First, the bad news: you haven’t picked the best time to start a hedge fund (assuming that you are reading this anywhere in between 2011 and the present day).
It was much better to get into the game early - i.e. the late 90′s or early 2000′s – before everyone else also wanted to start their own funds.
But if you have your heart set on becoming the next Ken Griffin, Ray Dalio, or John Paulson, I can’t talk you out of doing it.
I can point out, however, that hedge funds require start-up capital in the millions or tens of millions, eye-popping legal bills, and entail constant scrutiny by current and potential investors. It’s a tough business that’s only getting tougher as the government piles on more and more regulation.
So if you want any chance of success at all, you’d better have a novel, workable idea and the ability to raise tons of money.
Starting a hedge fund because it sounds like an easy ticket to models and bottles, because you can’t find another buy-side job, or because you think you have a brilliant investment idea but haven’t tried it yet are all surefire ways to lose money.
You also need to be entrepreneurial – as the founder of your own hedge fund, not only are you a portfolio manager, you’re also a small business owner. Thankless tasks like managing overhead, IT, HR, and marketing will fall on your shoulders. Even if you hire people to do this for you, expect to spend 20 – 30% of your time on administrative matters.
If you still have your heart set on starting your own fund, though, here’s what you need first:
Got a Strategy?
Your investors will want to know exactly how you plan on making them money. Just saying you’re a global macro fund or a value investor won’t cut it – you need to show that you have a different way of executing those strategies with a repeatable process.
Got a Track Record?
You also have to prove that your strategy has worked in the past under a variety of different market conditions. This is harder than it looks because you may be prohibited (by your firm and/or the law) from using your past performance record in marketing materials for your new fund.
Institutional investors (endowments, pensions, etc.) usually look for a 3 year-long track record. Funds-of-funds, family offices, and high-net worth individuals are comfortable with a 12 to 18-month long track record.
If you can use your old numbers, they’ll need to reflect your investment decisions and show that the strategy used was similar to what you’re using in your new fund.
If you were a research associate at a long-only dividend fund, don’t pretend that your performance there means that you can be the portfolio manager of a long/short international growth strategy fund.
And if you can’t use your old numbers or you’re not coming from the buy-side, invest your personal account with your strategy and have the performance audited by a top firm – expect to pay around $10,000 USD for a Big 4 firm to do it.
As one hedge fund manager told me, “If you can’t afford to audit your performance, you aren’t that good.”
You’ll need initial investors to get going. These initial funds could come from:
- Your own money
- Friends and family
- Family offices
- University endowments, pension funds, and foundations
- Hedge Fund seeders
Investors like to see that the managers’ own money is a significant portion of the fund: having skin in the game increases your incentive to perform well.
You investors will probably have to meet the SEC definition of an ‘accredited investor’, although this varies a bit from state to state; international requirements may also be different.
There’s no minimum amount that you have to raise, but you should consider the startup and ongoing costs of the fund, your fee structure, and work backward to a level of assets under management (AUM) that can support that.
As a starting point, most prime brokers won’t work with funds under $5 million in AUM.
The optimal situation is to be a superstar at a traditional firm and get money from them to start your new fund. Hedge fund seeder firms operate the same way: they give you capital in exchange for a portion of your fee income.
And don’t think that your fundraising efforts end when the fund launches: marketing, fundraising, and yes, networking, are crucial to growing your fund.
Even the biggest hedge fund managers with dedicated marketing departments can’t escape it – they’re still brought it at the end of the pitch to close the deal.
Got Office Space?
Some creative ideas for office space:
- Your house. Ken Griffin started Citadel this way, and Michael Burry of The Big Short ran his fund from home.
- A hedge fund hotel. Usually set up by prime brokers, managers get office space at below-market rates in exchange for steering brokerage business to the hotel’s host firm.
- Sharing space with other managers. Make sure you get along and aren’t directly competing with each other.
Renting an office can be a huge expense, especially in financial centers like New York and London, so you’re much better off going with cheaper options when you first start out.
When you get to $100 million in AUM and you have $2 million per year in management fees to cover your office, consider upgrading – but until then, frugality is the name of the game.
Got Service Providers?
Even a single-person hedge fund must rely on a team of external partners to make the fund run. Be prepared to pay for quality – institutional investors will consider the reputation of your service providers a reflection of your credibility.
So if you don’t spend enough on the right providers, you’ll have trouble growing your fund and getting better-known investors on-board. Here’s who you’ll need:
A good attorney should be your first call when you decide to start your own fund. Your fund lawyer will guide you through the whole startup process and provide referrals to other service providers.
Though the best-known hedge fund law firms are in New York, any city with a bulge bracket bank presence will have a local firm or two known for hedge fund law.
The actual hedge fund structure depends on whether your investors are taxable or tax-exempt, whether or not they’re US citizens, and the investment terms. Some points to consider:
- Fee Structure. The standard fee structure used to be “2 and 20”, meaning a quarterly management fee of 2% and annual performance fee of 20% on the gains. The trend now is for lower management fees and higher performance fees. And some funds are even more aggressive – SAC Capital famously charges “3 and 50,” the highest fees in the industry.
- Lockup Term. This is the length of time that investors’ money has to remain in the fund before it can be withdrawn. It should match your strategy – a global macro fund trading ETFs all day will have the liquidity to support a short lockup term, whereas an activist fund needs a longer lockup term to reflect the longer time it takes to realize the strategy.
- Redemption Terms. How much notice do investors need to give when they want to take their money out? Usually funds only allow redemptions at the beginning of an accounting period (quarterly or annually).
- Performance Targets. Are you trying to outperform a particular index? Is there a rate of return you have to beat before collecting performance fees?
You may have to register as an investment advisor with your state or the SEC if your fund meets certain criteria.
For example, all hedge funds have to register as investment advisors in Louisiana, but funds in Massachusetts are exempt if all of their investors are accredited investors. Outside the US, registration requirements vary wildly so you’ll have to do your own research there.
For a simple hedge fund setup, expect to pay between $10,000 and $50,000. More complicated setups can go into hundreds of thousands of dollars.
Outside auditors will also have to verify your performance on a regular basis, and institutional investors will demand to see that performance before investing money.
An administrator handles the majority of your back office operations, like trade reconciliation and allocation. Again, institutional investors will be looking for a quality, reputable administrator – you can’t ignore this just because it’s “the back office.”
Third-party marketing firms find potential investors and pitch on your behalf. They either work on retainer for a specified time period or get paid a cut of the funds they raise for you.
Prime Brokers provide leverage, let you borrow securities to short, and custody your assets. They also manage the brokers and dealers you trade through.
Smaller funds (under a billion dollars) may prefer to use an introducing broker, who’s partnered with a major prime broker but who customizes the services for smaller funds.
IT and Technology Providers
You’ll also need Bloomberg terminals (around $1,500 USD per month, each) and possibly other technologies to support all the trades you make.
The good news here is that IT expenses tend to be much lower for fundamentally-oriented funds with little active trading; if you’re a quant fund or you’re doing any kind of automated trading, though, you’ll need serious computing power and serious cash to pay for it.
Got Cash for Yourself?
Don’t expect millions to come rolling in after you flip the switch on for your fund – most managers don’t even pay themselves a salary until their AUM gets big enough for management fees to cover overhead with plenty of room to spare.
And even if they get amazing returns in their first few years, they’ll re-invest most of those performance fees back into growing the fund itself.
In the meantime, you still need a place to live and food to eat. So make sure that you have enough savings or another income source to cover your daily living expenses – and remember that it may take years to establish the AUM you need for long-term success.
Raising capital, setting up everything above, and figuring out your strategy are just the first steps of a long and grueling process when starting a successful hedge fund.
You’ll also need to plan your day-to-day strategy, hire investment professionals, and figure out your own exit strategy if things don’t quite work out – all of that and more is coming up in parts 2 and 3 of this series.
Complete Series - How to Start Your Own Hedge Fund:
- How to Start Your Own Hedge Fund – Introduction and Overview
- A Day in the Life At Your Own Hedge Fund
- Part 1: Raising Capital and Launching Your Fund
- Part 2: Hedge Fund Investment Strategies and the Technical Side
- Part 3: How to Hire Your Team and Build an Organization
- Part 4: What If Your Fund Doesn’t Work Out, and Exit Opportunities