What Happens If You Start Your Own Hedge Fund and It Doesn’t Work Out?

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Starting Your Own Hedge Fund: Failure and Exit OpportunitiesWe’re back today with the conclusion of this series on how to start your own hedge fund.

When you’re presenting a stock pitch in interviews, one common mistake is failing to address the downside risks and how you might hedge yourself.

And the same is true when starting your own fund or your own company: everyone likes to watch The Social Network and pretend they’ll be the next Mark Zuckerberg, but 90% of start-ups fail within the first 5 years.

With hedge funds, that failure rate is 80% in the first year alone.

So here’s what happens when your own fund doesn’t quite work out – from what you do next to the toll it takes on your body, family, and bank account.

This is my favorite part of the entire series because it addresses the human side of a profession that most people mistakenly believe is completely driven by numbers:

Fund Mergers & Acquisitions: The Right Way to Exit?

Q: You mentioned in Part 1 that you decided to roll your own fund into a larger, multi-strategy fund.

How common is that?

A: It has definitely been a growing trend over the past few years – in my case, the regulatory environment in my area has made it difficult for small funds to operate, and surviving below a certain AUM was close to impossible.

So a lot of smaller funds have merged into bigger ones lately, and some have even returned outside capital to LPs, effectively turning into “family offices.” This has also been true of larger, well-known funds whose managers simply didn’t want to put up with the extra scrutiny.

Michael Burry (of The Big Short fame) said, “Investing without investors is the best kind of investing” – if you have enough personal or family capital to manage, you can pursue your strategy without worrying about compliance, administrative fees, and other headaches.

The Partners at my new firm have all run multi-billion dollar funds before – most of them are here because they enjoy investing and want to keep doing it, but don’t want to deal with all the other annoyances.

Q: Right, so in addition to the administrative burden, why else do so many funds shut down so quickly and where do people go afterward?

A: The other issue, of course, is performance. If you don’t have good returns, you can’t do much to get around that

It’s the same as in any other industry: 80% of people underperform, but the difference here is that there’s no tolerance for underperforming.

If you don’t perform well, most likely you’ll just leave the industry and do something else.

If you had decent-to-good results but were not good at the business side of things, most likely you’ll join another fund that uses a strategy similar to your own.

Sometimes, you’ll also see people grow their funds to several billion dollars – or join existing funds in that AUM range – and then leave because they want to pursue other interests.

Q: One theme you’ve been hinting at is how difficult it is to scale a fund, both from the start-up stage to $1 billion+, and then from that level into the tens of billions or even higher.

Do you think we’ll see someone start a fund post-financial crisis and grow it to the size of Bridgewater in the future?

A: There are a few different factors at play there, but in general it’s easier to go from $100 million AUM to $1 billion, or even $5 billion, than it is to go from $1-5 billion to $100 billion+.

There’s so much more competition now that it’s definitely gotten more difficult to realize solid returns; some of the biggest funds today were founded in the 70s and 80s before most people even knew what a hedge fund was.

That gave the early funds a big advantage in pioneering strategies and building up a reputation with institutional investors over time.

Time also plays a huge role in AUM growth. If you look at the history of these massive funds, the general pattern goes like this:

  1. Puddle along with decent performance for years at a time;
  2. Have 1 or 2 spectacular years and attract a lot of new investors;
  3. Suddenly ramp up AUM as a result.

That process often repeats itself over several decades, and there’s no telling when you’ll have one of those spectacular years that attracts tons of investor interest.

Long story short: yes, I think someone today could potentially start the next Bridgewater, but the market environment is far less favorable and it will take more time to reach that level.

Things Just Didn’t Quite Work Out…

Q: Great, thanks for sharing your views there.

To move back to our original topic in this interview: what do most people who start their own fund end up doing if it doesn’t work out?

Let’s say they want to stay in the industry.

A: It depends on the reason(s) it didn’t work out – it’s not like getting fired from a normal job where you run off and find a similar job.

If your performance was good but you ran into issues with the business itself, most likely you’ll do what I did and join a larger multi-strategy fund that offers a “platform” for different fund managers.

The capital comes from only one source, but you still retain your own business and your own identity – and since the administrative side is managed for you, you can focus on investing.

Sometimes, it doesn’t work out because you disagree with your Partners.

Here’s an example: one friend of mine quickly grew his fund to close to $1 billion after starting it with a Partner from his previous hedge fund.

They had great performance at their previous fund, but the first year at this one was only “so-so.”

He and his Partner had very different views on the markets, specifically on how government intervention would affect asset values, and they couldn’t agree on their investment strategy.

So they split up, returned the capital to investors, and started their own separate, much smaller, funds instead.

Q: That’s an interesting example because it’s not exactly “poor performance,” but more “decent performance hampered by ‘management disagreements.’ ”

What if you have truly poor performance? Will you ever get a second chance?

A: No!

And I’m only slightly exaggerating on that one…

The culture of start-ups in Silicon Valley is completely, 100% different from the culture at start-up hedge funds or other investment funds.

In the tech industry, failure is embraced and even if your previous 3 companies haven’t done well or have only done “OK,” you could easily get another chance with a new venture.

But in the investment industry, you really only have one shot to establish a track record that’s 100% yours and prove that you can run your own fund successfully.

John Meriwether of Long-Term Capital Management was a famous exception to this rule, but even his luck is running out.

It’s 100% about the numbers, which is  true whether you’re on your own or you’re a portfolio manager at a larger fund.

This is one of the reasons why I don’t necessarily recommend starting your own fund very early on (NOTE: Past interviewees agree with this assessment).

With tech start-ups it can make sense to start at a young age, but there’s a reason why most HF managers have a long track record first before going off on their own.

A Post-Mortem for a Post-Fund Life?

Q: Well, thanks for clarifying that point. I think some readers might be reconsidering their plans now.

Besides this notion of “one shot and never again,” was there anything else you wished you had known before you started your own fund?

A: The physical and emotional toll it takes on your body is incredible.

Yes, everyone knows about working 100 hours per week in investment banking

But there’s a BIG difference at your own fund because there’s no “downtime” and you are responsible for 100% of what happens.

You’re not working those hours because a client asked you to revise a 137-page Board presentation no one’s going to read, but because you’re responsible for keeping the ship afloat.

Let me put it this way: at my current firm, everyone has come from different backgrounds and run funds of different sizes and strategies. Some funds did well, some blew up, and some wound down over time.

The one thing everyone has in common?

They all have some type of chronic illness developed while running a fund.

Autoimmune disorders are very common, as are stress-related disorders.

Q: I can already anticipate snarky comments saying, “Aha! They just couldn’t cut it! I’m different and I can work 120 hours per week, every week, for the rest of my life!”

A: I would laugh at them. Who do you think starts their own funds?

Everyone in this business has a Type-A personality and is extremely smart, ambitious, detail-oriented, and perfectly willing to kill themselves to get ahead.

And yet, they all suffered from health problems and stress-related disorders.

So why do you think you’ll be any different?

Then there’s the emotional toll that comes from rarely seeing your family or friends or getting to do much outside of work.

And, ironically, the more senior you are, the more pressure you’ll be under.

Not only are you responsible for the capital, but you’re also responsible for a business and all your employees.

That is a massive burden and way beyond what “9-to-5 people” ever deal with.

Q: Wow. So are there any ways to reduce risk, both to your own health and to your fund?

A: Well, I don’t think there’s a great solution to the health / family / emotional issues – that is just the nature of the industry and what you have to deal with when following the public markets.

For minimizing risk to the fund itself, there’s a lot of merit to the traditional “path.”

You should work in a team that does well first, and then spin off to start your own fund with co-founders instead of doing the solo thing.

I was impatient, scoffed at that, and said, “I don’t need to wait until I’m much more senior! I can do it now, by myself!”

You really need to be patient when starting your own fund or any type of business – my parents, who are both entrepreneurs, have a saying: “Every overnight success takes 20 years.”

Q: Is there anything you can do to “test the waters” first?

A: Keep in mind that you don’t have to start your own hedge fund to express your own ideas, or to test out different investment strategies.

As one example, I have a friend who might be interested in starting her own fund one day. To get a track record that’s 100% hers, she has taken $100K of her own money, put it into a separate legal entity, and runs all her trades through that.

Since she’s doing that as a side project and still works her normal full-time job, there’s very little risk of “losing everything” or screwing up once and not being able to start her own fund in the future… plus, even if she somehow loses all her money, it’s just her money rather than outside investors’.

After 5 years of doing that, she might get her performance audited and then think about going through the fundraising process.

Or, she could take that same performance record and then leverage it to join someone else’s growing fund.

So that’s the smarter way to do it and test the waters before you leap right into running your own fund.

Q: Awesome, thanks for sharing those examples.

Any final thoughts before we wrap up?

A: I realize I may have sounded quite negative in this interview, but I’m not saying, “Never start your own fund!”

I’m merely saying, “Sure, start your own fund… but only after you have understood and appreciated everything I’ve described in these interviews.”

I would give the same advice that families with kids often give to couples who are considering children: “It’s going to be so much better and so much worse than you can possibly imagine.”

You absolutely, positively, must get your personal life in order before doing this.

Having significant outside commitments, dysfunctional relationships, financial problems, family troubles, and so on will make you go insane.

One scenario I’ve seen many times before: guys will get to their 40s and then decide that they want to start their own fund… but they’re already married with a house and 2 kids.

But depending on the fees and expenses, if they don’t get to $500 million in AUM within the first year they may not even be able to pay for their mortgage or cover their other bills.

And that is a massive amount of pressure to be under when other people are relying on you.

So you need to take a brutally honest look at yourself, your family, and your finances, and then decide whether or not it’s right for you.

If you’re really passionate about investing, making money, or starting your own business, there are easier and less stressful ways to do all of those… and the last thing the world needs is another failed hedge fund, so think long and hard before you get into this game.

Q: Great! I really appreciate you taking the time out to do this interview series.

I think everyone reading will get a lot out of this, even if they have no interest in starting a fund – or even if their interest decreased after reading these interviews.

A: Sure thing. Thanks for letting me contribute to the site, and I hope to share more about my experiences in the future.

Complete Series – How to Start Your Own Hedge Fund:

About the Author

is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys learning obscure Excel functions, editing resumes, obsessing over TV shows, and traveling so much that he's forced to add additional pages to his passport on a regular basis.

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25 Comments to “What Happens If You Start Your Own Hedge Fund and It Doesn’t Work Out?”

Comments

  1. George says

    Great article, as always! Hiding your portfolio until it’s good enough to audit is a great idea.

    The point about some funds joining with larger ones is very interesting. In other articles, you’ve said that institutional asset managers and hedge funds will sometimes hire people with private equity backgrounds. Is it possible for a hedge fund to “acquire” an entire private equity firm in the same manner, assuming that the PE firm encountered the same sort of administrative problems?

    On that note, might a PE firm do the same with another PE firm, if they saw some sort of synergy (e.g. complementary industry focuses)?

    Thanks for your insight!

    • says

      I think either one of those is possible, but for whatever reason it seems to happen more often with hedge funds acquiring other hedge funds. It might just be because more people start hedge funds in the first place.

  2. ValueAdderl says

    Have not read to the end yet, because i’m driving to a parter dinner right now. But let me share some of the things that were roaring through my mind this day – and they happen to be extreamly connected with todays topic.

    Why funds or asset managers fail (especialy in the CEE).

    Number one reason – old business relationships. Most of the independed AM or any other funs spin out in the CEE from big banks or institutions – mainly former heads of research, sales and distribution (yes!) and goverment funds. And in this case – for the market being so much local and small – new funds simply steal old cilents. And in this case old employers simply sue to death new funds. It occured numerous times here. Simply you are killed by the banks.

    Numer two reason – new funds do not manage to raise enough funds to be profitable. You do not see anyone funded by foreign funds or institutions. And rolling with wealth mamagemt level of AuM won’t drive you anywhere.

    Third – the lack of finacial instruments to trade. In CEE there are no MECHANISMS to short sell, hedge or anything like that. The only liquid product are the futures contracts for the blue chip index. So baisicaly – new fund that are launched are focused on long only equity investments. So why bother in investing in a new fund, when you have esablished ones that’ve been here for over 20 yeras. Obviously, the case might be different for PE funds. But the competiton between growth/buyout funds here with deal size of over €100€ is crazy, there is simply no room for new people, so thats why yous see people staying in one PE fund here for over 15years – no space for new investments.

    Thats my 5 cents regarding the failures of AM firms in CEE.

    Apparently I have now reached lobby in the hotel. Feel free to follow up with some questions later one.

    As always – brilliant site Brian, thanks.

    Cheers.

    • David says

      @ValueAdderl: you said there is not enough liquidity in financial instruments (other than most basic ones) for many strategies to work.

      Do you relate mainly to the fact that there are not enough exchange-traded comples derivatives etc.?

      I’m in the CEE and work mainly with issuers on capital markets and investment firms. I was under the impression that the OTC market is deep enough to satisfy at least the big players.

      Thanks,
      David

  3. Nick says

    Great article Brian. Thanks.

    I wish I read this 2 years ago… I had just graduated and launched a long short equity hedge fund. The team was myself and a wealthy relative with a trading background. We experienced ALL the above pitfalls and disappointments.

  4. Long time reader says

    Holy shit, that’s a brutally honest interview. You weren’t kidding when you said some readers might probably be reevaluating their plans right now.
    Kudos to the interviewee for being so upfront about the past on a public platform, that couldn’t have been easy.
    This is easily the most in-depth series every published on this site. Great work.

  5. butch vanterpool says

    I have just read your article a dozen times, it’s one of the best truthful hedgefund interview I ever read. I have around 250k and is hoping to start a small fund but want to test the waters first, you recommend a legal entity and trade from there. Could you expand on that and provide other wise advise please?

    • says

      Thanks! You can just form a simple LLC and start trading from there… no point in forming anything more than that at this stage. And transfer the funds to a bank account in the LLC’s name, and then use a brokerage account in the LLC’s name to trade.

      • butch vanterpool says

        Many thanks for your kind reply, really appreciate it, however I came across an article today that also suggested setting up an incubator fund then converting to a full hedge fund in the future, will love to get your feedback on an incubator fund?

        • says

          You could do that – really depends on your track record. I would definitely not start the fund as an individual, either start with your team from an existing firm or join an incubator and recruit a team there.

  6. Bob says

    Thanks for the article Brian. Our of curiosity, why did your friend establish a separate legal entity to invest her $100K? To prove her performance, couldn’t she just have invested the money using her PA and show future investors her PA account instead?

  7. says

    If you’re really passionate about investing, making money, or starting your own business, there are easier and less stressful ways to do all of those…

    Would you please suggest some of these ways? Invest your personal money?

    Thanks a lot. Great article.

    • M&I - Nicole says

      Yes you can do that if you’re really good at it; it can be stressful though I think the type of stress is different vs working at a bank because you’re only accountable to yourself by investing your personal money. But if you’re very passionate about investing and are actually good at it, investing for yourself and working at a top fund (learning from the top managers) can actually be very fun

  8. John says

    Any chance of getting some examples of the financial obligations a manager will face when starting a fund? She mentions several times that a PM won’t even pay themselves a salary because the overhead is so high, but then she says that smaller funds around 100AUM only have 2-3 people in them. Even at 1%, how in the world are you struggling to pay yourself a salary with $1mm a year in management fees? Perhaps I am missing the context here? My partner and I are starting a fund with only $10mm and we will have more than enough to cover overhead and still pay a small salary. It’s not going to be $80k a year or anything, but at least enough to keep the lights on at home. Operating expenses shouldn’t be more than $3k/mo for 2 people and the majority of legal fees are paid up front by the founder anyways, not taken out of the management fee.

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