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HFMWEEK
S P E C I A L
R E P O R T
H O W T O S TA R T A
HEDGE FUND IN
THE US 2012
DISTRIBUTED WITH HFMWEEK
FUND SEEDING
Capital-raising challenges for start-ups and fund seeders
COMPLIANCE
Ensuring efficient and cost-effective compliance
SERVICE PROVIDERS
Launching with the right team
FEATURING Concept Capital Markets // Dechert // Equinoxe //
Ernst & Young // The IMS Group // Marcum // Sadis & Goldberg
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H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 2
INTRODUCTION
L
ast year will be long remembered in
hedge fund circles as the one in which
poor performance was widespread and
increasingly stringent regulatory reforms
began to make their presence felt. Market
uncertainty, growing infrastructure costs
and increasingly judicious investors only
added to the pressure.
Towards the end of last year and
through the early months of 2012 there has been a slew of traders
jumping ship to launch their own funds as proprietary trading
desks close in order to comply with the so-called ‘Volcker rule’
element of the US government’s Dodd-Frank Act.
As a result, the US market is awash with fresh, enthusiastic
managers offering a wide range of strategies and headed up by
eager and recently unshackled industry professionals – but the
reality of going it alone is not a challenge to be undertaken
lightly. And from capital raising issues to ever greater due
diligence requirements, the quest to run a viable and successful
new hedge fund has never been more fraught with expectation
and demand.
So what can the newly independent managers do to make
life, and the establishment of a hedge fund, that little bit
more straightforward? By taking in a wide range of industry
professionals, HFMWeek hopes to be able to provide some
answers in this, our latest special report.
Jon Yarker
REPORT EDITOR
HEDGEFUNDMANAGER
HFMWEEK
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H F M W E E K . CO M 3
CONTENTS
H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 2
LEGAL
06
SUCCESSFULLY LAUNCHING A HEDGE FUND
ADMINISTRATION
16
There are numerous paths and options open to start-up managers
when launching a hedge fund. Ron Geffner, of Sadis & Goldberg,
discusses the decisions that need to be made when in pursuit of
hedge fund success
08
As the fund industry grows and continues to undergo a
phenomenal evolution, the path from establishing a fund to
success has never been more complicated. Rod White and Chris
Foy, of Equinoxe, discuss the heightened importance of a fund
having an effective administrator on board
PRIME BROKERAGE
HOW TO LAUNCH A HEDGE FUND
Frank Napolitani, of Concept Capital Markets, highlights the main
issues to consider when launching a hedge fund in the US for 2012
SERVICE PROVIDER
19
FINANCIAL SERVICES
Mike Serota, of Ernst & Young, talks to HFMWeek about the barriers
managers need to be aware of when launching a hedge fund in the
industry’s current climate
CORPORATE GOVERNANCE
With many traders leaving their firms with high hopes of launching
their own successful hedge funds, Dennis Schall of Marcum lists the
essential points to keep in mind before a launch
4 H F M W E E K . CO M
USING TECHNOLOGY TO STREAMLINE YOUR
COMPLIANCE AND OPER ATIONS
One of the biggest challenges for start-up managers is keeping on
top of the ever developing regulation climate. Jordan Schwartz, of
EvenWheel Solutions (which is part of The IMS Group), discusses
the benefits of using technology to assist with this aspect of a
launch
11 CHALLENGING TIMES
14 FOUR THINGS TO CONSIDER BEFORE A
LAUNCH
WHY ADMINISTR ATION? BUILDING A
BUSINESS FOR LONG-TERM SUCCESS
LEGAL
21
SEED CAPITAL ARR ANGEMENTS
With the initial capital barrier for start-up managers becoming
an increasingly challenging hurdle, the option of seed capital is
becoming more popular. Kevin Scanlan, of Dechert, discusses the
details of entering into such an arrangement
ONE COMPLETE MULTI-PRIME
SERVICE PLATFORM
DESIGNED TO LET YOU FOCUS
ON WHAT’S IMPORTANT
Concept Capital Markets, LLC offers a comprehensive suite of brokerage services that provide
global investment managers with solutions that are customizable and scalable. The firm was built by
former investment managers to serve traditional institutional customers, hedge funds and
registered investment advisors with turn-key solutions and a full range of fund services designed
to free investment managers to focus on their core competencies. Our multi-asset trading,
clearing, financing and reporting capabilities combined with our dynamic, relationship driven
culture differentiates us in an ever changing market. The company was established in 2010
following the spin-off of the Concept Capital division of Sanders Morris Harris Inc., whose origins
date back to 1995. Concept Capital Markets, LLC is headquartered in Garden City, NY and operates
branch offices in New York City, NY, Greenwich, CT, Chicago, IL, and Bernardsville, NJ. Concept Capital
Markets, LLC is a member of FINRA and SIPC.
Prime Brokerage | Risk Management | Fund Administration | RIA Service | Family Office Services
Michael S. Rosen
Senior Managing Director
516.746.5723
[email protected]
Frank L. Napolitani
Managing Director
646.747.5228
[email protected]
www.conceptcapital.com
NEW YORK, NY
|
GARDEN CIT Y, NY
|
GREENWICH, CT
|
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H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 2
SUCCESSFULLY L AUNCHING
A HEDGE FUND
THERE ARE NUMEROUS PATHS AND OPTIONS OPEN TO START-UP MANAGERS WHEN LAUNCHING A HEDGE FUND. RON GEFFNER, OF
SADIS & GOLDBERG, DISCUSSES THE DECISIONS THAT NEED TO BE MADE WHEN IN PURSUIT OF HEDGE FUND SUCCESS
T
Ron S. Geffner,
partner, is a member of
Sadis & Goldberg LLP and
oversees the financial
services group. He regularly
structures, organises and
counsels private investment
vehicles, investment advisor
organisations, broker-dealers
and commodity pool
operations, and provides
legal services to hundreds
of various funds.
he hedge fund industry has matured over the
past 10 years. Investors and regulators continue
to evolve, becoming more sophisticated and asking more probing questions than the previous
year. Now more than ever, successfully launching a hedge fund is dependent upon selecting
the proper structure and complying with the ever changing
federal and state regulations governing hedge funds.
Structuring a hedge fund involves both the creation of one
or more entities through which investments will be made (domestic and offshore hedge funds), as well as the management
entities through which the advisory services will be provided
to the hedge funds (the general partner and/or the investment manager). The structure and domicile of the hedge fund
is primarily dependent upon two variables: (i) the nature and
demographic of the prospective investors, and (ii) the investment strategy employed by the investment manager. The
structure and domicile of the investment manager is primarily determined by the citizenship and tax considerations of its
owners, as well as the regulatory regime of the domicile.
STRUC TURING A HEDGE FUND
Investors can be divided into three classes: (i) US taxable
investors, (ii) US tax-exempt investors, and (iii) non-US
persons. In the majority of circumstances, if the investors are
US taxable investors, the fund will be formed as a US limited
partnership or limited liability company. The US fund is often
referred to as a “domestic fund”. Most domestic funds are organised in Delaware.
If the investors are US tax-exempt investors or non-US
persons, the fund generally will be formed in a jurisdiction
outside the US as a corporation (or other analogous entity).
The non-US entity is often referred to as an “offshore fund”.
Most offshore hedge funds organised on behalf of US-based
investment managers are organised in Bermuda, the British
Virgin Islands and the Cayman Islands. US tax-exempt investors typically prefer to invest in an offshore fund set up as a
corporation because if the offshore fund purchases securities
on margin (often referred to as leverage), an offshore fund
which is set up as a corporation blocks the unrelated business
taxable income (UBTI) that would otherwise be taxable to
the US tax-exempt investor.
ECONOMIC ANALYSIS
In determining whether to form both a domestic and an offshore hedge fund, it is imperative to determine the amount of
anticipated assets that will be invested in the hedge funds at,
or shortly after, the launch of the funds. In short, the anticipated aggregate investment at, or shortly after, the launch of
6 H F M W E E K . CO M
the business may not justify the creation of both a domestic
fund and an offshore fund. Additionally, to create both would
impair the investment manager’s ability to survive due to the
organisational expenses and the costs of maintaining both domestic and offshore hedge funds. With early stage managers,
cash burn is often overlooked and can be critical to the survival of the newly formed asset management firm. The manager
must have an opportunity to establish a proven track record.
THREE COMMON STRUC TURES
Managers seeking to launch both domestic and offshore funds
have several options available in structuring. The three most
common structures are side-by-side, master-feeder and minimaster. In a side-by-side structure, the domestic fund and
the offshore fund make direct investments pursuant to the
investment strategy and trade tickets are allocated between
the domestic fund and the offshore fund. In a master-feeder
structure, a third entity is created (the ‘master fund’) and the
domestic fund and the offshore fund, rather than making direct investments, invest all of their assets into the master fund
and in turn, the master fund makes the investments on behalf
of the domestic fund and the offshore fund (often referred to
as the domestic feeder and offshore feeder).
The mini-master structure generally is comprised of two
entities; an offshore feeder and a master entity. While the
offshore feeder is taxed as a corporation to benefit US tax
exempt investors and block UBTI, the master entity may be
structured for tax purposes as a partnership. Rather than the
US-based manager receiving its incentive as a fee from the
offshore fund and being subject to ordinary income tax, the
US-based manager may receive the incentive as an allocation
from the master entity, in an attempt to benefit from capital
gains tax treatment.
There are many legal and commercial drivers in determining the ideal structure. For example, if the strategy calls for
significant investment in illiquid or thinly traded positions
which are difficult to allocate among two brokerage accounts,
a master-feeder structure may be preferred as the investments
will be allocated on a pro rata basis at the master fund yet only
require the investment manager to purchase and sell the positions through one brokerage account.
Also, in many transactions involving early stage or ‘seed’
investment, if the seeder is located offshore, it may prefer a
master-feeder structure so that all fees and allocations may be
taken at the master fund and thus avoid the US tax regime.
Conversely, employing a tax-efficient strategy for US taxable investors may be of little benefit or detrimental to US taxexempt investors and non-US persons. Thus, a side-by-side
structure allows the investment manager the ability to employ
LEGAL
tax efficiency with the domestic fund, while maximising the
entry and exit points of securities positions without regard to
long-term tax gains for the offshore fund.
INVESTMENT MANAGERS
The structure and domicile of the investment manager is primarily determined by the citizenship and tax considerations
of its principals. Empirical evidence suggests that the super
majority of hedge funds are managed by US-domiciled entities structured as either limited liability companies or limited
partnerships, which are taxed as flow-through vehicles (rather
than as corporations).
In circumstances involving non-US persons, if the non-US
persons own the majority of equity in or receive the majority of the economics from the investment manager and their
interests are controlling, the investment manager may be organised in an offshore jurisdiction to accommodate the tax
needs of the non-US persons.
Federal and state regulation often impacts the location at
which the investment manager will maintain its office in the
US. Certain states, such as Colorado and Texas, to a certain
degree, have compulsory registration requirements that require an investment manager with an office in their state to
register as an investment adviser, either with the state government or the US Securities & Exchange Commission (SEC),
prior to the launch of the hedge fund. Many managers choose
to maintain offices in neighbouring states which do not have
compulsory registration requirements so as to avoid having to
register as an investment advisor.
A FIRM WITH
STRUCTURAL ISSUES IS
LESS LIKELY TO ATTRACT
INVESTMENT AND MORE
LIKELY TO BE PLAGUED
WITH INVESTOR
LITIGATION, REGULATORY
PROSECUTION,
LIMITATION ON CAPITAL
RESOURCES AND
REPUTATIONAL DAMAGE
”
RESPONDING TO INVESTOR DUE DILIGENCE
Due diligence is a critical part of the hedge fund investment
process. A successful launch also depends upon providing
prospective investors with comfort regarding non-investment
considerations, such as the manager’s operations, compliance
and risk management.
Having a standard due diligence questionnaire (DDQ)
is recommended. It is critical that managers be consistent in
all of their disclosures to investors. Consistency across documents is vital to the maintenance of a manager’s credibility in
the due diligence process. The same level of care and consideration should be invested in marketing material, DDQs and
requests for proposals. Each of these documents should respond to each item in the same manner. A different sentence
or even a single word can change the message or meaning and
result in a different understanding to the investor.
CONCLUSION
While cash burn is critical to a new manager, the quality of
the firm’s infrastructure cannot be sacrificed. Having spent
approximately two decades practising law in this industry,
both as an enforcement attorney with the SEC and in private practice, I have witnessed many successes and failures.
It is important to use service providers who have corporate,
tax and regulatory experience in connection with structuring
hedge funds. Failure to properly structure your firm will have
material opportunity costs. A firm with structural issues is
less likely to attract investment and more likely to be plagued
with investor litigation, regulatory prosecution, limitation on
capital resources and reputational damage. The costs associated with fixing a problem far exceed the costs of doing the
job correctly at the outset. Q
H F M W E E K . CO M 7
H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 2
HOW TO LAUNCH A HEDGE FUND
FRANK NAPOLITANI, OF CONCEPT CAPITAL MARKETS, HIGHLIGHTS THE MAIN ISSUES TO CONSIDER WHEN LAUNCHING A HEDGE FUND IN
THE US FOR 2012
Frank L Napolitani
is managing director, prime
services group, Concept
Capital Markets.
T
he past three months have seen a flurry
of activity of portfolio managers at larger
hedge fund complexes inquiring about
the next steps to launching a hedge fund
during the first half of 2012. A number of
factors are driving the increased activity:
poor performance in 2011 at larger hedge funds, increased interest from global investors to invest with
emerging managers and access to early stage/seed
capital. The 2012 launches are shaping up to be the
most promising that we’ve seen in quite a while.
We touch on several new launch topics below and
hopefully provide some insight on what managers
need to consider as they prepare to launch a fund in
2012.
DEVELOP A BUSINESS PLAN
It is imperative to develop a business plan describing
why your team has the ability to start and grow a successful alternative asset management firm. With the
continued institutionalisation of the industry, simply
taking a ‘cottage industry’ approach won’t cut it in the
current environment if your goal is to attract institutional capital and grow a scalable business.
8 H F M W E E K . CO M
As a start-up business, managers should look to get
as much ‘bang for their buck’ and look to align with
service providers that can work with you at launch at
a smaller asset base and be able to grow as your business grows. Knowing who those service providers are
and forging a partnership are often key for a fund manager’s success as he or she attempts to launch.
PICKING THE PRIMARY FUND SERVICE PROVIDERS
Like any important business decision, you’ll want
to work with service providers that understand your
business plan and investment strategy, and a group
that you feel comfortable working with. Before picking any service provider, you’ll want to make sure the
firm has name brand recognition within the hedge
fund community and confirm their expertise in dealing with hedge funds and the specific asset class and
structure you intend to manage. The key service providers you’ll need to engage with are legal, audit/tax,
fund administration and prime brokerage.
KEY COMPONENTS OF RUNNING YOUR FUND
Multi-custodial platform
A key advantage of using a boutique prime broker-
PRIME BROKER AGE
age service provider like Concept Capital Markets is
the multi-custodial platform we provide to clients. We
work with several of the most reputable global custodian banks, which provides our clients the ability to
multi-prime across various custodians while having to
deal with a single support team at Concept.
Global trading capabilities
Concept Capital Markets serves its clients with
a “high touch”, multi-asset class and complete outsourced trading solution. We serve as a “one stop
shop” for execution of equities, ETFs, options, futures, fixed income and forex. In addition to trade
execution, we support our clients with experienced
traders to provide continuity, while acting as your
“partner” who is focused on your needs.
can be disregarded for the purposes of the Form.
Smaller hedge fund advisers that are required to file
Form PF will be required to file on an annual basis.
Large hedge fund advisers will be required to provide
additional data and to file quarterly.
A private fund is considered a large hedge fund adviser for a fiscal quarter if they had at least $1.5bn in
regulatory assets under management calculated in accordance with Form ADV and attributable to hedge
funds as of the last day of any month in the quarter.
In determining whether you are a large hedge fund
adviser, you are required to include hedge fund assets
under management of any related person, as related
person is defined for the purposes of Form ADV, unless that related person is separately operated.
RiskONE manages every step of the reporting system from:
• Obtaining, reconciling, mapping and storing of
key information
• Creation and review of customised metrics
• Review and interpretation of risk-based information
• Integrating the system effectively into investment management efforts
• Sharing appropriate information with outside parties
Risk management & advisory*
The RiskONE risk analytics team provides outsourced risk analytics and management services to more than 70 hedge funds, which oversee
more than $70bn AuM across all strategies.
The risk analytics team provides the following
customised analytics to its clients:
• Exposure reporting
• Stress testing/scenario analysis VaR
• Risk budget/volatility sizing
• Limit exception monitoring
• P&L time series and attribution analysis
• Capital allocation simulations
• Investment strategy allocation
WE SERVE AS A “ONE
STOP SHOP” FOR
EXECUTION OF EQUITIES,
ETFS, OPTIONS, FUTURES,
FIXED INCOME AND FOREX
Middle/back office support
In addition to the multi-prime/multi-custodian capabilities we provide to fund managers,
ConceptONE can also serve as a fund’s outsourced
middle and back office and facilitate aggregated portfolio reporting. This service provides fund managers
with significant cost savings and the ability to allocate
all of its resources to the investment process. Through
the use of leading technology providers including
SAS, Advent Geneva and Paladyne Systems, we provide our clients with multi-custodial, multi-asset class,
multi-currency reporting through one aggregated set
of reports. We currently work with approximately 15
custodians and provide an aggregated reporting package to our clients each morning.
Regulatory requirements – Form PF
In addition to the requirements of having to file as
an investment adviser, the Dodd–Frank Wall Street
Reform and Consumer Protection Act are requiring
the alternative investment community to implement a
new way of reporting to the regulatory bodies.
On 31 October 2011, the Securities and Exchange
Commission (SEC) and the Commodities Futures
Trading Commission (CFTC) adopted a new rule
requiring investment advisers to periodically file the
new Form PF if they are registered or required to register with the SEC, or have at least $150m in private
fund assets under management. If the adviser has principal offices outside the US, then funds that are not
US persons and are not offered or owned in the US
”
Infrastructure support and start-up services
Having assisted a large number of investment
teams in launching funds since the mid-1990s,
our relationship managers in the prime services
group at Concept Capital Markets often act as
business consultants to our clients during the
prelaunch stage by helping them budget their
prelaunch and first year expenses, choosing service
providers (e.g. legal, audit, fund administration, outsourced compliance services, etc), general infrastructure items (e.g. office space, IT, etc), and developing
marketing materials to present to prospective investors. After launch, we continue to work very closely
with our clients as they tackle the ongoing issues of
running a business, not just running a portfolio.
IT managed services
Concept provides a significant number of our hedge
fund clients with outsourced IT services, including:
• Managing and hosting domain services including file sharing, email communications, network
communications, server maintenance, network
maintenance, and firewall protection
• Providing VolP phone service and high-speed
internet connectivity
• Assistance in drafting and implementing an IT
business continuity and disaster recovery plan
integration of various trading systems based on
manager preference. Q
Disclaimer: Concept Capital Markets is a registered broker
dealer and registered investment advisor with the SEC, a member of the Financial Industry Regulatory Authority (FINRA),
and a member of the National Futures Association (NFA).
H F M W E E K . CO M 9
WE PRACTICE LAW
BUT WE LIVE BUSINESS
Sadis & Goldberg represents over 500 hedge and private equity funds.
Above all else, we value our client relationships. Our attorneys strive to provide excellent,
consistent, practical and efficient legal services. We distinguish ourselves from other law
firms by assisting our clients in the development of their businesses. This comprehensive
approach has often earned us recognition as one of the top five law firms in the U.S.
for our hedge fund practice. Invest a few minutes to learn what our attorneys can do
for your business.
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H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 2
FINANCIAL SERVICES
CHALLENGING TIMES
MIKE SEROTA, OF ERNST & YOUNG, TALKS TO HFMWEEK ABOUT THE BARRIERS MANAGERS NEED TO BE AWARE OF WHEN LAUNCHING A
HEDGE FUND IN THE INDUSTRY’S CURRENT CLIMATE
I
t could be argued that launching a fund has never
been more difficult. Before a manager can even
get around to running a portfolio and conducting
investments, there are the considerable barriers of
start-up capital, infrastructure establishment and
regulatory compliance to attend to. HFMWeek
talked to Mike Serota, of Ernst & Young, about the current challenges start-up managers are having to deal with
and the potential issues they should be aware of.
Mike Serota is the
co-leader of the global
hedge fund practice at
Ernst & Young. With nearly
30 years’ experience, he
has worked worldwide as
a trusted business advisor
to the financial services
industry serving hedge
funds, funds of funds,
private equity funds, prime
brokers and mutual funds.
HFMWeek (HFM): What are the biggest challenges
that start-up managers need to overcome?
Mike Serota (MS): There are three challenges. First,
capital raising. Raising capital is more difficult than it
was a number of years ago. The typical fund that we see
now launches with $25m to $50m, and if they’re lucky
they launch with $100m to $150m. Four or five years
ago, before the financial crisis, it wasn’t uncommon for
a fund to launch in excess of $500m. Second, the hiring
of a qualified CFO. A CFO is critical for the success of
any start-up organisation. Without a qualified CFO with
relevant industry experience, institutional investors may
not invest in the fund and it will be very difficult for the
fund to raise capital. Third, there is a lot of seed investing
happening in the market right now, with many qualified
funds trying to get money through seed investors. The
issue here is negotiating with seed investors and understanding how the money will be invested and what the
structure of the fund will look like. In many cases seed investors have the upper hand in the relationship between
the two parties, as well as the negotiations regarding the
structure of the fund.
HFM: What time to market would start-ups generally
be looking at in the current US hedge fund industry?
Does this vary with different fund structures?
MS: It is certainly going to vary. The more complex fund
structures and strategies will take longer; a minimum
of three months but it can take as long as six months.
A fund that invests globally operates in multiple jurisdictions and trades throughout the world via a global
platform, may have a component of its AuM invested in
private equity-like structures. The underlying structure
for such a fund is more difficult to create, the regulatory
and cross-jurisdictional issues may be more complex and
tax issues will certainly be much more difficult to deal
with. A structure like that could easily take six months
to get launched. A very basic fund, such as a long/short
equity fund, could take three months to go to market
because the offering documents and management company agreements need to be created. Sometimes a fund
manager will only focus on the fund and not on
the management company which is a
mistake. The fund manager
H F M W E E K . C O M 11
FINANCIAL SERVICES
H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 2
needs to focus on the management company structure
and make sure that all aspects have been fully-vetted (i.e.
corporate governance, buy-out provisions etc).
HFM: In today’s heavily-regulated environment, what
tax and multi/jurisdictional issues should fund managers be aware of?
MS: Countries all around the globe are raising their taxes.
While there are certain jurisdictions that are trying to encourage external investments into their capital markets
(such as Hong Kong) there are other jurisdictions that will
heavily tax cross-border transactions and trades. It can limit the
ability of a fund to invest in those
markets. So one aspect a fund manager should be concerned about, no
matter where the fund is resident,
is the need to consider what the
ramifications of cross-border trading are, what the tax implications
are and how to work with the type
of product that they are trading. It
is a very critical issue that needs to
be monitored closely. I think some
funds tend to underestimate the
importance of the tax function. That
is a significant risk management issue and it has to change if the fund
is going to be successful in the longterm. Tax is developing to become
so complex and pivotal that time
needs to be taken with it.
Also, many funds have not begun to process their succession planning, which is a critical
point. They need to think about what the next generation
of leadership is going to look like inside the fund. In fact, in
a recent survey that Ernst & Young conducted (EY’s 2011
Global Hedge Fund Survey – Coming of Age), we found that
two-thirds of investors said a well-articulated succession
plan is important to their investment decisions.
Another item is transfer pricing. Some of the largest
funds have significant global operations and they have to
look at the transfer pricing policies as part of it. As governments look to generate revenue, transfer pricing will
indeed become a bigger issue for funds.
HFM: Is capital introduction proving an important
factor for start-ups in light of current capital raising
difficulties?
MS: Capital introduction is not as important a factor as
it was a few years ago, simply because of the use of seed
investors. It certainly is a critical and valuable function for
those funds that aren’t getting seed
capital or using it in conjunction
with seed capital.
FOR A FUND TO SURVIVE,
GIVEN THE COSTS OF
THEIR INFRASTRUCTURE,
CORPORATE GOVERNANCE
AND REGULATORY
COMPLIANCE, ITS AUM
NEEDS TO BE SOMEWHERE
NORTH OF $200M
HFM: What can you see the
next 12 months holding for new
funds in the US and how they are
brought to market?
MS: There are going to be a number
of issues. First, heightened regulation will mean that funds are going
to need to adapt to survive. The typical view is that for a fund to survive,
given the costs of their infrastructure, corporate governance and regulatory compliance, its AuM needs
to be somewhere north of $200m. If
the fund is under $200m, it can be
difficult to survive in the long-term,
as there may not be enough money
to justify the structure and all of its
associated costs. Second, CFOs will
become strategically imperative. It is going to become considerably difficult to launch without a qualified CFO. This
will be a difficult point for funds to contend with. It calls
into question how many sufficiently experienced and capable CFOs are available in the market. I think investors will
place a fund under greater scrutiny as they exercise more
due diligence. Such facts will affect how institutional investors make choices concerning their investment. Q
”
1 2 H F M W E E K . CO M
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H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 2
FOUR THINGS TO CONSIDER
BEFORE A L AUNCH
WITH MANY TRADERS LEAVING THEIR FIRMS WITH HIGH HOPES OF LAUNCHING THEIR OWN SUCCESSFUL HEDGE FUNDS,
DENNIS SCHALL OF MARCUM LISTS THE ESSENTIAL POINTS TO KEEP IN MIND BEFORE A LAUNCH
S
Dennis J. Schall
is a partner in Marcum’s
national alternative
investment industry group.
With more than 20 years’
experience, Mr Schall
provides leadership to the
group’s New York operations
and assists with practice
development, strategic
planning and the setting of
policies and procedures.
o the story goes: you have been working for
a big Wall Street firm for years and you’re
tired of making millions of dollars for other
people and want to make it for yourself.
Your co-worker sitting next to you feels the
same. One night, over some cocktails at the
local watering hole, the two of you decide ‘hey, enough is
enough; let’s start our own hedge fund’. The next day, you
both quit your jobs and call your former college roommate who is now a real estate attorney and ask him to
write your fund documents. He goes to the internet and
downloads fund documents. You and your partner bring
subscription documents to your friends and family and
raise $10m. You deposit the money and start trading on
your E-Trade account. In less than one year, you lost half
the money, your friends and family want the rest back,
and you are now unemployed.
This unfortunate story is too often the reality for the less diligent
emerging managers. So if you are
considering launching your own
hedge fund here are four things
you should consider before making that first trade.
time to execute his trading strategy and meet his investment objectives.
Revenues, expenses and profits/losses are now the responsibility of the emerging manager. Every business has
to deal with these issues and your business is no different.
The emerging manager has to establish budgets and forecasts in order to be able to properly develop a strategic
plan for the business.
Revenues for the emerging manager are typically generated in two ways (i) a management fee (typically 2% of
Assets Under Management – AuM) paid to the management company and (ii) a performance allocation (typically 20% of the fund’s profits) allocated to the general
partner of the business.
The emerging manager needs to understand what the
fixed costs and the variable costs of the business will be
for the week, month and year.
Fixed costs are the costs that remain constant regardless of the
amount of revenue generated by
the operation of the business. An
example of a fixed cost is office
rent. Variable costs are costs that
fluctuate depending on the activity of the business. An example of
a variable cost is broker fees.
In the ideal situation, the management fees will cover all the
costs associated with the day-today operations of the business.
If not, then the emerging manager will have to cover these costs
personally. The emerging manager should not rely on the performance allocation, because of the
inherent uncertainty of profitability. Investors know that
past performance cannot be relied upon to predict future
results and the emerging manager would be foolish to
adopt a different view.
MANY EMERGING
MANAGERS FAIL BECAUSE
THEY DON’T UNDERSTAND
THAT A HEDGE FUND IS A
BUSINESS AND NOT JUST A
TRADING STRATEGY
1. You are running a business,
not a trading desk
From this point forward your
hedge fund is the ‘business’. Many
emerging managers fail because
they don’t understand that a
hedge fund is a business and not
just a trading strategy. While the
trading strategy is very important
and it is the engine that will generate profits for the business, there is a lot more to running
a business.
As an emerging manager, you will be forced to deal
with issues that in the past were taken care of by someone
else. You will be making decisions regarding office space
rental, the purchase or lease of computer equipment, the
acquisition of a phone system and subscription to a variety of research services. You will also have to develop an
internal service team. Thus, you will become a recruiter
and a human resources manager charged with hiring
the best employees, determining their salaries, selecting
their benefits package and processing their questions and
complaints. These decisions can become distractions for
the emerging manager who still must find the necessary
”
14 H F M W E E K . CO M
2. Your service providers are your allies
Selecting the proper service providers is crucial to the
long-term success of your business. They are a reflection on you and your business and with proper selection,
your credibility can increase. Emerging managers should
select service providers based upon (i) their expertise in
hedge funds, (ii) their reputation in the industry, and
(iii) their ability to grow with the business.
When selecting service providers, it is necessary to
FINANCIAL SERVICES
perform the same due diligence you perform when selecting your medical doctors. Service providers come
in all shapes and sizes so you need to pick the right fit
for you. There is a wide range of costs between service
providers. The low bid is not always the best bid when
it comes to choosing service providers. As we are all often reminded in life: you get what you pay for. The most
common service providers are:
i. Prime broker – services include the execution of
trades, the extension of credit, operational support, custody of investments, and provision of reports and accounting for trades executed by other
brokers.
ii. Attorney – services include drafting fund documents; the formation of the fund, the general partner and the management company; and the registration of the investment adviser under federal or
state law.
iii. Auditor – services include the audit of the fund’s
financial statements and generally the preparation
of applicable tax returns.
iv. Fund administrator – services include the preparation of books and records, the receipt and
disbursement of funds, including the receipt of
subscriptions from investors and the payment of
withdrawals to investors.
Other service providers to consider include:
i. Regulatory consultant – even unregistered investment advisers should have an operations and
compliance manual and all registered investment
advisers must have an operations and compliance manual. A regulatory consultant can provide
invaluable assistance to the emerging manager
when developing an operations and compliance
manual.
ii. Independent valuation consultant – depending
on the fund’s investment strategy, it may be appropriate to hire an independent consultant to value
all or part of the emerging manager’s portfolio.
iii. Information technology consultant – services
include the design and implementation of the
fund’s information technology platform.
iv. Professional employer organisation (PEO) –
an outsourced employee management firm that
handles employee benefits, payroll and other human resource functions.
3. Infrastructure and compliance – it is not just
about performance
Raising capital has become very difficult in recent
years for emerging managers. To give your fund a better chance in raising capital, the business infrastructure
should be in place.
i. Have all your service providers selected prior to
the launch of your business.
ii. Provide best practices in writing!
iii. Complete the operations and compliance manual
in advance of the launch.
iv. Have the proper information technology infrastructure in place.
4. They are not limited partners – they are your
customers
Your investors are customers. They can do business with
you or they can leave your fund and invest with someone
else. Treat your investors the same way you would like
to be treated when you are someone’s customer. For too
long, emerging managers have relied solely on performance. Performance is an important ingredient to keeping your customers happy. However, in today’s business
environment there are some things that are just as important to your customers. Communication and transparency is critical to be successful in today’s business
environment. Customers don’t like surprises. Monthly
and annual reporting must be timely. When reporting
is delayed beyond reasonable expectations, customers
get nervous and nervous customers make withdrawal
requests.
If you are considering launching your own hedge
fund, remember it is a business and the infrastructure
needs to be in place before you open. In preparation for
that fateful day you dreamed about (when you decided
‘hey, enough is enough’) you should (i) know in advance
how much capital you will need to operate your business
for at least two years, (ii) select of all your service providers before you speak with prospective investors, (iii) be
prepared to answer all an investor’s reasonable due diligence questions, and (iv) remember that your limited
partners are really your customers.
If you diligently prepare in advance and you have a
trading strategy that works, your story will be one of success. Competition among emerging managers is tough
enough. Don’t get in your own way by being unprepared
and remember that you get what you pay for. Q
H F M W E E K . C O M 15
H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 2
WHY ADMINISTRATION?
BUILDING A BUSINESS FOR
LONG-TERM SUCCESS
AS THE FUND INDUSTRY GROWS AND CONTINUES TO UNDERGO A PHENOMENAL EVOLUTION, THE PATH FROM ESTABLISHING A FUND TO
SUCCESS HAS NEVER BEEN MORE COMPLICATED. ROD WHITE AND CHRIS FOY, OF EQUINOXE, DISCUSS THE HEIGHTENED IMPORTANCE OF A
FUND HAVING AN EFFECTIVE ADMINISTRATOR ON BOARD
N
Rod White
is a director of Equinoxe US
and is regional CEO.
Chris Foy
is a director of Equinoxe
US and head of global
operations.
o longer can a trader walk out and attract
capital without building a proper infrastructure surrounding their business to
support their talent at making money. Investors today have seen or experienced
losses associated with a weak operational
control environment, poor corporate structure or lack of
information and are determined to not be exposed to this
risk in their portfolios.
What implications does this have on the factors involved in setting up a hedge fund or restructuring an existing hedge fund to raise capital in today’s environment?
Investors and due diligence
firms have become much more
sophisticated and today demand
that a hedge fund is supported by
a proper business structure with
many different skill sets (compliance, legal, financial, etc) to
be successful in the ever changing environment. This change in
structure raises the barrier of entry for managers looking to enter
the market. However, with every
barrier, an opportunity is created in that the decrease of participants shifts to a higher quality
market over the current market of
quantity.
The manager has to build a
business and surround themselves
with a strong support network that
can aid them in the lifecycle of
the fund. Navigation through the different challenges of
sophisticated capital/regulatory requirements and guidance in best corporate practices requires a partnership approach with the service providers and the ability to draw
from their experiences and knowledge base.
One area of support available to the manager that is
too often seen as a ‘necessary evil’, sometimes chosen
without much consideration given to the impact it may
have on the manager’s operations or marketing efforts,
or even its culture fit, is the third-party administrator of
the fund.
While these factors are at times overlooked, there are
plenty of managers that get it right. Why is third-party administration important to the business model of a hedge
fund and what are some of the key criteria and best practices to be considered when selecting an administrator?
KEY CRITERIA
1. Independence – free from any conflicts with the
manager (i.e. other revenue streams associated with
the relationship outside of administration)
2.
Audited control environment – SAS70/SOC 1 designation
3.
Utilisation of “best of
breed” technology platforms
4.
Proven record of topquality client management
5.
Easy access to its management team in addition to its main
contacts
6.
Low staff turnover and
high morale in an administrators
staffing
7.
Experienced
management team
8.
Ability to support a wide
range of domiciles, structures, strategies and asset classes even outside
of current mandate to support future potential growth
9. Flexibility in the administrators structure to adopt to
the ever changing market environment
INVESTORS AND DUE
DILIGENCE FIRMS HAVE
BECOME MUCH MORE
SOPHISTICATED AND TODAY
DEMAND THAT A HEDGE
FUND IS SUPPORTED
BY A PROPER BUSINESS
STRUCTURE
”
16 H F M W E E K . CO M
BEST PRACTICES
1. Fully independent third-party provision of its services – no NAV Light or Balance Sheet Verification
services
2. Independent reconciliations to external parties
A D M I N I S T R AT I O N
3. Trade file received directly from the manager
in order to complete a three way reconciliation
4. A pricing policy (providing more detail than
what is normally outlined in a formation
document) developed prior to engagement
highlighting the pricing sources by instrument, the escalation procedures and disclosure requirements. The policy is then agreed
with the manager and the auditor
5. Control over – or participation in – the maintenance of the fund cash accounts and the authorisation of their movements
6. Multiple layers of review (four- or six-eye
principle) and a culture of zero tolerance for
errors
7. Monthly post-month end calls with its clients
engaging an administrator providing a sub-standard
service in place of proper third-party independent
administration.
Ultimately, one question a manager should ask
themselves is: Would I invest in my structure if I
knew my service providers don’t necessarily add
value to my structure? This is the first question
investors and due diligence firms ask themselves
prior to even looking at track record or investment strategies. Sophisticated capital dictates
that the results of due diligence visits and questionnaires are now the leading indicator of whether they should invest, and operational failures uncovered during these examinations are now cited
as the largest single reason for not allocating to a
manager. More often than not, in looking at administration services, the managers rely upon the cost of
service as the final decision factor without looking at the
value proposition. In actuality, the “burdensome” cost
of a quality third-party administrator may ultimately
lead to savings due to the part it plays in risk reduction.
While representing the fund when dealing with its investors, the administrator also plays a large part in the due
diligence operational risk review
of a fund. Overall, the additional
couple of basis points in cost
could be the difference between
attracting capital and failing an
operational review and not winning the allocation.
The true value of an independent administrator is largely unrecognised. However, stakeholders who examine the process and
understand the importance of a
quality service provider can influence the decision and benefit
from its increased transparency
in the market. An administrator
should always be transparent and
welcome due diligence queries
from any stakeholders and investors. If your administrator does
not welcome such due diligence,
perhaps it may be an opportunity
to consider what the market has
to offer. Q
THIRD-PARTY OVERSIGHT
HAS BECOME A PREREQUISITE FOR ANY FUND
LOOKING TO RETAIN
ITS INVESTOR BASE OR
ATTRACT NEW ONES
Since 2009, with large sophisticated investors demanding
a change, third-party oversight has become a pre-requisite
for any fund looking to retain its investor base or attract new
ones. While this has been embraced by the industry, many
start-ups tend to satisfy this ‘necessary evil’ requirement by
”
ABOUT EQUINOXE ALTERNATIVE
INVESTMENT (SERVICES) LIMITED
Equinoxe Alternative Investment (Services) Limited is a premium
boutique service provider founded in 2007 by experienced
hedge fund administration professionals. It is headquartered in
Bermuda, with offices in Dublin and Mauritius, with Singapore
scheduled to open in the near future. Equinoxe is a full-service
alternative investment fund administration company committed
to delivering a value added service in the same time zone as the
manager or primary investor base.
H F M W E E K . C O M 17
Alternative Investment Group
Straight to the Solution
Professional services exclusively for Hedge Funds and Investment Partnerships
Certified Audits, Reviews & Compilations
Investment Fund Formation & Structuring
Tax Compliance & Planning
Verification of Performance Results
Financial Statement Preparation
& Support
Internal Control Reviews
& SSAE 16 Reports
Portfolio & Business Valuation
Management Company Services
Strategic Business Consultation
Forensic Accounting &
Litigation Support
Estate and Financial Planning
Discover the
Difference
marcumllp.com
International Member of Leading Edge Alliance
SERVICE PROVIDER
H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 2
USING TECHNOLOGY TO
STREAMLINE YOUR COMPLIANCE
AND OPERATIONS
ONE OF THE BIGGEST CHALLENGES FOR START-UP MANAGERS IS KEEPING ON TOP OF THE EVER DEVELOPING REGULATION CLIMATE.
JORDAN SCHWARTZ, OF EVENWHEEL SOLUTIONS (WHICH IS PART OF THE IMS GROUP), DISCUSSES THE BENEFITS OF
USING TECHNOLOGY TO ASSIST WITH THIS ASPECT OF A LAUNCH
A
Jordan Schwartz
is a partner and managing
director at EvenWheel
Solutions, the software arm
of HedgeOp Compliance,
LLC. Both HedgeOp and
EvenWheel are part of The
IMS Group. Jordan is in
charge of the development,
growth and marketing
of EvenWheel’s software
products.
fter completing the initial steps of launching a hedge fund (e.g. forming the entities,
drafting the PPMs, registering with the
SEC and working with service providers),
the focus tends to turn more towards operations. From a compliance perspective, the
fundamental core of your compliance programme must be
your firm’s compliance manual and code of ethics. These
documents must describe in detail your firm’s policies,
procedures and employee responsibilities. This includes
items such as trading and brokerage practices, custody procedures,
valuation methods, marketing activities, ADV updates and personal
trading policies.
Whether your compliance manual is drafted internally, by legal
counsel or external consultants,
the important thing to remember
is that you must abide by what is
written, so it is vital to ensure that
the documents are tailored to your
actual practices. A successful compliance programme is about disclosure, organisation and preparedness. One of the cornerstones
is making sure that you are doing
what your policies say you’re doing
and technology can help ease the
burden in many of these areas, helping to ensure that your
compliance programme is running on track.
sis, which will help guarantee that everything in your compliance manual is being handled. For a more sophisticated
approach, an electronic compliance calendar (such as
EvenWheel’s ComplianceTrak) will automatically remind
you about tasks, let you track your activities and generate
detailed “audit-ready” reports. ComplianceTrak even provides you with a regulatory background, giving additional
guidance that you may need to complete the task.
CODE OF ETHICS – SUPERVISE YOUR EMPLOYEES WITH EASE
Monitoring code of ethics compliance (which governs your
employees’ responsibilities and
addresses conflicts of interest
and policies regarding personal
trading activities), is often one
of the most burdensome aspects
of a manager’s compliance programme. However, it needn’t be
so painful as technology solutions
can be used to monitor employee
trading, handle employee attestations, trade pre-approval and lots
more. By handling code of ethics
compliance electronically, you
free up a lot of time by automating
the processes and review, giving
yourself a major advantage when
it comes to responding to document requests from regulators.
When evaluating code of ethics software vendors, below
are some of the important things to think about:
• A cloud-based solution vs locally hosted – Cloudbased solutions (or “software as a service”) are becoming more and more prevalent in the investment
advisory space. Benefits of using cloud-based software include not having to worry about IT issues like
disaster recovery and the ability to take advantage of
economies of scale when it comes to hosting and
hardware costs. You should conduct proper due diligence to make sure the provider has the proper security and business continuity procedures in place.
• Number of broker links – One of the main benefits of using software to run your code of ethics is
that you eliminate the need to look through piles of
USING SOFTWARE
CAN HELP YOU TRACK,
MONITOR AND ARCHIVE
YOUR COMPLIANCE
ACTIVITIES, THEREBY
KEEPING TABS ON YOUR
VARIOUS TASKS
”
THE COMPLIANCE MANUAL – HOW DO WE KEEP TRACK OF
EVERYTHING?
A well written compliance manual is not just theoretical,
but is also practical in nature. It should be drafted so that
it is easy to transform what is written into practical, onthe-ground procedures. Using software can help you track,
monitor and archive your compliance activities, thereby
keeping tabs on your various tasks and ensuring that you
can swiftly and efficiently produce forensic reports of all
your actions.
At the most basic level, you can use Microsoft Excel to
create a line-by-line compliance calendar outlining your
tasks on a daily, weekly, monthly, quarterly and annual ba-
H F M W E E K . C O M 19
H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 2
SERVICE PROVIDER
beneficial. You should review the list of record keeping
requirements at the SEC site and then develop an internal
record keeping system that works for you, keeping in mind
the main tenets of redundancy and ease of access.
TRAINING – AN INFORMED STAFF MAKES YOUR LIFE EASIER
Training your staff about the parameters of your compliance programme makes it easier for you to ensure that
your compliance regime is running properly. All employees must get involved and ask questions and firms should
identify and address any changes that have been made
since the last training process. E-learning tools can be
used to distribute training programmes to staff, as well as
to handle periodic testing of employees.
MARKETING ACTIVITIES – GET RID OF THOSE SPREADSHEETS!
If you plan on actively marketing your funds or you have a
large investor base, keeping track of marketing and investor communications can be a huge hassle. Using spreadsheets to track this information has diminishing returns
and after a point becomes less and less useful. Using Customer Relationship Management software (CRM) is the
easiest and most efficient method of tracking marketing
and investor communications. CRM platforms usually integrate with Outlook and allow you to track each ‘touch’
that you have with prospects and investors. If you are
marketing private funds, then CRMs can also be used as a
method to demonstrate your “pre-existing substantive relationship” with a contact before they become an investor.
paper brokerage statements. You should put together a list of all of the brokers your employees utilise
and check to see if the software provider has electronic links to the majority of these institutions.
• How customisable is the solution? Code of ethics
software should be able to handle all your employee
compliance tasks. This includes affirmations, gift and
political contribution notices, disciplinary questionnaires, etc. Remember, though, one size does not fit
all! Just like a proper compliance manual, the software should be able to be customised for your needs
and your specific policies and procedures.
• Output – One of the great advantages of code of
ethics software is that you can easily generate forensic reports on employee compliance activities. You
should check what the output of the software products are and how easily you will be able to respond
to audit requests.
RECORD KEEPING – GET RID OF THOSE CARDBOARD BOXES!
In a world where digital storage gets cheaper by the week,
there is no need to have closets packed with boxes of
records. Firstly, developing an efficient system for cataloguing and maintaining paper records can be very time
consuming. Secondly, as any IT professional will tell you,
there should always be at least two back-ups of any digital
file. The same should apply for paper files and, as you can
imagine, this can be quite difficult. Tools like virtual data
rooms and even a simple process of scanning files and storing them in digital format with back-ups can be incredibly
20 H F M W E E K . CO M
CULTURE OF COMPLIANCE – DEVELOP A CULTURE THAT
COMES FROM THE TOP
The importance of developing a solid “culture of compliance” at your firm cannot be understated. The culture must
come from the top, so creating a system of regular reporting
to senior management on a variety of compliance issues is
always a good idea. Some of the tools mentioned earlier in
this article can be used for this type of reporting. Using a
compliance calendar or compliance management software,
will enable regular reminders and check-ins with employees
on compliance requirements and demonstrate for your files
that you are adequately supervising your staff.
CONCLUSION
There are many moving parts in any hedge fund operation,
so the key to its organisation is building out solid internal
processes. Leveraging technology can certainly help! Most
importantly, it will free up time for your CCO to focus on
other tasks. Q
ABOUT EVENWHEEL SOLUTIONS
EvenWheel Solutions is the software arm of HedgeOp Compliance,
LLC which is part of The IMS Group, the leading global provider
of regulatory compliance consulting services to the asset
management and securities industry. EvenWheel creates “best in
class” compliance software applications for investment advisers,
hedge fund managers, private equity managers and other financial
firms around the globe. Globally, the IMS Group has a staff of more
than 100 employees and services more than 700 firms.
LEGAL
H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 2
SE E D C A P I TA L
ARR ANGEMENTS
WITH THE INITIAL CAPITAL BARRIER FOR START-UP MANAGERS BECOMING AN INCREASINGLY CHALLENGING HURDLE, THE OPTION OF SEED
CAPITAL IS BECOMING MORE POPULAR. KEVIN SCANLAN, OF DECHERT, DISCUSSES THE DETAILS OF ENTERING INTO SUCH AN ARRANGEMENT
S
Kevin P. Scanlan
is a partner in Dechert’s
financial services group
and advises clients on the
structuring and formation
of, and investment in,
international and domestic
private investment funds,
including hedge funds,
private equity funds, real
estate funds, venture capital
funds and fund of funds.
ince the credit crisis hit in 2008, it has become increasingly difficult for new hedge
fund managers to raise capital for a hedge
fund they are marketing. In addition, due
to the various rules recently finalised by the
Securities and Exchange Commission (SEC)
that make it much more difficult to avoid registration as an
investment adviser and impose numerous filing and compliance obligations, the legal and compliance costs associated with starting a hedge fund organisation make it much
more important for a start-up hedge fund manager to raise
a substantial amount of capital at its initial closing.
Based on a recent analysis of Preqin’s Hedge Fund Investor Profile database, institutional investors (particularly
fund of funds and endowments)
retain a significant appetite for first
time funds given their potential to
generate higher returns than the
larger, more established managers.
In order to attract this capital, it is
often helpful if the start-up manager is able to secure an investment
from a hedge fund seeder. Fortunately, HFMWeek research from
late 2011 indicated that hedge fund
seeders have at least $4.59bn available to allocate to new hedge fund
managers, which should create a
lot of opportunities for emerging
managers in 2012.
to deepen the portfolio management team and build out
its back-office and compliance infrastructure. The seeder’s
investment generally is subject to a lock-up of two to three
years. However, the lock-up often expires upon the occurrence of certain events (for example the violation of certain investment guidelines/restrictions imposed by the
seeder, commitment of specified bad acts by the principals
of the manager, a major decline in value of the seeder’s
investment (for example loss of 20% in one year or 10%
over a longer period of time or a change in control of the
manager, and so on).
It is very important for the manager to analyse the
events that terminate the lock-up period to make sure they
can be objectively determined and that they are drafted as
narrowly as possible. It is also important for the manager to work
with experienced counsel to appropriately disclose the risk to investors in the hedge fund should one
of these triggers be satisfied and the
seeder decides to withdraw.
IT IS VERY IMPORTANT
FOR THE MANAGER TO
ANALYSE THE EVENTS THAT
TERMINATE THE LOCK-UP
PERIOD TO MAKE SURE
THEY CAN BE OBJECTIVELY
DETERMINED AND THAT
THEY ARE DRAFTED AS
NARROWLY AS POSSIBLE
ESSENCE OF THE BUSINESS DEAL
The basics of the business deal are
rather simple. A start-up manager
(manager) obtains a large slug of
capital (often $50-100m or more)
from a seed capital provider (a
seeder) in return for sharing a portion of its asset-based and incentive-based compensation
with the seeder.
Delving deeper into the details of the arrangement, the
manager is provided with the following benefits from this:
(i) additional credibility with prospective investors given
the investment by the seeder, (ii) the potential to receive
additional capital from the seeder or other persons (such
as other advisory clients of the seeder) that the seeder may
be willing to introduce to the manager and (iii) significant
ongoing cash flow and payment of start-up expenses from
the seeder’s investment that enhances the manager’s ability
STRUCTURE OF THE BUSINESS DEAL
Seeding arrangements are effectuated either through the entering
into a revenue share agreement or
through the seeder taking an ownership interest in the manager’s
advisory entities. The seeder’s
share of the manager’s revenue will
vary greatly from deal to deal, but
the manager should expect to surrender somewhere in the range of
15-25% of its revenue to the seeder.
The sharing ratio may also be subject to reductions should the manager’s assets under management
reach specified thresholds.
If a revenue-sharing agreement is used, the seeder’s
share of the manager’s revenue generally would be calculated on a gross basis. If the seeder receives an ownership
interest in the manager’s advisory entities, the revenue
sharing would be done on a net basis (however, the seeder
would generally insist on budgetary controls over the manager’s business to ensure these revenues are not offset by
additional expenses).
The revenue-sharing agreement approach suits both
parties – the manager is afforded greater freedom to operate its business and the seeder is not bogged down in budg-
”
H F M W E E K . C O M 21
LEGAL
H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 2
et negotiations. As a result, the use
of a revenue sharing agreement has
become more popular than the
other approach.
THE MANAGER MUST
MAKE SURE THE TERMS OF
THE ARRANGEMENT ARE
FAIR AND WITHIN MARKET
STANDARD AND ARE
APPROPRIATELY TAILORED
TO ITS INVESTMENT
STRATEGY AND EXPECTED
BUSINESS OPERATIONS
OBLIGATIONS AND RESTRICTIONS
THAT MAY BE IMPOSED ON A
MANAGER
In connection with its investment,
the seeder will obtain (i) enhanced
transparency with respect to the
fund’s portfolio positions (this
may include information provided
by a risk aggregation and reporting service), (ii) most favoured nations treatment, (iii) various consent rights (for
example obligation to consent to (a) the establishment of
a new fund, (b) the use of any new service provider to the
fund and (c) any corporate events affecting the manager’s
advisory entities) and (iv) a variety of covenants from the
manager and its principals, as set forth in more detail in the
following sentence. The manager and the principals will be
required to agree that the seeder’s revenue share will apply to
all investment management-related activities in which they
may engage. The principals will also be required to agree to
maintain a specified level of investment in the fund for the
duration of the seeder’s lock-up and to reinvest a certain
percentage of the performance allocation and excess assetbased fees (in particular fees remaining after payment of all
expenses of the manager’s advisory entities) in the fund.
Finally, the principals will be required to agree to a noncompete and non-solicitation covenant (in particular a
prohibition on soliciting any employee or investor of the
fund or the seeder for one to two years), the devotion of
certain time and attention to the affairs of the fund and the
maintenance of a certain minimum ownership percentage
in the manager.
portant to get experienced counsel’s opinion on whether the terms
are within market for this type of
arrangement. It is also important
for the principals of the manager
to review with counsel the obligations and restrictions to which they
are agreeing in connection with the
seeder’s investment. For example,
it is fair that the seeder’s revenue
share would apply to any new funds
the manager or the principals form,
whether at the manager or as a
principal of a new hedge fund group. Otherwise, it would
be easy to circumvent the seeder’s right to a share in revenue. However, the initial draft of the documents for these
types of arrangement often could be interpreted to allow
(and may be intended to permit) the seeder to participate
in a departed principal’s salary and bonus received as an
employee at an investment bank in connection with the
management of a fund. Also, to the extent the manager has
grown in size and no longer needs the capital and credibility associated with an investment by the seeder, the manager should be able to buy-out the seeder and eliminate its
revenue share. The price associated with the buy-out right
will vary from deal to deal but counsel can provide some
guidance as to what is an appropriate formula.
Finally, another area on which the manager should focus is any software or intellectual property the manager
may own. Should any revenue arising from the licensing of
this software be subject to the revenue share of the seeder?
Is the intellectual property owned by the manager an asset that the seeder has bargained for in connection with
its investment?
Accordingly, although there should be abundant opportunities to receive capital from a seeder, the manager must
make sure the terms of the arrangement are fair and within
market standard and are appropriately tailored to its investment strategy and expected business operations. Q
”
ISSUES A MANAGER SHOULD CONSIDER
Because each deal can vary greatly from others, it is im22 H F M W E E K . CO M
A successful
alternative investment firm
needs to grow its business
not its list of to-dos.
At Equinoxe, we understand the walk along the efficient frontier taken
by alternative investment managers like yourself. So when we administer
your account, you have seasoned professionals dedicated to your fund
and its investors. This experience, coupled with our bespoke operating
model and flexible reporting, lifts the weight of every administrative
detail from your shoulders and places it squarely on ours.
www.equinoxeais.com
Stephen Castree, [email protected], global
Chris Foy, [email protected], usa
Rod White, [email protected], bermuda
Alan McKenna, [email protected], ireland
Irfaan Hossany, [email protected], mauritius
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