By Dennis Schall, CPA, Partner, Alternative Investments Group at Marcum LLP
So the story goes: you have been working for a big Wall Street firm for years and you’re tired of making millions of dollars for other people and want to make it for yourself. Your co-worker sitting next to you feels the same. One night, over some cocktails at the local watering hole, the two of you decide“ Hey, enough is enough; let’s start our own hedge fund!” The next day you both quit your jobs and call your former college roommate who is now a real estate attorney and ask him to write your fund documents. He goes to the internet and downloads fund documents. You and your partner bring the subscription documents to your friends and family and quickly raise $10,000,000. You deposit the money and start trading on your E-Trade account. In less than one year you lost half the money, your friends and family want the rest back, and you are now unemployed. This unfortunate story is too often the reality for the less diligent emerging managers. So if you are thinking about launching your own hedge fund, here are four things you should consider before making that first trade.
1. You are running a business not a trading desk
From this point forward your hedge fund is the “Business.” Many emerging managers fail because they don’t understand that a hedge fund is a business and not just a trading strategy. While the trading strategy is very important and it is the engine that will generate profits for the business, there is a lot more to running a business. As an emerging manager, you will be responsible for dealing with issues that in the past were taken care of by someone else. You will be making decisions regarding office space rental, the purchase or lease of computer equipment, the acquisition of a phone system, and subscription to a variety of research services, among others. You will also have to develop an internal support team. Thus, you will become a recruiter and the human resources manager charged with selecting the best employees, determining their salaries, selecting their benefits package, and processing their questions and complaints. These decisions can become distractions for the emerging manager who still must find the necessary time to execute his trading strategy and meet his investment objectives.Revenues, expenses and profits/losses are now the responsibility of the emerging manager. Every business has to deal with these issues and your business is no different. The emerging manager has to establish budgets and forecasts in order to be able to properly develop a strategic plan for the business.
Revenues for the emerging manager are typically generated in two ways:
(i) a management fee (typically 2% of Assets Under Management “AUM”) paid to the management company and
(ii) a performance allocation (typically 20% of the fund’s profits) allocated to the general partner of the business.
The emerging manager needs to understand what the fixed costs and the variable costs of the business will be for the week, month and year.
(i) Fixed costs are the costs that remain constant regardless of the amount of revenue generated by the operation of the business. An example of a fixed cost is office rent.
(ii) Variable costs are costs that fluctuate depending on the activity of the business. An example of a variable cost is broker fees. A manager also needs to evaluate which expenses should be paid by the management company and which expenses can be absorbed by the fund. For example, salaries of employees are customarily incurred by the management company.
So, if the books and records and monthly Net Asset Value (NAV) calculation of the fund are being maintained internally, this would be a management company expense. Conversely, if the books are records and NAV calculation are outsourced to a fund administrator, this is typically an allowable fund expense and can be absorbed by the fund.In the ideal situation, the management fees will cover all the costs associated with the day to day operations of the business. If not, then the emerging manager will have to cover these costs personally. The emerging manager should not rely on the performance allocation, because of the inherent uncertainty of profitability. Investors know that past performance cannot be relied upon to predict future results and the emerging manager would be foolish to adopt a different view.
2. Your service providers are your allies
Selecting the proper service providers is crucial to the long term success of your business. They are a reflection on you and your business, and with proper selection, your credibility can increase. Emerging managers should select service providers based upon (i) their expertise in hedge funds, (ii) their reputation in the industry, and (iii) their ability to grow with the business and adapt to change. When selecting service providers it is necessary to perform the same due diligence you perform when selecting your medical doctors. Service providers come in all shapes and sizes and you need to pick the right fit for you. There is a wide range of costs between service providers. The low bid is not always the best bid when it comes to choosing service providers. As we are all often reminded in life, “You get what you pay for.”
The most common service providers are:
Prime Broker – services include the execution and clearing of trades, the extension of credit, operational support, custody of cash and investments, and provision of reports and accounting for trades executed by other brokers.
Attorney – services include drafting fund documents; the formation of the fund, the general partner and the management company; and the registration of the investment adviser under federal or state law.
Auditor – services include the audit of the fund’s financial statements and the preparation of applicable tax returns. Auditors can also review and opine on portfolio performance reporting.
Fund Administrator – services include the preparation of books and records and the calculation of the NAV; and investor services such as conducting AML procedures on prospective investors, the receipt and disbursements of subscriptions and withdrawals from/to investors and shareholder reporting. Administrators can also assist with daily cash and investment reconciliations between the trading system and prime broker.
Other service providers to consider:
Regulatory Consultant – all registered investment advisers must have an operation and compliance manual and it is a best practice for unregistered investment advisers to have one as well. A regulatory consultant can provide invaluable assistance to the emerging manager in developing a compliance program and can act as Chief Compliance Officer (CCO) if limited resources preclude the emerging manager from hiring a full time CCO.
Independent Valuation Consultant – depending on the fund’s investment strategy, it may be appropriate to hire an independent consultant to value all or part of the emerging manager’s portfolio. Valuation consultants can also be hired on a one time basis to help the fund develop their valuation policy and review that the methodology is appropriate for the type of investment and in accordance with Generally Accepted Accounting Principles.
Information Technology Consultant – services include the design, implementation and maintenance of the fund’s information technology platform.
Professional Employer Organization (PEO) – an outsourced employee management firm that handles employee benefits, payroll and other human resource functions.
3. Infrastructure and Compliance – it is not just about performance
Raising capital has become very difficult in recent years for emerging managers. To give your fund a better chance of raising capital, the business infrastructure should be in place.Have all your service providers selected prior to the launch of your business.
- Provide best practices in writing!
- Complete the operations and compliance manual in advance of the launch.
- Have the proper information technology infrastructure in place.
4. They are not limited partners – they are your customers
Your investors are customers. They can do business with you or they can leave your fund and invest with someone else. Treat your investors the same way you would like to be treated when you are someone’s customer. For too long, emerging managers have relied solely on performance. Performance is an important ingredient to keeping your customers happy. However, in today’s business environment there are some things that are just as important to your customers. Communication and transparency is critical to be successful in today’s business environment. Customers don’t like surprises. Monthly and annual reporting must be timely. When reporting is delayed beyond reasonable expectations, customers get nervous and nervous customers make withdrawal requests.
If you are considering launching your own hedge fund, remember it is a business and the infrastructure needs to be in place before you open. In preparation for that fateful day you dreamed about (when you have decided “Hey, enough is enough”) you should (i) know in advance how much capital you will need to operate your business for at least two years, (ii) select of all your service providers before you speak with prospective investors (iii) be prepared to answer all an investor’s reasonable due diligence questions, and (iv) remember that your limited partners are really your customers. If you diligently prepare in advance and you have a trading strategy that works, your story should be one of success. Competition among emerging managers is tough enough. Don’t get in your own way by being unprepared and remember that you get what you pay for.
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Marcum LLP is one of the largest independent public accounting and advisory services firms in the nation, with offices in major business markets throughout the U.S., as well as Grand Cayman, China and Ireland.