How to Start a Hedge Fund

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So, you want to start a hedge fund and looking for step by step guide on how to start a hedge fund.

Great! In this post, I will give you step by step guide on what steps you need to take for your hedge fund formation.

 

A definitive guide to help you set yourself up for a hedge fund startup.

In short, I’m going to share with you 10 important steps you need to take for starting up your own hedge fund.

 

1. Research 

Starting a hedge fund is a very costly and time-consuming process makes sure you’ve thoroughly investigated and understood the basics.

The research will help you to determine whether you have the right personality and resources to start a hedge fund.

Hedge funds are generally very aggressive, you need to take the financial risk and are exclusive than mutual funds.

 

Just be sure that before getting into it, you’ve done your homework, talked with few potential mentors and understood the basics.

Develop a solid foundation for a stronger startup that will be powerful enough to bear the ups and downs of the market.

Your research plan should define clearly your intention and give you the data and information you need to go ahead.

If you are very serious and want to work in this industry go and learn as much as you can

 

1. Reading

Start reading about hedge funds you can start with books. Books will give you a wide overview of the industry so you’ll be able to see the bigger picture.

You’ll be able to understand how a hedge fund works, how they manage the funds and other relevant details that you need to know for your hedge fund formation.

 

2. Find an Expert

Get interesting hedge fund management tips and tricks directly from experts.

Find out industry expert who has developed enough expertise as an operating hedge fund.

An expert with a proven track record of success, they know from experience what solutions will be the best fit for you.

 

They can explain how initial decisions impact other decisions and phases of the project.

They’ll introduce you to a larger industry perspective and leverage their past experience to your advantage.

You’ll be able to learn the essential skills required in order to successfully run a hedge fund.

Then you can implement your learnings being guided by experts who have been there.

 

2. Hedge Fund Startup Costs 

Starting up your hedge fund is very expensive and requires a large initial minimum investment.

How much money do you need to start a hedge fund?

You can categorize your expenses into two parts that are one time expenses and ongoing expenses.

 

1. One Time Expenses

One-time expenses come from non-operating activities, that don’t include in your monthly budget.

These expenses do not fall into the company’s regular budget and do not expect to continue over time, at least not on a regular basis.

One-time expenses or revenues cover all the activities associated with legal fees to obtain a license.

Registering your company as a legal entity with taxing authority in your state.

You may need to spend anywhere between $15,000 to $50,000 in initial costs. This is just the cost to start up your fund or setting up your fund.

 

2. Ongoing Expenses

As we all know ongoing expenses are the cost of running the administrative and maintenance of a business on a daily basis.

These expenses will fall into the company’s regular budget, expect to continue overtime on a daily basis.

 

Ongoing expenses will cover all the activities associated with administrative operating expenses.

Apart from that, you have legal expenses like hiring an attorney, filing paperwork, administrative costs, marketing and more importantly raising capital.

Usually, these expenses will appear on a company’s income statement as indirect costs.

 

These expenses include things such as salaries for company managers and wages or salaries for employees, research and development costs.

Don’t forget to involve the cost you are spending on the lawyer.

This payroll is a part of the operating costs your company has to pay for, depending on the pay schedule.

 

Asset Under Management

AUM (Assets under management) also recognized as a market value of entire investments managed by a person or entity like hedge fund, mutual fund, money management firm on behalf of clients.

Assets under management are the amount of investment funds invested by the accredited investors or institutional investors the investment company manages.

 

These investments are kept in a hedge fund or other financial institutions like mutual funds, venture capital and managed by a portfolio manager.

Rising AUM (Asset Under Management) is the primary goal of a hedge fund manager or portfolio manager.

AUM plays a very important role when marketing yourself to potential investors.

 

Every hedge fund manager uses a high AUM as a selling point at the time of marketing themselves to potential investors.

Most of the investors compare the AUM of the company with competitors as a measure of success to figure out true performance over time.

 

Raising AUM is one of the biggest challenges faced by hedge fund startups.

Every potential investor is looking for a company with a high amount of assets under management before investing in your company.

 

Usually, high AUM is a signal of the size and success of the company.

So you can aim between $1 million to $5 million and this is going to be the more realistic target to aim for when all costs are considered.

 

According to Investopedia, with 5 million your hedge fund success rate will improve, 20 million will make you more noticeable to investors and $100 million hurdles, which will open the door to more institutional investors.

When all costs are considered and how much they’ll cost, you’ll get an idea of how much money you really need for your hedge fund startup.

 

3. What Licenses do you need to Start or Manage a Hedge Fund? 

You do not need any specific license to operate the hedge fund but it may vary depending on the type of investments the fund makes.

You may find it necessary or at least helpful to obtain certain licenses for your hedge fund formation.

There are more than 40000 separate licensing jurisdictions in the united states only and each has its own particular licensing requirements.

Licensing can differ widely from state to state, the exact licenses that you’ll need depend on the city and state in which you’re located.

 

1. Business License

A hedge fund manager needs to have a business license to make sure that the business is properly taxed and regulated by the authorities.

As I mentioned earlier the type of business license you’ll need to start a hedge fund varies from state-by-state, and not all states require a state-specific license.

 

You can visit your state’s government website to determine the requirements of your state.

You may need to visit the SBA website, you have to locate your state agency and narrow down your location by city or country.

You’ll get a list of links and information relevant to obtain the license.

 

2. Series 65

You may need to obtain a Series 65 license because as a hedge fund manager you are acting as an investment advisor.

Series 65 is a licensing program conducted by FINRA that authorizes a hedge fund manager to act as an investment adviser.

Series 65 license is mandatory in order to act as an investment advisor representative.

 

Series 65 exam will test an individual’s knowledge and ability to offer investment advice.

The exam consists of 130 plus 10 pretest questions that must be completed within 180 minutes.

It does not allow to sell securities, but rather, you can serve as an investment adviser.

To schedule the exam you should open enrollment window via FINRA.org and pay the examination fee. Here you can visit FINRA’s “Enroll for a Series Exam” page to register for a state licensing exam.

 

3. Series 7

Series 7 is a license allows the brokers to sell all types of securities products except commodities and futures.

In order to buy and sell the stocks directly on an exchange, you must take and pass the Series 7 test.

As a hedge fund manager if you wish to trade stocks the series 7 license will allow you to do that otherwise you will need to hire a broker.

 

4. Series 3

Series 3, also known as the National Commodities Futures Examination, conducted by the Financial Industry Regulatory Authority (FINRA).

The exam will test your expertise in the commodities and futures market to ensure that you are capable enough to advise clients on investing in them.

 

A Series 3 license qualifies candidates to register with the NFA and sell commodity futures contracts and options on commodity futures contracts.

If you are planning to trade commodities or other types of futures, your hedge fund manager will be required to take the Series 3 exam, which is given by the National Futures Association.

 

4. What Entity Should I Use for My Hedge Fund? 

Next, you’ll go through the several regulatory and legal requirements to set up your fund and start pitching your investment ideas to investors.

For that first, you need to determine how you are going to set up yourself? What types of business entity do you want to set up your hedge fund?

 

There are plenty of options available for forming a hedge fund, a limited liability company, or LLC, or a trust.

Do you want to form a limited liability company (LLC) or a limited liability partnership (LLP)?

The two have unique characteristics, but both also have some commonalities, including the way they are taxed by the IRS.

One of the major differences between an LLC and LLP is how the entity is allowed to be managed.

Both entities provide different protections against the business.

 

1. Limited Liability Partnership

A Limited Liability Partnership is right for forming partnerships to practice accounting, architecture or law.

Generally, a limited liability partnership or LLP is the most popular option for hedge fund formation.

All the partners share the profits of business just as partners of regular firms.

 

However, they have the freedom to decide the ratio in which they will share profits.

However, the partners generally do not participate in the management and are only liable to the amount of their investment in the partnership.

 

When it comes to an LLP, partners are personally accountable. One partner will not be responsible for the other’s actions.

This means each partner has liability protection from wrongs committed by the other partner. Liability only involves the partner’s direct financial investment.

 

In the case of going through the legal consequences of repayment of the debt, the personal assets of the partners will not liable.

Basically, the liability is limited you may lose assets in the partnership, but not those outsides of it (your personal assets).

 

2. Limited Liability Company

In the last few years, LLCs have become an increasingly popular structure among hedge and other pooled funds.

Limited Liability Company is good for small business owners and you can enjoy tax flexibility, easy to set up with fewer restrictions on members.

 

An LLC is an entity in which individuals called “members” own the company but they are not personally liable for the company’s debts.

With an LLC, all the members are protected from personal liability for any debts or lawsuits filed against the business.

Members who have been harmed by the business can’t sue any of the business members for debts.

LLC members enjoy great flexibility in structuring the management of their venture through the LLC’s governing document (operating agreement).

With an LLC, the manager of the fund set up won’t have personal liability as if the fund was set up as a limited partnership.

 

Therefore, a limited liability company is a better option than a limited partnership.

LLCs have a more flexible structure enabling managers more freedom to operate their fund.

 

Once you choose the right entity for your hedge fund the first step will be integrating the fund according to the state you are living in.

Requirements will vary depending on your state’s regulatory laws. These laws can change entirely based on the country and state in which you do business.

 

5. Prepare Documents 

Starting a hedge fund requires significant legal exposure, there are certain documents that every hedge fund manager has to prepare to launch the fund.

These documents are created to give an investor a clear picture of the fund’s investment strategy along with the risks involved in investing in the fund.

Improper or incomplete documentation may liable a fund manager to the risk of regulatory intervention and civil liability, both of which may carry significant costs.

 

1. Private Placement Memorandum

The private placement memorandum also known as private placement is a disclosure document provided to the potential investors outlining the terms and conditions of the hedge fund.

A PPM spells out all the information about the fund, what does the company do? How does it generate revenues? the terms of the offerings, the allocation process and the risk involved in the investment.

 

Basically, the offering memorandum describes the potential investors about everything they need to know about the company: the terms of the investment, the nature of the business, and the potential risk of the investment.

 

2. Limited Partnership Agreement

The limited partnership agreement is a legal document that describes the terms and conditions of the fund and rights of an investor and fund manager.

The limited partnership agreement is more complicated than a private placement memorandum.

 

The Limited Partnership Agreement describes all the terms of your limited business partnership, from ownership interests to buy-out options, and everything in between.

The agreement dictates the relationship between the general and limited partners along with the management powers of the general partner.

You can even define specific management roles for your partners, restrictions on transfers of partnership interests, voting rights of the partners, fees owed to the general partner, asset valuation, and much more.

 

3. Subscription Documents

The subscription agreement describes to the investor about all the steps necessary to join a limited partnership.

The agreement also gives the fund manager all the information about the investor. Every investor must execute a subscription agreement.

Basically, this is the investor’s contract with the fund, which outlines the fund subscription amount and outlines under what terms the investment is being made.

The subscription agreement makes sure that the investor understands the risks of the offering and are perfectly qualified to make the investment.

According to the document, an investor has to meet certain eligibility standards, such as “accredited investor” or “qualified client,” described by SEC regulations and state law in order to invest in the fund.

 

4. Investment Management Agreement

The investment management agreement is a written agreement between the fund and the investment management company.

It describes the services that a fund manager will provide. The agreement authorizes the fund manager’s power of attorney over the fund’s assets.

 

The agreement will give the fund manager the broad discretionary or non-discretionary authority to manage investor funds.

The discretionary authority will allow the fund manager to manage investor funds and securities in a manner that the fund manager believes without prior consultation with you.

With non-discretionary authority, the manager will need to obtain your prior approval for each transaction.

 

6. Register as an Investment Advisor 

A Registered Investment Advisor (RIA) is a firm or a person is involved in the act of offering advice to high-net-worth individuals on investments and manages their portfolios.

Registered Investment Adviser firms required to act as fiduciary. This means they have a fundamental obligation and requires them to provide investment advice focusing on the client’s best interests ahead of his or her own.

 

RIAs usually receive earnings in the form of management fees for providing financial advice and investment management.

Generally, financial advisors charge 1% to 2% of assets under management for ongoing portfolio management.

However, fees and compensation plans can fluctuate from advisor to advisor.

 

Depending on your business location, the number of investors and where your potential investors are located, what you are investing in and applicable state rules, your hedge fund company may need to register as an investment adviser before the fund’s launch.

You’ll need to pass a test and register with the Securities and Exchange Commission (SEC).

There are certain specific requirements but it’s a still good idea to go ahead and register as an investment advisor, this is a positive sign for future investors.

 

To register with the SEC as an investment advisor, your firm must need to have $100 million or greater in assets under management (AUM) at the time of investment advisor registration.

Once your firm crosses $100 million or greater in assets under management (AUM) then it becomes mandatory to register with the SEC as Registered Investment Adviser (RIA).

 

If in case of having less than $100 million in assets under management within 120 days of the effective date of the investment advisor registration, then you must need to register with state securities authorities as an investment advisor.

But if your firm acts as the investment advisor on behalf of an investment company it is mandatory to register yourself with the SEC, regardless of the number of assets under management.

If your firm managing a smaller asset base then you must need to register with state securities authorities.

 

How Much Will It Cost You to Register an Investment Advisor?

After successfully creating an account, the advisor or firm will get a CRD number and account ID information provided by FINRA.

Then the registered investment adviser will be able to file Form ADV Part 1A.

 

Generally, the sec will reviews only Part 1A as part of the initial application process then the investment advisor firm must have a Form ADV Part 2.

Usually, the process of preparing and submitting these forms will takes few weeks.

Then the SEC will respond to the application in order to approve or deny investment advisor applicants within 45 days.

 

7. Select a Hedge Fund Strategy 

You must need to understand how these funds make money and the risk they take when they buy the financial product.

No two hedge funds are identical, most of them achieve their returns using one or more of several specific strategies.

You can follow a number of different strategies, including:

 

1. Long/Short Equity

Long/short equity is very popular for startup hedge funds. As the name suggests, the long/short equity strategy seize long positions in stocks that are expected to appreciate and short positions in stocks that are expected to decline.

A long/short strategy engages a wide variety of fundamental and quantitative techniques to make investment decisions.

These funds tend to invest primarily in publicly traded equity and their derivatives and tend to be long-biased.

Getting a long position in a stock simply means buying it: you will make money if the stock increases in value.

On the other hand, buying a short position in a stock means borrowing a stock you don’t own (usually from your broker), selling it, then hoping it declines in value, at which time you can buy it back at a lower price than you paid for it.

 

2. Market Neutral

A market-neutral strategy seeks to avoid some form of market risk entirely to make a profit from both increasing and decreasing prices in one or more markets.

Constructing portfolios to mitigate market risk is the main priority of market-neutral funds.

At the time of high market volatility, factual results have shown that market neutral funds are likely to outperform funds using other certain strategies.

 

3. Global Macro

A global macro strategy is an investment strategy depends upon the interpretation and prediction of large-scale events related to national economies and political views of various countries or their macroeconomic principles.

Basically involves buying long and short positions in various equity, fixed income, currency, commodities, and futures markets.

 

Its a market bet on an event can cover a wide variety of assets, futures, currencies, index funds, bonds, and commodities.

The main goal is to find the right mix of assets to maximize returns if the predicted outcome occurs.

 

4. Event-Driven

An event-driven strategy is a type of investment strategy that makes substantial profits from temporary stock mispricing that can occur before or after a corporate event or bankruptcy, merger, acquisition or spin-off.

To execute this strategy successfully it requires a large amount of expertise to analyze the corporate events.

The goal of the investor is to exploit pricing inefficiencies caused by corporate reorganization, restructuring, merger or another major event.

The event-driven strategy will require a team of professionals who are experts in analyzing corporate actions and determining the effect of the action on a company’s stock price.

 

8. Hiring a Team 

Starting hedge fund you’ll have to deal with tax strategies, paperwork accountants, managing employees and many more.

Running a hedge fund involves a lot of work from investing, trading, risk management, accounting, legal compliance, and marketing.

Starting a hedge fund means you are going to handle investor’s money, the legal standards are very high.

You need to make sure your hedge fund legal documents are properly completed and filed.

You must need to hire a team, develop infrastructure, and a set of systems working together to earn active returns for your investors.

 

1. Attorney

You can outsource this great amount of work by hiring a good attorney. You have plenty of options available to help you through the journey but its really expensive.

A good lawyer will provide you the best service to help you protect your assets and offer excellent advice for complicated legal matters.

 

You need to make sure your attorney has sufficient experience background working with hedge funds.

You must need to understand the legal fee structure before hiring your attorney.

 

2. Portfolio Manager

A portfolio manager is a very important person to consider while starting a hedge fund.

A portfolio manager has a great influence on a fund and directly affects the overall returns of the fund.

Therefore your portfolio managers have to be well-experienced investors, broker or trader, with strong backgrounds in financial management along with successful track records.

 

3. Analyst

Hedge fund analyst plays a very important role and spends most of his time doing research, stays up to date on financial news and market forecasts.

The analyst is responsible to create financial models and calculating the results of trading their stocks according to different strategies.

 

To successfully accomplish this, a hedge fund analyst has to manage a lot of things apart from the research he holds a meeting with the industry experts.

Who provides insight into these types of market forces.

4. Trader

The trader is the person who actually involved in buying and selling assets on behalf of the portfolio manager.

Trading on the stock involves buying and selling a wide range of products on behalf of the company.

Traders are known for their speed, productivity, and profitability of their trades.

5. Sales/Business Development

Finding potential investors and raising capital is the hardest part of a hedge fund.

So’ You’ll need to hire a salesperson to go out and find new investors.

Generally, the investment in hedge funds comes from high-net-worth individuals and therefore it requires different sales approaches.

Makes sure to hire the right salesperson and these are the qualities you need to look in your salesperson

• Good communication skills along with the ability to describe complex financial problems in simple terms.
• He must need to have the best interpersonal skills in order to convince potential investors.
• It’s recommendable to hire someone with years of experience in the same industry.

 

9. Apply for an Employer Identification Number 

An Employer Identification Number (EIN) is commonly known as a Federal Tax Identification Number, is a nine-digit EIN number assigned to your company by the Internal Revenue Service.

If you are operating in the US you’ll need to set yourself up with the Internal Revenue Service (IRS) to get an employer identification number.

You’ll need it when filing your business’s income tax return or payroll tax return.

The purpose of issuing employer identification numbers is for tax administration.

 

The process takes only a few minutes you can visit their website and fill out the necessary forms.

The process to get an employer identification number is very easy you can apply it online, you’ll need a valid Taxpayer Identification Number (SSN, ITIN, EIN).

You’ll need to complete the application in one session and after verification is done you will get your EIN immediately upon completion.

 

10. Raising Capital 

Forming a hedge fund, your biggest challenge will be raising capital, you must need to have a significant amount of assets under management (AUM) that what potential investors want to see before entrusting you with their money.

Attracting investors to your hedge fund is very very challenging you’ll need to prepare proper documents in which you can explain your fund’s goals.

As a hedge fund manager, you have to prove yourself with the positive results so that investors are interested to invest their money.

Raising capital for your hedge fund will require investment from investors.

You have to know about how to take care of your investors. Here business skills play a very important role and help you to raise capital for your hedge fund.

 

1. Friends and Family

To raise the capital for your hedge fund you have to establish an investing track record and to do that you have to act like an investor and invest a substantial amount of your money for starting your own hedge fund.

Initially, you can consider starting through your friends and families. Most hedge funds use this method to raise capital for their hedge fund.

Usually, investments from friends and family are the best method you can start with.

After you invest a noticeable amount of your money in the hedge fund, your friends will show confidence in your plans and invest money with you.

It’s less formal conversations than from professional investors.

It’s much easier to convince your friends or family than convincing other types of investors.

Your friends will have confidence in your plans and invest money with you.

 

2. High Net Worth Individual Investors

Do you have a network of high-net-worth individuals willing to invest in your fund?

These investors are high net worth individuals usually qualified clients and accredited investors often invest in hedge funds.

Generally, these investors have their legal teams to deal with hedge fund managers and the strategy.

If you don’t have a network with high net worth individuals you can start building your own network through plenty of channels such as hedge fund conferences, hedge fund databases or through other means.

Once you raise the capital from friends, the family now you’ll need to share your plans and strategies with these high net worth individuals.

So that they are interested in your proposal and help you to raise capital for the hedge fund.

 

3. Institutional Investors

Attracting investment from institutional investors is an excellent way to raise capital for a hedge fund but at the same time, it’s a very difficult process and requires long term planning and strategy.

To attract institutional investors you have to perform exceptionally well and show them excellent returns on investment.

 

To bring investment from an institutional investor takes a lot of time and more in-depth process than receiving money from friends and family or from a high net worth investor.

The fund manager has to hold a meeting with the institutional investor. Usually, the meeting will be at the office of the institution and the manager will get a chance to give his pitch.

After the meeting, the institution may take some time to invests in your fund.[Hedge Fund Law Blog]

 

11. Market Yourself

There are certain regulations that will prevent you from advertising your funds, but you can use digital platforms to set up your information.

 

1. Create a Website

Create a professional website with essential information related to the company, its capabilities, and credibility.

Having a professional website with detailed information about your company, the experience and you can provide investment strategies.

This website will give you an online presence and help you to develop trust in potential investors.

If you are not willing to create a website that conveys the wrong message to the investors that the firm is not really serious about market communication.

Your website should clearly define your institutional values, explain processes, showcase human capital and many more…

Your website will help you to generate investor’s attention by allowing visitors to draw their own conclusions about the firm and its potential to help them achieve their goals.

In order to raise the capital, you need to increase your salesmanship to convince investors that you can create value.

In addition to honing your pitch, you need to focus on your strategy, how your strategy works, why your strategy works, and how it has an edge over the competition.

It’s a proven fact that every investor wants to fund somebody with a proven track record.

You can offer a discount on your management fee to initial investors.

 

3. Networking

Networking is one of the best methods to raise the capital for your hedge fund.

Networking is similar to network marketing but operates a little bit differently.

Make a list of all your networks that you know you can add friends, family members or other contacts who are interested in such a partnership.

 

Try to contact someone who is aware of specific hedge fund openings and set up an informational interview with them, which as you know can eventually lead to a formal one.

Maybe you can find someone in your network who is happy to set you up with or be able to make direct introductions to potential investors.

 

Starting a hedge fund means most probably you have connections with the bankers and that is the best method it will allow you to explore new opportunities.

Tell them about the details of your strategies let them know what you are looking for.

If they know what you want, then if they hear anything relevant to it they are more likely to tell you about it.