How to Start Your Own Hedge Fund, Part 2: Investment Strategies and the Technical Side

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Start a Hedge Fund: Investment StrategiesLast time around, we went through the process of how to raise capital for your new hedge fund – and, more importantly, why you probably won’t be able to start your own fund…

Unless you already have a proven track record… on a great team… with excellent connections to institutional investors.

But assuming that you meet all of those requirements and that you’re daring enough to quit your job and launch your own fund, you need to lock down your investment strategies next.

One small problem, though: if you don’t already have a solid set of strategies, you should not even be thinking about starting your own fund.

Here’s what else we’ll cover this time around:

  • How to demonstrate that your strategy is scalable and repeatable.
  • The key structure to use with investment case studies and investor pitches.
  • How the valuation and modeling work differs at your own fund.
  • Why you’ll encounter some very thorny issues when it comes to “information gathering” and channel checks.

Strategic Brainstorming

Q: I think the most common question is simply how you come up with investment strategies in the first place.

A: If you’re asking that question, immediately give up on starting your own hedge fund right now.

People who start their own funds have been drawn to the markets since they were children; they spend their free time thinking about investing and coming up with ways to exploit market inefficiencies.

So you should be starting your own fund because you already have your own strategies in mind and need the capital and team to execute them – not the other way around.

If you are not passionate to the point of stubbornness about your views of the market, why they’re different from everyone else’s, and why you’re in a unique position to profit from that, then you should not start your own fund.

If your plan is to look at the same companies everyone else is looking at and use the same models with slight tweaks, there are lots of places where you can do that. And there’s nothing wrong with having a relatively stable job with better hours and limited upside and downside.

But it’s completely the wrong approach and philosophy for your own fund.

Q: OK, so let’s say you do already have ideas from your own trading and from your work experience.

How do you prove that they’re scalable / repeatable when pitching these ideas to potential LPs?

A: We covered the structure of a pitch last time around, but essentially you have to explain why the market is, in fact, not efficient.

Quants have it easier here because they can take their strategy, retro-fit it to market data going back years or decades, and then show the returns this strategy would have generated over time (there are flaws with that approach, of course, but at least they can point to numbers).

If you’re not pitching a quant strategy, though, you need case studies and examples of both successful and unsuccessful investments.

These case studies need to show why your view of the market presents opportunities and why you’re capable of taking advantage of those opportunities.

You will also need to discuss your risk management strategy, hedging, and leverage, and why each of those makes sense in light of your overall strategy.

Here are a few examples of case studies / examples you might present for different strategies:

  • Long / Short Equity: Examples of stock picks that performed well, ones that did not perform as well, and even ones where you lost money.
  • Global Macro: Examples of investments in commodities or FX (or anything else in this category) that performed well, and ones that didn’t perform well or ones where you lost money.
  • Distressed / Special Situations: The same idea, but now for investments in distressed companies’ debt or equity.
  • Merger Arbitrage and Event-Driven: Similar, but now you have to cite specific M&A deals, IPOs, spin-offs, and other events that you bet for or against, what the end result was, and why.

Q: Great, so what should these case studies and examples include?

A: First, note that the structure is NOT the same as what you’ve covered on hedge fund stock pitches – those are more for potential ideas you present in job interviews, whereas these are for previous ideas you’ve executed (or even ideas you’ve passed on).

The structure is similar regardless of whether it’s a positive or negative case study – here’s a quick example:

  • The Idea: “This healthcare company was undervalued because one division was dragging down earnings, and we thought there was a significant chance of a divestiture because of new competitors entering the market and increased pricing pressure, so we invested and expected to realize a gain within 12 months.”
  • How You Developed the Idea: You witnessed a similar event in a completely different industry, and then realized that undervalued companies with under-performing divisions might exist elsewhere – and that certain industries were more likely to come under pricing pressure than others.
  • The Work You Did on the Idea: You went back 5 years and analyzed the financials, valuation multiples, and market conditions of all similar cases (a divestiture of an under-performing division driven by competitive pricing pressure); based on that, you found 10 rules of thumb you could use to identify cases where there was an 80% likelihood of a company’s stock price appreciating upon announcement of a divestiture.
  • The Result: You invested in the company, and, as expected, it did end up announcing a divestiture within the next 12 months. However, its stock price only rose by 5% rather than the 10-15% that your analysis had predicted, and you sold off your position for a modest gain.
  • How You Applied the Results and What You Learned: Your thinking was not entirely off-base here, but you had underestimated the impact of new regulations introduced in the sector, which accounted for the difference. As a result of that, the company’s earnings growth was dampened anyway and the divestiture did not result in as much uplift as you expected. In the future, you decided to focus on sectors that were more lightly regulated, such as [Name Examples], and you demonstrated the viability of your strategy by… [You could go into case studies demonstrating this point here].

Q: Great. I’m assuming that it’s also a good idea to highlight ideas where you lost a significant amount… if you can explain why and how you applied the results to future investments.

A: Yes, exactly. If it’s a case where something completely random happened, then it may not be worth bringing up because you’ll just get questions you can’t answer.

I also kept track of ideas I passed on, just to see whether or not I was right.

You can even present these types of “non-investments” as case studies and use the same structure – explain why you ended up passing, what the result was, and how your correct or incorrect decision influenced your future strategies (Bessemer Ventures has some fun with this idea in their “anti-portfolio”).

And then, of course, when you’re actually at your own fund you should also do a post-mortem analysis of all your investments.

You’re not doing everything above just for pitching purposes – you need it to improve your own performance as an investor.

The same framework applies even for quant funds or global macro funds. The investments will be different, but the structure is the same.

Strategic Strategy Picking

Q: Do you think there’s any merit to picking different strategies because you’re at a start-up fund?

In other words, are certain strategies easier or more difficult to implement when you don’t have much capital?

A: Not really, no.

People will argue that quant strategies are more “capital-intensive,” and that value-oriented strategies are “capital-light and SEC-filing-reading-heavy,” so it may be in your interest to pick something less capital-intensive at first.

I don’t agree with that, though, because you should pick the strategy you know the best and the one that you can implement most successfully.

So don’t suddenly switch to merger arbitrage ideas just because you think it’s “easier” to get started with those.

One point to keep in mind, though, is that some strategies are more scalable and repeatable than others.

Going back to the example I just gave, you could also argue that quant strategies are more scalable because they’re algorithm-driven, whereas something that involves combing through SEC filings is extremely labor-intensive and therefore more difficult to scale.

These points shouldn’t influence the strategy you choose; I’m bringing them up because they will influence how you pitch the strategy and the questions you’ll receive from potential investors.

Q: What type of technical / modeling / valuation work do you do at your own fund?

A: It’s completely dependent on your strategy, but if you’ve worked at a bank or anywhere else in finance and you know accounting, how to value companies, and how to analyze transactions, it’s the same type of work here.

If your strategy is dependent on opportunistic short-selling, you’ll have to spend more time on analyzing surrounding events and catalysts and also how to hedge yourself in the much more severe “downside case” there.

On the other hand, if you’re doing distressed investing, you’ll have to focus more on valuation and predicting the timeline for getting out of bankruptcy or the threat of bankruptcy (or whether the company will just go down in flames).

And then you must think about what the company might look like in Chapter 7 vs. Chapter 11 vs. asset sale vs. entire-company-sale scenarios.

The main difference is that unlike in banking, you actually care about the numbers and you spend a lot more time on data gathering.

There is also a big difference between hedge funds and mutual funds: mutual funds don’t have the same level of pressure to perform since they’re judged relative to the market, so you won’t see people going to extreme lengths to gather data.

Q: Entertain me for a second here… what do you mean by “extreme lengths”?

A: Two examples I can give you:

  • One multi-billion dollar hedge fund I know of focused on the consumer retail sector, and they actually ran focus groups to get views on companies’ products. So they hired outside firms to bring in customers and give them direct feedback on the company’s products.
  • A commodities-focused fund I know of hired helicopters to fly over the Midwest of the US to get a better read on pipeline storage and activity.

When you’re first starting out and you have $100 million or less in AUM, these types of activities will be beyond your budget.

But the point is that you’re creative and willing to use tools from other industries to understand your investments better.

Q: You bring up some interesting examples there – but where do you draw the line between legal “information gathering” and illegal insider trading?

A: The truth is that the SEC’s rules on insider trading aren’t black-and-white.

For example, expert networks were endorsed by lawyers and compliance experts until the SEC decided they veered too much into illegal activity.

Anyone can go and visit a company’s stores, contact their suppliers, or speak generally with industry experts; on the other hand, you can’t get the FDA’s or FTC’s unannounced decision on something by bribing officials.

Beyond that, I can’t really give specific guidelines or rules because it wouldn’t be appropriate to give legal advice on your site.

But due to Dodd-Frank, all hedge funds over $150 million in AUM must have compliance officers now so you will have to think through these issues early on.

And as we’re speaking, many of these regulations haven’t even been written into specific laws yet, so there’s more to come…

Q: Great news for lawyers and bad news for the rest of us, I suppose.

A: Yeah, but what else is new?

Coming Up Next

In Part 3, we delve into how to hire your staff and build an organization at your own hedge fund…

And then in Part 4, we jump into the exit opportunities – what to do if things don’t go well or if you part ways with your existing team.

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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11 Comments to “How to Start Your Own Hedge Fund, Part 2: Investment Strategies and the Technical Side”

Comments

  1. Pat says

    Hi Brian

    I m doing my MBA at the moment. I just get to know a classmate who has been doing IB for a long time. How should I approach him and ask for help. Would it be too direct just to say ‘Hi my name is XXX Could you help me to get an interview in your firm.’ Thanks a million.

    • M&I - Nicole says

      I think that maybe too abrupt if you don’t know him. I’d approach him and befriend him. I’d also say something like I’ve know you worked in IB, can you share with me your thoughts on the industry? And once you’ve built a friendship (or at least have had multiple solid interactions), you can ask re. interviews.

    • says

      I would like to, but so far there are no willing volunteers. It’s also harder to find people who started a PE fund because it takes more capital and requires more work experience.

      • Dee says

        I just wanted to share my own perspective on this, as someone working for a pension fund (i.e. the people who would give you money for your PE fund):

        Under most circumstances, it will be nearly impossible for you to raise a PE fund with more than a few million of capital. It used to be possible back in the day (2007?), but now investors are a lot more discerning. You will have to explain your strategy, describe your team/organization and, crucially, present a very good track record. Unless you have the track record that convinces investors to give you their cash, it won’t happen.

        I actually recently worked on two first time private equity funds, raising over $400m each. Those two firms managed to raise this kind of capital because they had a clear strategy that made sense and a solid team already in place (i.e. a spin off) or very nearly completed. What was essential, though, was that the founders of those firms each had more than 12 years of private equity experience at other PE shops.

        What I would recommend is the following though: if you do want to raise a PE fund and meet the criteria I listed above, your very first step is to find yourself an anchor investor. Anchor investors are typically institutions with lots of capital such as CPPIB (Canadian pension fund), AlpInvest (fund of funds) who will sometimes back first time funds. Once you have a reputable anchor on board, the rest of them will slowly trickle in. There is a catch, of course: no anchor will accept to sponsor you as an anchor unless you sweeten the terms, i.e. move from a 2/20 fee structure to a more 1/15 fee structure for the money they give you. In the long run, that’s worth it though, especially if you end up raising a few solid millions. You won’t be paying yourself $5m salary a year, but you’ll have enough to cover your expenses, which is really what the management fee is for.

  2. Ivan says

    Off-topic: is there a way to know when each of the articles of this blog was published? I don’t see the date anywhere! Thanks

    • M&I - Nicole says

      Ivan, we don’t list dates on our articles because of the following reasons:
      – 95% of the content here is relevant regardless of whether it’s 2005, 1995, or 2015 – for example, telling your story in interviews and networking with bankers do not change much from year to year.
      – If we added dates to articles or comments, you would be biased against older content – even if it’s still completely relevant.
      – There actually are dates on news commentary articles or anything related to current events.

      http://www.mergersandinquisitions.com/faq/

  3. Banker says

    Hey Brian –

    A quick question: is Cornell MBA (Johnson)a target school for investment banking/PE recruitment? I know they have an investment banking immersion in their program – do you know much about it? (if it’s reputable on the street, number of people who got IB jobs from the program etc.)

    Thanks!

    • says

      I believe banks and PE firms do recruit there, but I haven’t seen as many graduates from the Cornell MBA as I have from other schools. But that doesn’t mean it’s bad, it might just be that people are less interested in IB/PE there. Not sure about the IB immersion program as we haven’t worked with someone who completed it yet.

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