About How to Start a Hedge Fund

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On the surface, a hedge fund looks like a regular pension or mutual fund. The manager will find investors, get a bunch of money, invest that money in certain securities and ideally, make more money. However, since hedge funds are unregulated, they have a lot of freedom to invest in high-risk, high-return assets outside the rank and file, and to design the way they manage those assets. They also have the power to set their own fees, which means it can be a lucrative career jump for anyone who's brave enough to start their own hedge fund.

Do You Need a License to Start a Hedge Fund?

First things first: regulation. Hedge fund managers are not regulated like stock brokers, so you won't need a Series 7 license to trade on behalf of investors. A Series 7 license is the license that authorizes brokers to place trades on stock exchanges.

What you will need is a Series 65 license. That's because the work of a hedge fund manager qualifies as giving investment advice. Most states will require you to register as an independent investment adviser, pass the Uniform Investment Adviser Law Examination, and get a Series 65 license. If you have more than $30 million worth of assets under your control, you'll also need to register as an investment adviser at the federal level.

There's some additional licensure to consider if you're planning to invest in commodities or any other type of futures. Now, you'll be required to sit the Series 3 exam, which is administered by the National Futures Association. You're about to hire a good law firm to prepare your private placement paperwork, so have your legal team check the licensing requirements for your state before you hang your name on the door.

What Should You Do Before You Start a Hedge Fund?

By far, the easiest way to start a hedge fund is to work at a big-name shop that everyone knows, get a track record of delivering great returns, earn a few million dollars in startup capital and then spin out on your own with your boss's blessing – and possibly some of his money invested in your fund. In reality, not everyone has followed this path.

Running a hedge fund is far different than playing the stock market in your spare time. If you haven't already, take some time to educate yourself in how this risky and potentially lucrative field works. The classic hedge fund is called a "long/short," which means buying shares you think will rise and "shorting" those you think will fall. You'll be borrowing shares from a broker and selling them in the open market, in the hope that you can buy them back for a lower price, return them to the broker and pocket a tidy profit along the way.

Other strategies are much more sophisticated. If you're planning to operate a hedge fund based on event-driven investing, emerging markets or arbitrage, you need to know what you're talking about so you can explain your value proposition to investors.

The bottom line is, you need to learn about the industry before you dip your toes in the water. Besides books and internet resources, get hold of everyone you know who operates a hedge fund, has thought about operating a hedge fund or who used to operate a hedge fund. Ask them, how did you do it? What problems did you face? Who are your service providers – your lawyer, accountant, broker? How much did it cost you to get started? What do you know now that you wish you knew then?

How Do You Become a Hedge Fund?

Launching a hedge fund is complicated; you'll need to hire an experienced lawyer at the earliest possible opportunity. The first step is to incorporate in the state you are operating in: options include a limited liability partnership, a limited liability company or a trust. You could do business as a sole proprietor, but it's probably better to shield your personal assets from any liability down the line. Once incorporated, you'll need to register your company with the Investment Advisory Registration Depository. You'll also have to register with the Securities and Exchange Commission if you are planning to have 15 or more investors.

There are several other legal and infrastructure documents your lawyer will put together for you, such as your private placement paperwork, due diligence paperwork and your investor agreements. It's a good idea to have your lawyer vet your pitch deck and website, too, to make sure they are compliant. Websites like hedgeco.net maintain a directory of attorneys and other professionals who provide services to the hedge fund industry.

How Do You Find a Prime Broker?

Once upon a time, all you needed to start a hedge fund was a clever name and a Bloomberg terminal. Now, you'll be facing a lot more competition – finding a prime broker that you can afford, and who supports the investing strategy you intend to run, is key. This will be the investment house or bank that will lend you money, execute trades and perform financial services on your fund's behalf.

Blue-chip names like Goldman Sachs or Bank of America can give you instant credibility, but many prime brokers won't work with funds that have less than $5 million worth of assets under management. Boutique brokers can potentially give you a much more affordable and personalized service and may be more motivated to meet your needs.

The introducing broker model may be beneficial. IBs are brokerage firms that introduce clients to a large brokerage house for a commission or fee. The brand-name house has custody of the fund's assets and handles all the transactions, which goes a long way to comforting investors on such matters as asset protection. Generally, IB provides a route to working with the larger houses that typically would not deal with you directly as a standalone client.

How Do You Find Seed Investors?

Now for the tough part:-landing investors. Unless you are very wealthy and can seed the fund yourself, you're going to have to persuade some early investors to come on board so you can work your magic with their money. You'll want to fish in the deepest waters possible, ideally by tapping up a network of wealthy individuals you know from a previous life as a broker or financial adviser. If you're coming into the business cold, do you know people who can introduce you to high-net-worth individuals? Can your lawyer, accountant or tax adviser connect you to potential investors?

Understand that unless you're well connected, finding investors is going to be a time-consuming, drawn-out process. The hit rate for an unknown fund is typically very low because the tolerance for failure is low, and there's a risk that you'll go belly-up and lose all the investors' money. There's also a chance that your launch may be up against some billion-dollar launches from pedigree managers spinning out from the largest funds. Investors are going to be far more comfortable allocating funds to managers with a track record of returning alpha than to a fund that's relatively unknown.

The good news is, as a startup, you have a lot of leeway to incentivize investors to allocate capital with you. Incentives such as fee breaks or giving up a percentage of the top-line revenue share might be enough to pull investors in. You're going to need a great strategy, a great pitch deck and preferably some winning case studies on the top-tier returns you've delivered to bring these early investors on board. Be prepared to think outside of the box with your marketing strategy.

How Do You Set Your Fees?

Hedge funds have a reputation for being enormously lucrative. Traditionally, the standard fee arrangement is the so-called "2/20" structure, which means the fund manager takes 2 percent of the client's money up front as a management fee, then takes a further 20-percent cut of the profits. The management fee alone makes launching a hedge fund attractive, but if you are successful, the incentive arrangement can make for a phenomenal payday.

The one caveat is that incentive fees are calculated against a "high-water mark." This means that any losses you've experienced must be set off against compensating gains before you're entitled to receive an incentive fee. So, if you lost $20 million in one year and gained $30 million the next, the incentive fee would be computed on the net $10 million gain.

More recently, the economics of the industry have been changing. These days, you may struggle to negotiate a "2/20" deal, especially as a new fund with a limited track record. Investors increasingly are pushing fees and incentives down, such that "1/20" and lower percentage cuts are now fairly typical deals.

How Much Does It Cost To Set Up a Hedge Fund?

In theory, you can "bootstrap" a hedge fund, which in the world of hedge fund investing means having a startup pot in the region of $50,000-to-$150,000. The only mandated expenses are whatever your lawyer and accountant charge you to set up your hedge fund and the cost of getting your licenses. As with any business, it's a good idea to save at least two years' worth of operating capital before you launch your hedge fund. This gives you a financial buffer while you find your groove. From there, it's all about returning to investors what you said you would.

In reality, the barrier to entry is extremely high. The consensus is that you'll need a minimum of $1 million worth of assets under management to keep the lights on – a critical mass of $5 million-to-$20 million AUM is a healthier proposition. You might think you can do it cheaper, but why would an accredited investor bother with a discount shop when there are thousands of other options with better infrastructure?

How Much Money Does a Hedge Fund Manager Make?

The top-earning hedge fund manager of 2017 was Michael Platt of Bluecrest Capital Management. He made $2 billion that year according to Forbes, with three other fund managers making well over the $1 billion mark. Manager number 25 on Forbes' "Highest-Earning Hedge Fund Managers" list pulled in around $200 million in the same year. So clearly, you can make exorbitant amounts of money in this job.

At the more realistic end of the spectrum, SumZero's 2017 Fund Compensation Report puts the average compensation for fund managers somewhere in the region of $350,000 annually, with some variation depending on the manager's experience and size of the hedge fund. Things get a little more complicated when you own the hedge fund as you keep what's left over after all the salaries and expenses are paid. Plus, you may have invested some of your own money into the fund so there'll be profits from those investments as well. There are too many variables to come up with a definitive figure, but the profit potential is there if you're prepared to work for it.

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About the Author

Jayne Thompson earned an LLB in Law and Business Administration from the University of Birmingham and an LLM in International Law from the University of East London. She practiced in various “big law” firms before launching a career as a business writer. Her articles have appeared on numerous business sites including Typefinder, Women in Business, Startwire and Indeed.com. Find her at www.whiterosecopywriting.com.