The Basics of Hedge Funds

Hedge funds are pooled investments that involve aggressive trading strategies to generate very active returns for their investors. They've gained quite a big name because of these returns. But they aren't an option for the average investor, mainly because initial investment requirements are usually fairly high and can only be fulfilled by accredited investors, such as institutional investors and high-net-worth individuals (HNWIs).

Hedge funds are just like mutual funds because both allow investors to purchase and sell shares. But because they involve aggressive investment strategies and vehicles, hedge funds come with more risk to the investor. Regulation of the hedge fund industry was fairly lax, but things changed after the financial crisis.

These funds are a complicated beast, not only for investors but also for those who manage them. Establishing one comes with hurdles—many more in the United Kingdom than in the United States. The process, which can take at least three months to complete, often leads many new firms to hire an external company to establish and ensure the fund is fully compliant with all laws and regulations.

Still interested in starting your own hedge fund? Keep reading to learn more about the basics of hedge funds and the steps you need to take to start your fund in the United Kingdom.

Key Takeaways

  • Starting a hedge fund in the United Kingdom is more complicated than it is in the U.S.
  • Hedge funds in the U.K. are highly regulated and transparent.
  • Founders must meet strict regulatory requirements, file the necessary documents, and seek approvals before they can begin operations.
  • Key elements of a hedge fund include the jurisdiction, structure, oversight and providers, and components.
  • Most hedge funds charge a two and twenty fee, which comprises 2% of the total assets and 20% of the profits.

Regulations and Approvals

Hedge fund managers must get approval to start funds in the U.K. under the Financial Services and Markets Act 2000. The first and most fundamental step is learning how to navigate the governing body. Regulation and authorization approval falls under the Financial Conduct Authority (FCA), formerly known as the Financial Services Authority (FSA).

Applications submitted to the Financial Conduct Authority can take up to six months to be approved. Part of the approval process requires the investment manager to demonstrate adequate financial resources and appropriate staff, systems, and controls to manage the fund. There are several prerequisites:

  • Establish financial resource requirements depending on whether the fund falls within the Markets in Financial Instruments Directive (MiFID) of the European Community.
  • Prove investment staff competency by passing an exam in full or part based on experience in management outside the U.K.

Hedge funds may be monitored for up to a year after approval. This oversight includes rules related to the conduct of business, financial records and reporting, compliance, and complaints. Fund marketing is governed by the Alternative Investment Fund Managers Directive (AIFMD). Investment managers must receive approval from the regulator in their established country in order to market funds in a European Union (EU) country.

3,635

The number of active hedge funds in the U.S. in 2021.

 

Key Elements

Navigating the external regulations and authorizations is only one of the challenges hedge fund managers must consider. Before they begin operations, fund founders must also decide on the:

  • Jurisdiction
  • Structure
  • Oversight and providers
  • Components

Let's take a look at each factor and how they relate to the hedge fund industry in the United Kingdom.

Jurisdiction

This is the geographic location of the hedge fund's operations. The jurisdiction doesn't have to be in the same location as the fund's administrator. So why is it important? The fund's headquarters defines its tax structure or how it is taxed.

Many funds are based in tax havens offshore. Countries like the Cayman Islands, Bermuda, Luxembourg, or Ireland are popular choices because they have very favorable corporate tax laws. For instance, the Cayman Islands is one of the largest offshore financial centers in the world. Businesses set up in the region are not taxed.

Hedge funds benefit from offshore jurisdictions because it's the investor, not the fund, who is taxed on the fund portfolio's appreciation.

Fund Structure

The structure of the fund is chosen based on the type of investors and their needs. This includes tax status, the ability to use leverage, and voting rights.

The typical structures for hedge funds are:

  • Stand-alone: This is a single fund in which several investors purchase shares.
  • Segregated portfolio companies: These are separate legal entities where each investor has a separate fund account with their own assets and liabilities.
  • Master/feeder and umbrella funds: These funds fall in the middle of the two extremes listed above. Firms use this structure to satisfy different investor requirements, such as tax status or leverage restrictions. Feeder accounts feed into the master fund, which then trades on behalf of the feeder funds.

Oversight and Providers

British law calls for hedge funds to have at least two independent directors, who, for tax purposes, must be based offshore. The Investment Manager Exemption (IME) allows a hedge fund to appoint a U.K.-based investment manager if they meet certain criteria.

Many funds are set up as self-managed funds. In these cases, management teams represent the fund's appointed officers, saving both time and money. Other providers who want to start a hedge fund include administrators, independent auditors, custodians and/or prime brokers, legal counsels, and tax advisors.

Regardless of how oversight and providers are set up, managers must act independently when they provide investment management services and all transactions must be conducted in the ordinary course of business. Managers receive customary fees in return for their services. But they cannot comprise more than 20% of the fund’s assets.

Fund Components

Management needs to make certain decisions about the components of their fund before it can be established. Here are the components that must be taken into consideration.

  • Share classes: Many hedge funds create different share classes, such as management and investment share classes. Management shares usually hold voting rights while investment shares are considered nonvoting. Separate share classes can also be established for any officers and employees of the investment manager, which allows them to avoid paying fees. There can also be a share class for U.K.-taxable investors.
  • Fees: Hedge fund fees come in many different forms. But they have traditionally followed one simple structure. The two and twenty fee structure pays a 2% management fee out of the assets under management (AUM) and a 20% performance fee of the appreciation or hurdle rate exceed.

Withdrawal Restrictions

One of the biggest components that management must determine is how withdrawals are treated and if there are any fees attached.

One of the most common provisions is called the lock-up period. Investors aren't allowed to cash out their shares by selling or redeeming them during this time, usually one to two years. That's because the fund manager needs time give to rebalance their portfolio in certain circumstances.

Funds may charge fees if investors break the lock-up provision. They may also charge redemption fees just like some mutual funds.

Investors can file complaints directly with the Financial Conduct Authority when things go awry with their hedge fund investments.

Special Considerations

Fund managers need to consider establishing a track record and proving they have what it takes to succeed. The length of a fund's track record depends on any special conditions potential investors have as well as the manager’s pedigree or experience. Investors generally like to see an apples-to-apples comparison by comparing the manager's track record from another firm with the same strategy.

Seed capital is also important, especially when it comes to regulatory requirements. It allows the fund to be set up with ease, ensuring that operating costs do not negatively impact the fund's performance. Having the right structure in place means that costs are external to and do not supplant the fund's overall performance.

Marketing and Solicitation

As stated above, the AIFMD governs how hedge funds can market and solicit their assets. The AIFMD has explicit rules on how firms can market their funds and solicit assets.

As of 2018, U.K.-based hedge funds must adhere to the AIFMD. This wasn't always the case, though. Prior to 2018, these funds were able to simply adhere to private placement rules without the need to follow the AIFMD as long they met the following criteria:

  • They only marketed their offerings in the U.K.
  • Marketed the fund outside the European Union
  • Relied on reverse solicitation where the investor approaches the hedge fund and not the over way around

Managers who will solicit assets in the EU must comply with these rules to establish a marketing license.

The Bottom Line

Hedge funds in the U.K. are subject to more regulatory establishment criteria than funds in the United States. If you're looking to start your own fund, make sure you contact the proper governing bodies to ensure that you're in compliance with the stringent rules and regulations.

Depending on the complexity of your planned hedge fund firm, you may choose to hire an outside company to help you wade through the process. Your understanding of and compliance with all requirements will help provide a strong backbone to the new hedge fund.