them to become investors by touting a track record of repeated success with your initial funding, a clear and understandable investment strategy that has a specific mandate, and a highly-skilled and experienced team on the front and back ends.

Hiring a professional marketing team to sell your fund to outside investors is a common strategy. This team will hone your pitch by crafting the right narrative, explaining the investment process used, and highlighting the fund's successes.

Create a Website

Hedge fund managers are hampered in their efforts to raise funds by regulations that prevent them from publicly advertising a specific fund. They can, however, set up informational websites that explain their investment strategies and experience. Fund managers often seek a wider audience by offering specific trading ideas on these websites.

Hedge funds are often marketed by the fund manager, who networks with friends and business acquaintances or through third-party placement agents. The agents are individuals or firms that act as intermediaries for pension fund managers and similar professional and institutional investors.

Sometimes fund managers offer seed investment arrangements to initial investors. In exchange for a substantial investment in the fund, the investor receives a discount on fund management fees or partial ownership interest in the fund. These initial investors often do their own networking to solicit other investors.

Hedge fund managers generally produce brief marketing materials to give to prospective investors. Known as a "pitch book" or "tear sheet," this covers the basic information on the fund's strategy and manager, and its terms for investing.

3 Ways to Get the Legal Work Done

Once you've secured the capital, you have to work through the legalities of setting up the fund.

If you're going to give out investment advice, first pass a test and register with the Securities and Exchange Commission (SEC). This is legally required under certain circumstances and it's a good idea in any case as future investors will see this as a positive sign. You'll also need to set yourself up with the Internal Revenue Service (IRS) to get an employer identification number.

There are three possible ways to take it from there, depending on your budget and your need for professional hand-holding.

Hire a Lawyer

You may consider hiring an experienced hedge fund attorney to help you sort through the paperwork, which can be cumbersome. It will also save you from making any costly mistakes like misfiling a form or forgetting one.

Granted, this is the most expensive option. An experienced hedge fund attorney will charge between $20,000 and $150,000 just for the legal formation of your fund.

Experienced attorneys come with a long list of client recommendations and good reputations. Still, you'll be paying top dollar for work that is mostly completed on document templates by junior staff.

Use an Incubation Platform

Another option is to try to find a hedge fund incubation or emerging manager platform solution instead of fully forming your own hedge fund.

The emerging manager platform's business model allows you to start trading in your hedge fund and seeking investors while building an audited track record within its larger legal structure.

If you decide this is the way to go, network with people in the field to identify which platform to use. They seem to come and go and you want a stable and competent place.

This method significantly cuts down your startup expenses and allows you to spend more money on talent, systems, and other service providers such as fund administrators, prime brokers, auditors, and third-party marketers.

Use a Template Service

The final option is to use a hedge fund formation template service, which could cut costs and reduce your startup expenses by 60% to 90%. These services give you access to the same legal templates the high-end attorneys use. Hedge fund formation templates give you the freedom—and responsibility—to establish your fund hands-on.

Don't discount the fact that you may need legal representation down the road. You still have the option of retaining a full-blown, high-end attorney as your ongoing compliance and legal counsel. But you may be able to put it off until a later date.

This option is growing in popularity. As long as the fund is formed correctly, there is often a better payback by investing more of the startup money in operations and advisors rather than lawyers.

Article Sources
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  1. Bloomberg in Partnership With Alternative Investment Management Association (AIMA). "Hedge Fund Start-Up Guide," Page 10.

  2. Electronic Code of Federal Regulations. "Title 17: Commodity and Security Exchanges; Part 275 — Rules and Regulations, Investment Advisers Act of 1940."

  3. Grant Thornton and Stonegate Capital Partners. "How do you start a hedge fund?" Page 10.

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