Including to not only start a fund down the road but to get my foot in the door someplace to build connections and experience at existing funds. Set up the fund so it is structured with a hurdle rate before the GP ever gets paid.
This team will hone your pitch by crafting the right narrative, explaining the investment process used, and highlighting the fund's successes. When hedge funds were exotic alternate asset classes (rather than the well-oiled, fee-generating unregulated mutual funds they've become), they were actually useful to both their clients and to the economy at large. You can find plenty of articles about “how to start a hedge fund,” but they all tend to make the same glaring mistakes: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: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 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.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, 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 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.For more on the economics of hedge funds, please see the 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 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:You need to review your employment agreement and see what it allows because firms have different policies.As a result, the “new fund marketing process” is often more about Potential investors in your new fund, such as funds of funds, endowments, pensions, To make this concrete, let’s look at two quick examples.This strategy might seem reasonable, but there are several problems.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).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.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:When you’re presenting your past investments, you might use a structure like the following for each one: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.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.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.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 The success rate with investor meetings of all types is You might have to contact hundreds of LPs before you start to see success, so the odds are much worse than those in Also, endowments and pension funds are extremely conservative and almost always avoid brand-new funds unless they already know the manager(s).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.So, the “capital raising process” is also about putting 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’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.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 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 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.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.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 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.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 Without someone else to handle these tasks, you might spend 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 Having a degree from Harvard or Oxford or 3 years of experience at Goldman Sachs are 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 Many large hedge funds have a 1:1 ratio of investment personnel to non-investment personnel, and sometimes it’s closer to 1:2.Despite all these obstacles, you’ve managed to raise capital for your fund, hire a small team, and start investing.Here’s what you might expect if you start a small value-oriented fund: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.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.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.Everyone seems to be doing poorly this quarter, and you wonder what percentage of funds will die within the next 2-3 years (50%?
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