How hard is it to start a hedge fund?
July 20, 2006 7:54 AM   Subscribe

I know several people who have started in small-scale hedge funds that seemed to be initiated by a single investor/founder who happened to have some capital. What steps are required to start a hedge fund? What kinds of relationships should a founder have before starting one? What kind of restrictions are there on hedge fund creation?
posted by Big Fat Tycoon to Work & Money (8 answers total) 2 users marked this as a favorite
From Wikipedia's entry on hedge funds, How to setup a your own hedge fund.
posted by SeizeTheDay at 8:08 AM on July 20, 2006

This is a potentially complicated question, despite the lax regulations on hedge funds. The best bet is to hire an attorney at a firm with an Asset Management group or something similar.
posted by Falconetti at 8:51 AM on July 20, 2006

Recent SEC rules, which have been struck down by one Federal court but which aren't quite dead yet, require most hedge funds to go through a quite onerous registration process, and have key personnel meet a number of qualifications.

Absent those rules, almost anyone can set up a hedge fund at a quite minimal (relatively speaking) legal and administrative cost.

However, succeeding as a hedge funds requires legal access a minimally sufficient range of investment products, and sufficient assets to attract dealer coverage and counterparty approval and to support prime brokerage services. $5 million in assets, which is the threshold for being an "institutional accredited investor" under U.S. law, might suffice for a few minimally-levered styles and strategies, but much more is going to be needed for most others.

Another threshold ($100 million in assets) is needed to cross over into status as a "qualified institutional buyer" -- being a QIB is legally required for accessing the secondary market in private securities, which is a critical piece of supply, and is also practically required for the higher levels of counterparty credit and coverage. There are plenty of non-QIB hedge funds, of course, but most of them are really simply trying to prove out their strategies in order to attract the investors it takes to get over the QIB line, where it becomes possible to make serious returns.
posted by MattD at 9:20 AM on July 20, 2006 [2 favorites]

posted by JohnnyGunn at 10:05 AM on July 20, 2006

Oops. Try
posted by JohnnyGunn at 10:06 AM on July 20, 2006

You don't need relationships, you need investors (Limited Partners or "LP"s). You want to start with as big a fund as possible--it's been a few years but as I recall you can amortize organizational expenses but not offering expenses--spreading out the startup costs helps immeasurably.

Manage to convince people you can handle their money well enough to earn the famous 2%/20%, or more. "Two and twenty" is an entry-level-type fee for such a fund, although managers will often cut this for the first fund. Managers receive 2% of the total amount under management to cover overhead (the "Management Fee") and 20% of all gains after the investor has recovered its (inflation and risk-adjusted) original investment (the "incentive fee").

Most of all potential LPs want to see a track record. Demonstrable, preferably GIPS-compliant (or GIPS-congruent) performance by the manager or management team over an extended period of time.

Verifiable, lengthy track record should ideally be built using the same investment policy as the proposed fund. Funds of funds, seed funds, and incubators will look at track record as a proxy for future performance and skill (with the usual caveat). This term applies to the constraints upon the manager as much as to the way in which the manager hopes to achieve gains. Types of strategies include long-only, long-short, growth, long bias, absolute return. Google these to find out more. Excellent summary here. [pdf]. Constraints include specific limits on investment size relative to the whole fund and the target company, use of leverage, shorting, and timing of investments.

Big generalizations follow: Funds of funds will tend to look at you after you have a critical mass--say U.S.$ 10-20 million. Seed funds will want part of the management company or a fee rebate, and perhaps an earler-than-normal exit option. Incubators will take you on to manage a small account before introducing you to larger investors.

For GPs, the structure is popular because above a certain point it can be wildly lucrative for the manager; there's also a strong presumption of alignment of interest between manager and LP due to the incentive fees. This isn't always the case.

Tough business.
posted by Phred182 at 11:01 AM on July 20, 2006

Sorry: GP and LP are shorthand terms for the manager and investor, respectively, assuming a limited partnership structure.

Because it's a pet peeve, the term "hedge fund" is a misnomer. Hedging in this context tends to mean "performing some risk-management in additional to principal investment activity," or "able to use options and exotic securities to protect or enhance returns." It rarely means that there is full downside protection: a perfect hedge would result in a zero-return fund.

Or so it's always seemed to me.
posted by Phred182 at 11:28 AM on July 20, 2006

a perfect hedge would result in a zero-return fund.

Or the risk-free rate minus expenses.
posted by Kwantsar at 1:30 PM on July 20, 2006

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