Start a Hedge Fund

Becoming the manager of your own hedge fund will give you the opportunity to invest other people's money for them, which can be profitable for you and your investors. If you're an experienced financial advisor, it may be advantageous for you to step out from under the umbrella of the investment banking industry and strike your own path. To start a hedge fund, you'll need to create and register a fund and start an investment company to be the fund's general partner. In this endeavor, the investors will act as limited partners in a private partnership.

Steps

Planning a Hedge Fund

1. Learn the basics of a hedge fund. Hedge funds are pools of investor money that use a large range of different strategies to both generate returns for investors and manage risk. Hedge funds are typically only available to sophisticated investors with large amounts of assets to invest (often over $1 million).
   • The term hedge fund comes from the practice of "hedging", which is the practice of reducing risk in an asset by taking a position in a related security to offset any downward price movements. These related securities often take the form of derivatives like futures, options, and forward contracts. Essentially, this strategy is intended to protect capital in the event of a negative event that causes an asset to lose value.
   • Hedge funds often use a wide range of complex strategies to maximize returns like using leverage (or borrowed money), using derivatives to profit from global economic trends, trading currencies, and investing in stock and bonds in markets all around the globe.
2. Distinguish between hedge funds and mutual funds. Mutual funds and hedge funds are similar in that they are both pools of money managed by a fund manager. Other than this, however, there are several key differences. These differences are important to consider when starting one.
   • Firstly, hedge funds are not as regulated as mutual funds, and so they can invest in a more diverse and risky range of securities, as well as use strategies that mutual funds cannot use. Hedge funds can use large amounts of leverage (or borrowed money), short sell, and perform riskier trades on behalf of their investors, whereas mutual funds cannot.
     • Note that the strategies available to the hedge fund manager must be identified in the private placement memorandum that must be available to the investor before purchase.
   • Secondly, hedge funds and mutual funds have different levels of availability. Mutual funds are publicly-registered securities with SEC-approved prospectuses and are available to all investors. Hedge funds are funded through private placements to accredited investors, who must have a net worth of over $1 million (not including the value of your home) or an annual income of over $200,000 (now and going forward).
   • Thirdly, hedge fund investors are typically "locked-in" for a period. Whereas a mutual fund investor can sell their shares whenever they want, a hedge fund shareholder may be restricted for a certain period of time.
   • Finally, hedge fund managers are compensated differently from mutual fund managers. Mutual fund managers receive a set percentage of total assets managed each year, whereas hedge fund managers typically receive a set percentage of total assets (usually about 2%), plus a percentage of profits that are earned. This percentage is usually about 20%.
     • Manager compensation is defined in the hedge fund's prospectus and is agreed to by the investor.
3. Select a hedge fund strategy. Hedge funds managers usually get their start by achieving a successful investing track record throughout years of industry experience. This is how they attract their first clients and build out their funds. But even with the requisite experience, you'll also need an overall vision for your fund, including an idea of how it will generate returns for investors. Hedge funds can follow a number of different strategies, including:
   • Market Neutral Strategy: This is a popular strategy that involves purchasing a group of investments that are expected to go up, and then offsetting these investments dollar-for-dollar by short-selling the overall market (one of the S&P 500 Index ETFs, for example). If the portion that is expected to go up does better than the short-sold portion, the fund would make money. This can be a useful strategy to market to investors who are concerned about market crashes.
   • Hedged equity strategy: This strategy is similar to the market neutral strategy, except instead of shorting the entire portion of the portfolio that you expect to rise on a dollar-for-dollar basis, only a portion would be shorted. For example, if you had a $1 million portfolio, $300,000 may be shorted. This means if the market were to collapse there would be some protection, but generally speaking your fund would be structured to make money from markets rising.
   • Global Macro strategy: This type of strategy seeks to make money from large economic trends. If you have extensive knowledge of economics, global economic trends, global economies, and how these pieces fit together, this may be a good strategy to pursue. Global Macro strategies make money by forming an idea of what will happen to a particular country's (or multiple countries), stock index, interest rate, currency, or inflation/deflation levels.
   • Hedge fund managers typically pursue a strategy to reduce the volatility of a portfolio while maximizing the upside profit potential. In times of expected market declines, this may mean buying low velocity stocks while shorting high velocity security. In this way, the decline in the former would be offset by greater gains in the latter.

Creating a Hedge Fund Entity

1. Hire a law firm. When starting a hedge fund, it is absolutely certain that you will need a lawyer throughout the process at some point. It is always advisable to establish contact with a group of lawyers experienced in financial law who will be be able to help you not only with the initial incorporation, but also with other aspects of establishing the fund. This is not the time for a silly paperwork slip-up that could cost you. Consult the experts.
   • Look around for lawyers that are experienced in financial law, and even better, lawyers that have experience specifically working with and starting hedge funds.
2. Decide what kind of entity you want to create. The fund entity type that you are able or required to create will depend on your state's regulatory laws. Limited partnerships, limited liability companies, and trusts are the typical entities used to create a hedge fund, but you'll need to research local laws regarding the formation of business entities to learn more. Contact the commerce department in your state.
   • A limited partnership has two parts. It will have a general partner, who will serve as the manager and is personally liable for all the business's debts and obligations. Corporations can serve as general partners. It will then have limited partners, who are not liable for the debts of the company.
   • For the most part, hedge funds are typically formed as limited partnerships, in which an incorporated group of investors acts as the limited partners, and an investment advisor acts as the general partner
3. Assemble an investment team of trusted advisors. If you're spinning off from an investment bank, it's typical to try bringing some coworkers with you to your new venture. A good team is essential to success.
   • It's hard to sell yourself to investors without first establishing a successful track record. Choosing workers with great employment histories and successful track records buying and selling securities will help in the long run, seeding your company with human capital and enabling you to hit the ground running.
   • When establishing a team, your goal should be to first finding people who you have a strong personal chemistry with, and who share your vision. Your next criteria should be experience. For example, if you are starting a market neutral fund, choose analysts who have experience doing the kind of high-level analytical work that is associated with creating a fund like that.
4. Name your fund. Your fund needs to have a name attached to it before you can fill out the proper paperwork. It should be something that sounds memorable, stable and reputable. Use the name to promote your image.
   • Try to connect the name of your fund to its overall strategy in some way. For example, if you are operating a market neutral fund that attempts to eliminate exposure to the overall market and generate steady, reasonable returns, your name should reflect this vision.
5. Apply for a tax ID number. In the U.S. your fund entity will need to get a Federal Employer Identification Number (FEIN) from the Internal Revenue Service (IRS). This can be done by calling the IRS or going to its website and filling out the necessary forms.
   • It's free to get your ID number. The process takes only a few minutes and can be completed online.
6. Register as an investment advisor. You will need to register with the Securities Exchange Commission (SEC) as an investment advisor if you have 15 or more investors associated with your fund. If you have less than 15, you generally do not have register with the SEC, but it is advisable to do so anyways since it adds to your overall credibility.
   • In addition, most states require an prospective investment adviser to pass the Uniform Investment Adviser Law Examination (Series 65). Some states will waive exams for holders in good standing of professional designations such as the CFP, CFA, or CIC.
   • To register you'll also need to take the Series 65 regulatory exam. This three-hour test covers your basic knowledge of securities laws and practices as well as your understanding of ethics. When you pass the exam you will be a licensed investment advisor in your state.
   • Fill out a form U-10 with your state to register for the examination, then pay the small exam fee and schedule your test. It typically costs around $30.

Incorporating Your Hedge Fund

1. Create a corporate partner. An investment advisor has two basic choices in structuring a fund: you can either run your hedge fund as a sole proprietor, or you can create a corporation to partner with you and limit your own liability. It's a common practice to seek protection from liability by creating a corporation to act as the general partner of your fund entity. This partner will be your investment advisory company.
   • Remember that with a limited partnership, the general partner is completely responsible for all the firms debts and obligations. So, if you incorporate your general partner, your personal assets are protected in the case of a lawsuit or in the case of debts. This is because a corporation is a separate legal entity.
   • Fill out the articles of incorporation in your state.
   • Always consult your lawyer before incorporating, they can guide you effectively through the process.
2. Write your corporate bylaws. Your firm will need to compile an in-house rulebook to move forward with incorporation and register with the SEC and the regulatory bodies in your state. The bylaws are yours to choose but might commonly include:
   • A compliance manual
   • An ethical code of conduct
   • A manual for supervisory procedures
   • An advisor's portfolio-management agreement
3. Register your company as the Registered Investment Advisor (RIA). Do this on the website of the Investment Advisor Registration Depository to make the partnership legal. The process is free but will take several hours to complete. You may want to speak to your legal team before moving forward with the process of registry.
   • This process is necessary to make your company able to manage assets and provide financial advice.
4. Register yourself as the Investment Advisor Representative (IAR). After your fund is legally a Registered Investment Advisor, you must register yourself as the investment advisor for your fund.
   • You can register yourself as the investment advisor for the fund by going to the same website you went to when you registered your company as the Registered Investment Advisor. To complete the process, you'll need to submit a Form U-4 and pay the fee to the IARD.
   • The fee is about $30
   • This establishes you a representative of your company.
5. Register the fund offering with the Securities and Exchange Commission (SEC). Hedge funds don’t technically register with the SEC but do register the "offering" of the limited partnership to investors. Just as corporations offer stock and LLC's offer memberships, limited partnerships offer "interests", and the offering of this interest must be registered with the SEC.
   • Offerings exempt under Regulation D from registration must comply with specific limitation on the solicitation and sale of private securities. This includes restrictions on the type and number of investors solicited as well as the interests sold and requirements for adequate disclosure of the investment's details.
   • To register, fill out Form D with the SEC. You'll also need to fill out Form D in each state in which you intend to offer your fund.

Raising Your Fund and Growing

1. Write offering documents. In order to attract investors to your hedge fund, you will need to create a set of documents that explain your fund's goals and terms of investment. This generally takes the form of a prospectus or private placement memorandum (also called an offering memorandum). This document both protects the hedge fund, by assigning liability for losses to the investors, and the investors, by providing specific strategies that will be employed by the hedge fund.
   • These documents are not optional. They are required by securities regulators and must disclose specific information. Consult with professional legal counsel to ensure that you meet all of the necessary disclosure requirements.
2. Create an online presence. Despite regulations that prevent hedge funds from publicly advertising their funds, they are allowed to set up informational websites. These websites can display the experience and backgrounds of the fund's partners and provide information on the partners' investment strategies. Having a clean, professional, and informative website can help foster trust in potential investors.
3. Seek anchor capital to seed your fund. Getting the cash to get your fund off the ground can be the most difficult part of starting a hedge fund. You need assets under management, which you'll have to get from investors unless you're independently wealthy and want to seed the fund yourself. The best way to make your case to investors is to have an air-tight operation as well as an established track record of success during previous employment.
   • You will need to approach banks, venture capital firms, and wealthy investors with whom you or your team have prior relations with. It may be useful to establish strategic partnerships with these institutions where possible.
   • In addition, many hedge fund managers gather seed money from friends and business acquaintances.
4. Promote your hedge fund. Ultimately, seeking capital requires salesmanship, and you will need to convince investors that you can create value. To do this, when speaking to potential sources of capital, focus relentlessly on your strategy, how your strategy works, why your strategy works, and how it has an edge over the competition. Secondly, focus on your team, and your experience, strengths, and successes.
   • Investors are more likely to fund somebody with a proven track record of success, so be sure to play up your prior successes, as well as those of your partners or employees if you have them.
   • Consider offering reductions in your management fee or partial fund ownership to early investors.
   • Be aware of the regulations affecting the marketing, solicitation, and sale of private interests on a Federal and state level.
5. Attract investors through success. Initially, many hedge fund managers start with a small fund that is made up of a large amount of their own funds. Even with a prior record of success outside of hedge funds, investors are still skeptical of new funds until they have proven themselves. After an initial period of success, if you earn large returns on your investments, you will find it much easier to attract investors.
6. Find a "prime-broker". A prime broker is a bank that essentially provides you with all the financial services you need to run your fund. This includes lending you money, executing trades on your behalf, and providing you with what you need to do things like short sell stocks. They can also help you find investors for your fund.
   • Approach institutions like Goldman Sachs, Morgan Stanley, Bank of America, or any other investment bank for these types of services.
7. Hire brokers. If your hedge fund is performing well and you feel comfortable enough to expand operations, it's a good idea to start attracting talented brokers to expand your operation and start performing more transactions. You should to look for dedicated employees who want to make money in a fast-paced and competitive environment. Get the word out that you're looking for the best.
   • Growing doesn't necessarily mean taking on more employees. Some hedge funds are successfully in business as one-man operations.
8. Purchase more office space. As soon as you can afford it, move into a space appropriate for your business. Start small, but build a corporate office that will display the professionalism and spirit of your operation.

Tips

• Hiring a law firm to help you through the setup process can make things easier, but the costs can be substantial.

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Sources and Citations

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