How to Start a Hedge Fund – and Why You Probably Shouldn’t
You can find plenty of articles about “how to start a hedge fund,” but they all tend to make the same glaring mistakes:
- They fail to explain that only very specific types of people even have a chance of starting a hedge fund;
- They fail to explain that “beating the S&P in your personal account” won’t be taken seriously by anyone and that it is not at all sufficient for starting a fund; and
- They fail to disclose starting a hedge fund is probably a bad idea.
If you want to start a hedge fund, as of 2019, I’d say you’re somewhere in between “a bit crazy” and “total reality distortion field.”
Not only has the industry performed poorly for the past decade, but fewer funds are forming each year, and management and performance fees have been falling for a long time.
So, here’s why it’s probably a bad idea – but how to do it anyway if you insist:
The Blunt Truth About Starting a Hedge Fund
You might have a personal trading account with $100K, $200K, or even $1-5 million+.
Your average annualized returns over the past 5 years were 15%, beating the S&P 500, which only produced 9%.
As a result, you believe that you’re a good candidate to start a hedge fund.
First of all, high returns on small amounts of capital (i.e., millions of dollars or less) do not mean that much.
Second, results from “personal accounts,” no matter the account size, are not taken seriously.
Third, you need to be part of an existing team at a hedge fund, asset management firm, or prop trading firm to have a good chance at starting a new fund.
To start a true, institutional-quality hedge fund that uses the LP / GP (Limited Partner / General Partner) structure and has large external investors, such as endowments, pension funds, and funds of funds, you’ll need to raise hundreds of millions of USD.
The bare minimum to get noticed is $100 million, but realistically it’s more like $250 million+, and ideally more like $500 million – $1 billion.
You have no chance of accomplishing that unless you have deep connections to potential Limited Partners and a great track record over many years at an existing fund.
Yes, you could start with much less capital, or go through a hedge fund incubator, or use a “friends and family” approach, or target only high-net-worth individuals.
But if you start with, say, $5 million, you will not have enough to pay yourself anything, hire others, or even cover administrative costs.
It will also be extremely tough to re-invest, grow, and attract new investors with that amount of capital.
Not only has the industry has performed poorly ever since the 2008-2009 financial crisis, but compliance and legal costs have increased substantially, the traditional “2 and 20” fee structure is now much lower, and strategies such as global macro and long/short equity have fared poorly.
There are some bright spots, such as quant funds, but they’re a few specks of light in a bloody field of corpses and rubble.
But if you believe that “ignorance is bliss,” and you have a solid track record and team at an established firm, here are the steps to start a hedge fund:
How to Start a Hedge Fund, Part 1: Raising Capital
First, note that even if you do have a solid track record at an established firm, you may not be able to use your results for marketing purposes.
You need to review your employment agreement and see what it allows because firms have different policies.
Also, even if you can use these results for marketing purposes, you won’t necessarily have 100% ownership of the results since you were in a team.
As a result, the “new fund marketing process” is often more about your process, your story, and you as a person than it is about historical results.
Potential investors in your new fund, such as funds of funds, endowments, pensions, family offices, and high-net-worth individuals, want to see three characteristics in your investment process and story:
- Specific – You need to do much better than “find and invest in undervalued companies.”
- Repeatable – Your strategy can’t be dependent on specific economic conditions or government policies or a key individual.
- Understandable – Institutional investors want strategies they understand 100% rather than potentially-higher-return-but-complex-and-unclear strategies.
Good Pitches vs. Bad Pitches
To make this concrete, let’s look at two quick examples.
A “bad pitch” would go something like this:
- Story: New healthcare regulations have created undervalued medical device companies and overvalued health insurance companies. The market hasn’t yet priced in the impact of these regulations, which has created investment and M&A opportunities.
- Process: You’ll focus on specific geographies and verticals and pore through companies’ filings, call suppliers and medical professionals, do patient interviews, and complete fundamental analysis to find the best long and short candidates.
- Returns: You’ve been using this strategy for 2 years in your personal account of $100K, and you’ve averaged 20% returns each year, verified by a Big 4 audit.
This strategy might seem reasonable, but there are several problems.
First, it’s far too dependent on current government policies – what if something changes, or the regulation gets rolled back?
Second, the process is not scalable because it’s extremely labor-intensive.
Finally, your track record is linked to your personal account, and strategies that work with $100K might not work so well with $100 million (oh, and 2 years of results might not be enough – 3-5 is better).
A better pitch might go like this:
- Story: You’ve identified 15 key signals in “mergers of equals” scenarios that correlate strongly with the probability of the M&A deal going through. The market has continuously mispriced companies’ stock prices in these situations, creating opportunities to earn market returns but with significantly less risk.
- Process: You track M&A activity in a sector and apply these rules of thumb about the exchange ratio, stock price volatility, and others, and then you confirm your findings with a review of corporate filings and additional due diligence.
- Returns: Working in a team of 3 with $20 million in capital at a generalist hedge fund over the past 5 years, you’ve averaged 11% annual returns, always in a relatively narrow band from 8% to 15% in any given year.
This strategy is specific, not tied to a fad or trend, and the process is more repeatable and scalable.
It’s also less dependent on you, and your returns have been more consistent with a much larger amount of capital over several years.
In addition to honing your pitch, you need to be personable because institutional investors often place just as much weight in your character as they do in your strategies and returns.
The Capital Raising Process from Beginning to End
Once you’ve refined your pitch, the process of raising capital differs depending on the types of investors you target.
For example, if you pitch to a $10 billion endowment that only invests in funds with over $500 million AUM, it will be slower and more bureaucratic than pitching to a small family office.
With large institutional investors, you can expect the following:
- Introduction – Get an introduction via other fund managers, trustees, your prime brokerage provider, or anyone else you know.
- Phone Interview – Answer questions about your strategy, how you make decisions, and qualitative aspects of your fund.
- Informal Background Check – They’ll ask about you in the community to figure out your reputation. “No search results” can be worse than negative findings!
- In-Person Pitch Day – If they like your story and reputation, they’ll invite you in to present for an entire day. You’ll go through your slides, your story, your process, your risk management, your team, your performance, and more.
When you’re presenting your past investments, you might use a structure like the following for each one:
- 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 different industry, and then realized that undervalued companies with underperforming 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; 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 announced a divestiture within the next 12 months. However, its stock price rose by only 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 wrong, but you had underestimated the impact of new regulations in the sector, which accounted for the difference. As a result, the company’s earnings growth was dampened, and the divestiture resulted in less uplift than you expected. You decided to focus on sectors with lighter regulations, such as [Name Examples].
The #1 mistake in day-long presentations is focusing too much on your successes and not enough on your mistakes.
You might be tempted to walk in and give them 10 case studies of investments where you earned 50%, 70%, or 100% within 12 months.
But no investor is perfect, and everyone loses money sometimes.
If you want a higher chance of closing the deal, throw in a few stories about mistakes and what you learned from them as well.
After you present, you might have to wait up to a year to receive a definitive “yes/no” answer.
You might also have to pitch to different groups, and they might visit your office and speak with other team members.
If all of that goes well, they might submit a proposal on your fund to the ultimate decision-makers, such as the Board of Trustees for an endowment, and then you’ll have to come in and deliver the “final pitch” to them.
Other Process Points
The process is quicker if you focus on smaller family offices and HNW individuals – you might get an introduction, speak on the phone, and then visit in-person for a day or two to answer more questions and complete the paperwork.
But it will also take more meetings and individual investors to reach a critical mass of capital if you do it that way, so there is a clear trade-off.
However, if you have less than $100 million in AUM, you pretty much have to start with these smaller offices and individuals because large institutions have a minimum check size and concentration limits (i.e., they don’t want to be 40% of AUM in a $75 million fund).
The success rate with investor meetings of all types is very low unless you have a great reputation at a top firm and you’re starting a new one with the same team.
You might have to contact hundreds of LPs before you start to see success, so the odds are much worse than those in investment banking networking.
Also, endowments and pension funds are extremely conservative and almost always avoid brand-new funds unless they already know the manager(s).
Consultants (i.e., placement agents) play a big role in the fundraising process as well, but there is a “size bias” there, and it’s tough to get their attention if you’re under a few hundred million AUM.
If you manage to raise enough capital to get started, you’ll then have to send out monthly or quarterly updates and an annual letter to your LPs.
Investors will also call you randomly to ask how things are going or to explain the strategies you’re currently using.
Large firms will scrutinize you closely, often devoting entire departments to fund monitoring, while HNW individuals and small family offices will be more hands-off.
Having skin in the game is quite important, and many investors won’t commit unless you also put a significant portion of your net worth into the fund.
So, the “capital raising process” is also about putting your own capital into play.
How to Start a Hedge Fund, Part 2: Setting Up the Paperwork and Legal/Corporate Structure
So, let’s say you’ve been meeting with investors, you’ve presented a solid pitch, and you’ve managed to win commitments for $100 million in AUM.
You need to think about logistical issues next.
You’ll have to tackle some of these issues before you even raise capital – but we’re labeling it as “Part 2” here because without capital, nothing else happens.
First, you’ll need office space, which is expensive in places like in NY and London.
To save money, you can start from your home at first, use a “hedge fund hotel,” or share space with other managers.
Until your management fees are enough to cover office rent and your other administrative expenses, frugality is the name of the game.
You’ll also need service providers, such as lawyers, auditors, administrators, marketers, prime brokers, compliance officers, and IT.
You might be tempted to save money by using cheaper, lower-quality providers, but that would be a big mistake because incorrect legal or compliance procedures could kill your fund.
Also, potential investors will look at the quality of these providers to judge your fund.
The legal requirements to start a hedge fund vary widely by state and country, so we’re not going to attempt to address them here.
At a high level, nearly all hedge funds are structured as Limited Partnerships because of the LP and GP split in the hedge fund structure.
A good attorney should be your first call when starting a hedge fund, and your investment agreement should include these terms at the bare minimum:
- Fee Structure: As a new fund, you’ll most likely have to settle for lower management fees (~1%) and performance fees (under 20%). The industry-wide trend is toward lower fees, with more weight given to performance fees.
- Lockup Term: This is the length of time that investors’ money has to remain in the fund before it can be withdrawn, and it should match your strategy (e.g., longer for an activist fund that acquires large stakes in companies, but shorter for a global macro fund with high liquidity).
- Redemption Terms: How much notice do investors need to give when they want to take their money out?
- Performance Targets: Are you trying to outperform a particular index? Is there a rate of return you have to beat before collecting performance fees? Is it based on the fund’s “high water mark” NAV instead?
You may have to register as an investment adviser and complete a literal ton of other paperwork and licensing, depending on where you set up.
Altogether, you can expect to spend tens of thousands of dollars, up to the hundreds of thousands, just for the legal fees.
Beyond lawyers, you’ll need auditors to monitor your performance, administrators to handle trade reconciliations and allocations, marketers to find more investors, prime brokers to manage the brokers and dealers you trade through, and compliance staff to manage reporting requirements.
IT costs vary based on your fund type – expect higher costs for quant funds and ones using algorithmic trading, and lower costs for fundamental-oriented ones.
The bottom line is that because of all these expenses, you will not earn much for the first few years of your fund.
Until your AUM grows enough for management fees to cover overhead with some breathing room, you will be in “frugality mode.”
Supplemental income sources and high savings are highly recommended because it could take years to reach the AUM required for long-term success.
How to Start a Hedge Fund, Part 3: Hiring a Team
So, let’s say you’ve made it through everything above, you’ve set up your fund, and you have around $100 million in AUM.
Now you need to think about your team because even with external service providers, you can’t do everything by yourself.
We label this “Part 3,” but you’ll have to build your team from the start because you’ll get questions about it in your pitches.
And you don’t even have a great shot of starting a fund unless you have an existing team that has worked together for years.
First, note that $100 million in AUM is barely enough to support a “team”: you might earn $1.0 – $1.5 million in management fees from that, and infrastructure, overhead, and compliance expenses will eat up a good portion of those fees.
You might have a few investment professionals at that level, a few support staff, and many outsourced service providers.
Once you move closer to $1 billion in AUM, you might hire several more investment professionals, a few more support staff, and even more outsourced services.
Quant funds have more IT needs and tend to have bigger teams, but many value-oriented funds start with just the Founder, one person on the investing side, and someone else in support.
If you only have the funds to hire one person, make it someone on the administrative/operational/marketing side.
That may sound crazy, but you will spend an unbelievable amount of time on non-investment-related tasks, such as talking to lawyers and accountants, reviewing legal documents, and answering questions from potential investors.
Without someone else to handle these tasks, you might spend 50% or more of your time on them, which limits your ability to create and implement investment strategies.
Hedge Fund Hiring: What Qualities Do New Hires Need?
But let’s say that you have grown your AUM, and now you can afford to hire more full-timers and interns.
…but at a startup hedge fund, that’s the wrong approach.
Yes, investment staff need to understand all of that, but the most important quality is that they MUST be willing to get any task done no matter how random or ridiculous it is.
Having a degree from Harvard or Oxford or 3 years of experience at Goldman Sachs are extremely poor indicators of this quality – in fact, they’re often negative indicators!
Your best bet is to tap your network and reach out to co-workers from previous jobs, and if you need to go beyond that, start asking those co-workers for referrals.
As your fund grows beyond the “startup” phase, the hiring process will become more traditional, with decisions based more heavily on discussions of investment ideas.
As your AUM grows, your headcount won’t necessarily grow linearly with it, especially if you’re running a quant fund; there are multi-billion-dollar funds with only a few investment staff.
Your headcount is more likely to scale up linearly if you’re running a value-oriented fund that requires more people for research and due diligence.
As you grow, the non-investment headcount might increase more rapidly because your compliance and reporting requirements will increase – but you won’t necessarily need to come up with more investment ideas.
Many large hedge funds have a 1:1 ratio of investment personnel to non-investment personnel, and sometimes it’s closer to 1:2.
How to Start a Hedge Fund, Part 4: Surviving the Job and a Day in the Life
Despite all these obstacles, you’ve managed to raise capital for your fund, hire a small team, and start investing.
Your average day will be quite chaotic because you will be doing much more than investing – you will be managing an entire business.
Here’s what you might expect if you start a small value-oriented fund:
6 AM – 7 AM: Wake up, get ready, check email, and head into the office while reading the news or listening to a podcast.
7 AM – 9:30 AM: Arrive at the office, read news about your current positions, and call your prime broker to sell one of your positions that’s vulnerable to a big overnight move in the GBP/EUR exchange rate.
Then, you meet the team, listen to everyone pitch new ideas, and decide to look at some declining companies with underfunded pensions as potential Short candidates.
9:30 AM – 11 AM: U.S. markets open, things are stable, and you spend a few hours reading through a merger agreement for a newly announced M&A deal involving one of your Longs.
11 AM – 12 PM: A trader stops in to tell you that one of your companies has been penalized by the EPA and is awaiting news of the exact fine. You scramble to figure out how bad it might be, but the company has more than enough cash to pay the highest possible fine.
12 PM – 1 PM: Go back to reading the merger agreement while eating at your desk.
1 PM – 2 PM: Do a call with a potential investor and answer questions about your fund’s strategy, risk management, and ability to take in new money.
2 PM – 4 PM: The stock of the company penalized by the EPA is down 15%, and now it’s also under investigation by the Department of Justice.
You pull the team together to start looking through old EPA cases to get a sense of expected vs. actual fines, and the stock falls another 5% while you’re doing this.
But you decide the market has overreacted, and you decide to buy more shares.
4 PM – 7 PM: U.S. markets close, so you round up everyone and go over research and work tasks for the day and decide which names you’ll focus on for tomorrow.
Then, you go back to your desk and do some uninterrupted research for two hours, focusing on SEC filings, court documents, and bankruptcy proceedings for a potential distressed idea.
7 PM – 9 PM: Go to a dinner party for new funds, hosted by a hedge fund service provider.
Everyone seems to be doing poorly this quarter, and you wonder what percentage of funds will die within the next 2-3 years (50%? 75%?).
9 PM – 11 PM: Go home, pay the bills for service providers, update the books, and start outlining your quarterly investor letter.
You take 5 minutes to respond to non-work emails from friends and then go to sleep.
You may not be working the hours of an investment banking analyst, but you are still going to have a bad-to-non-existent personal life when your fund is brand new.
The biggest difference is that there’s almost no “downtime,” and you are 100% responsible for everything that happens.
It is incredibly common for hedge fund managers to develop chronic illnesses, including autoimmune and stress-related disorders.
You deal with the stress from making investment and hiring decisions, the market moving against you, investors being upset with you, and keeping the lights.
Also, the job can become more stressful the more senior you are because you’ll gain even more responsibilities outside of investing.
The bottom line is that you must get your personal life in order before starting a hedge fund.
Significant outside commitments, dysfunctional relationships, a pending divorce, sick parents, or a brother who always needs to be bailed out of jail will make you go insane.
How to Start a Hedge Fund, Part 5: Exit Opportunities If It Doesn’t Work Out
So, you’ve raised capital, started your fund, hired a team, and had a few good years without having a heart attack…
…but then investors sour on your strategy, or you have one bad year, or you have a major disagreement with your Partners, and now you have to shut down or leave the fund.
This outcome is very likely because around 80% of all new hedge funds fail – not necessarily in the first year, but within the first few years before they can raise enough AUM to survive.
If this happens, your options depend on why it failed.
For example, was it because of bad performance (i.e., you consistently underperformed the S&P by 5% per year?), or was it because of business reasons such as a disagreement with your Partners or not being able to raise enough capital?
If you failed because of bad performance, you’re unlikely to get a second chance.
The culture of investment funds is 100% different from the Silicon Valley tech culture, where VCs can look past multiple failures and still fund your company if they think it has even a small chance of succeeding.
In the investment industry, you only have one shot at establishing a track record that’s 100% yours and proving that you can run a fund successfully.
If your startup fund doesn’t perform well, you’ll most likely leave the finance industry and do something else: go back to school, get into technology or join a fin-tech startup, start or buy a traditional small business, or go into teaching or a completely different career.
This is why it’s a bad idea to start a hedge fund when you’re very young: if something goes wrong, you’ve eliminated one career option.
If you had decent-to-good results, but your fund failed because of the “business side,” a viable strategy in the past might have been to join another, larger fund using a similar strategy.
For example, a small single-manager fund could have rolled up into a larger, multi-manager fund.
But I use the past tense here because this strategy is increasingly difficult due to the oversupply of failed hedge funds in the market.
It’s still possible, but it’s no longer quite as easy as interviewing at a few larger funds or joining a mutual fund – especially with the rise of passive and automated investing.
Hedge funds and mutual funds everywhere are suffering from fee compression, so hiring new employees with failed hedge funds on their track records is not a top priority.
As a result, your exit opportunities might not be that much different than if your fund failed due to poor returns.
Should You Ever Want to Start a Hedge Fund?
If you have a spectacular team, a great, repeatable, scalable strategy, and you understand exactly what a startup hedge fund entails, sure, go ahead.
However, if you’re a smart, ambitious person who’s willing to put in long hours, there are dozens of easier ways to become financially successful:
- It’s never been easier to start an online business – and even if your team is all remote, you can still achieve significant scale (e.g., Automattic). You can potentially even reach the millions or tens of millions in revenue without raising outside capital.
- You could invest your own funds in a personal account or take the “family office” approach and not make it a true hedge fund with outside investors.
- You could invest in real estate and rent out properties long-term or flip them for quick profits.
- You could launch your own freelance consulting or coaching services and eventually turn them into products or subscription services.
- You could join a promising startup as an early employee and cash out if the startup gets acquired or goes public.
- Or you could take the tried and true route of joining an established bank, PE firm, or hedge fund, and rising through the ranks.
None of these offers guaranteed success, but the probability of success is much higher than it is in starting a hedge fund.
The downsides of starting a hedge fund are so massive that they outweigh the potential upside in ~95% of cases:
- It’s extremely difficult to raise enough capital to scale and become institutional quality.
- Management and performance fees are falling.
- You are not just investing, but also running a business – and you may not even get that much time to invest.
- Most non-quant strategies have been out of favor.
- If you fail, unlike with tech startups, there are no second chances.
- Starting the fund will place an unbelievable amount of stress on your body and personal life.
- Oh, and since you must commit a significant portion of your net worth, you could lose not just time and health, but also money.
In light of these points, you really have to ask yourself if it’s worth it.
My answer is a clear “no” – but if you feel like torturing yourself, enjoy the ride!
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