How to start a hedge fund

With prop traders being forced out of investment banks because of the Volker Rule, starting a hedge fund has become an increasingly popular option. But most hedge funds don’t last long, and getting one off the ground is tricky.

How long does it take to start a hedge fund? It’s a bit more complicated than leaving a your investment banking trading job on Friday and opening a new office on Monday.

Allow for eight or nine months, says Bob Guilbert, managing director for marketing and products at Eze Castle Integration in Boston. The firm has 650 asset management and investment clients around the world and specializes in supporting hedge funds.

Get the infrastructure in place

The process starts with lawyers to create the legal framework for the company and its founders. Early on the founders may decide they need more people because it’s not enough to just have investment ideas — you also need marketing, IT support, fund-raising, compliance, and accounting.

This is costly – and one of the reasons why a lot of hedge funds struggle to survive – but increasingly this can be outsourced.

“Many of the people who are the investment guys need to surround themselves with operational expertise such as accounting, financial, compliance, operations and technology. That’s when they need to consider hiring or outsourcing,” says Guilbert.

Choose technology and decide whether you want it on premise as a capital expense or in the cloud where technology can become an operating expense. Guilbert says most new firms choose to put their operations in a private cloud. A cloud operation that specializes in investment is superior to a general cloud operator like Amazon Web Services or Microsoft Azure because it can offer the specialized features a hedge fund requires, such as market data feeds, FIX connections, and technology geared to order management and portfolio management systems, he said.

Study the vendors and service providers to make sure they have all the features the fund will need both now and in the future. Are the suppliers financially stable, can they provide audited financials? Does an outsourcing provider understand the business, the fund’s key applications and how to support them? Do the applications on the fund’s shopping list interact with each other, or are they on proprietary platforms which will be difficult to integrate?

Get a marketing plan in place

If the fund is going to attract outside investors it will need a marketing plan and it will need to prepare for a long list of questions about its operations. Obviously, employing marketing staff is the expensive way of raising funds, but there are plenty of third-party marketing firms who will pitch to potential investors on your behalf on either retained basis or will get a cut of the fees they raise for you. A list can be found here.

Drumming up interest in your hedge fund can be tricky. Yes, there’s always the potential to raise funds from family and friends – but this assumes your connections have a lot of disposable income – but hedge funds are now relying more and more on institutional investors. Here, you need to prove that you have a track record and often this means having a buy-side background and is difficult to prove if you’re moving from an investment bank. It is possible, however, to have your performance audited by a Big Four accounting firm – this costs around $10k.

Even marketing plans are becoming more complex, however. Seven or eight years ago a fund could get by with a backup plan and a description of its disaster recovery policy. Now investors take that as a given and want to know if a fund has a written security plan and a security officer, the last time they tested for vulnerabilities, do they have intrusion detection for their network and security for their physical offices. The SEC is also pushing firms to improve their cyber security.

Getting the right prime broker(s)

Even startups are going with multiple prime brokers, Guilbert says, and suggests that anyone considering their prime broker needs to “trust and verify”.

Wendy Beer and Andrew Volz of Wells Fargo Prime Services, say it is important for hedge funds to understand the new rules prime brokers operate under. “While Basel III is the primary driver of this change, perhaps the most significant shift in the PB model has been the introduction of the return on assets (ROA) metric on a pre-tax basis as opposed to the pure top line revenue that previously drove the business,” they suggest.

Funds should take the time to understand a prime broker’s key metrics such as the Liquidity Coverage Ratio (LCR), Net stable funding ration (NSFR), Tier 1 capital ratio and High-Quality Liquid Assets (HQLA).

Do your homework, Guilbert recommends. As anyone who has experienced a divorce knows, going into relationships is very easy, but things happen and you need a way to exit your relationships with any service provider.

“Once you are up and running with all your data on the system, you want to make sure you have made your best choice from the start, since the platform is running your business.”