How to Start a Hedge Fund – Part II

See Part I for an overview of the hedge fund industry.

Legal and regulatory requirements

First and foremost, hedge funds are subject to securities laws and regulations ⁽⁴⁾, just like any other investment product. This means that they must register with the appropriate regulatory agencies, such as the Securities and Exchange Commission (SEC) in the United States.

Hedge funds must also comply with anti-fraud laws and regulations, which prohibit them from making false or misleading statements to investors or engaging in other types of deceptive practices.

In addition, hedge funds are typically subject to a number of operational and disclosure requirements. For example, they must provide detailed information about their investment strategies, fees, and performance to their investors. They must also maintain detailed records of their activities and provide regular reports to regulatory agencies and investors.

Hedge funds may also be subject to specific regulations based on their investment strategies or the types of assets they invest in. For example, funds that invest in commodities or derivatives may be subject to additional regulations under the Commodity Futures Trading Commission (CFTC) in the United States.

Another key regulatory requirement for hedge funds is the need to limit the number of investors they accept. In the United States, for example, hedge funds are generally limited to no more than 100 “accredited investors,” who are individuals or institutions with a certain level of wealth or sophistication.

This is designed to protect less-sophisticated investors from the potential risks associated with investing in hedge funds.

Finally, it’s worth noting that regulatory requirements for hedge funds can vary significantly depending on the country or region where the fund is located. For example, hedge funds in Europe may be subject to different regulations than those in the United States, and funds that operate globally may need to comply with regulations in multiple jurisdictions.

Last but not the least, to sum it up, hedge funds are subject to a wide range of legal and regulatory requirements, designed to protect investors and ensure the stability of the financial system.

These requirements can vary depending on the fund’s location, investment strategies, and other factors, so it’s important for hedge fund managers to stay up-to-date on the latest regulations and compliance requirements.

Selecting the right service providers

Now, let us get to what you’ll need to set up your legal structure.

You will be requiring the service providers such as auditors, administrators, lawyers and compliance specialists for setting the legal requirements.

Although it may be tempting to choose less expensive providers for your fund, doing so could be a costly mistake if the providers you choose do not meet the necessary legal or compliance requirements, potentially causing your fund to fail.

Also, potential investors would want to find out if the providers in your hedge fund are good with experience and have a good reputation.

Moreover, the legal requirements to start a hedge fund are different for every state and country. So, you will need to figure it out based on your location.

Apart from the lawyers, you’ll need:

• Auditors to monitor your performance
• Administrators to handle trade reconciliations and allocations
• Marketers to find more investors
• Brokers or dealers for trading
• Compliance staff to manage reporting requirements.

There are different regulations for different countries. For example, in India, hedge funds are known as Alternative Investment Funds (AIF). An AIF is required to be registered with the Securities and Exchange Board of India (SEBI) ⁽⁵⁾.

For registering an AIF, the applicant is required to go through the SEBI (Alternative Investment Funds) Regulations, 2012 for making sure to include everything required for setting up an AIF.

Similarly, in Singapore, the hedge fund is known as Licensed Fund Management Company (LFMC), and the registration of the same requires a minimum capital of 250,000 SGD. Also, every LFMC is required to maintain risk-based capital of 120% of the total calculated risk.

There are other office-related requirements as well as compliance functions ⁽⁶⁾ that one must be knowledgeable about before registering an LFMC.

Develop marketing and fundraising strategies

One of the most crucial aspects of beginning a hedge fund is finding and convincing the investors. Hence, attracting investors requires a significant investment in marketing.

By implementing a good marketing strategy, one can attract these investors. Marketing strategies are divided into two broad categories namely, direct and indirect.

Direct marketing targets identified potential investors or groups of investors by directly sending them communications via calls and emails. Indirect marketing focuses on creating general brand awareness among the public.

The costs associated with marketing depend upon the type of marketing employed. It could include print media, website and online presence, and television as well as radio commercials.

Also, raising the capital is essential for starting a hedge fund. Since you will be needing the capital for several things, you must shortlist all the things you would be requiring capital for. That way, you can create the marketing strategies for those particular aspects and raise capital.

Coming to where all you will be spending the raised funds, basically, you’ll need office space, which is expensive in some developed cities such as New York and London.

You have the option of starting from your home first or sharing a space with other startups for lowering the capital requirements.

Going forward, you’ll be needing a rough idea about which departments you’ll be needing in your hedge fund and also the employees that you’ll be hiring. This will help you include the expense of paying the salary to the employees.

Similarly, there will be such expenses relating to the bonuses of the employees, management, maintenance, etc.

Launch the fund and begin operations

This is as straightforward as it sounds.

Once you’re set with the fund structure, the service providers and the marketing strategies for fundraising, the only remaining step is launching the fund and creating a successful beginning!

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Key considerations for a hedge fund

Let us now find out the key considerations for a hedge fund, which are:

• Regulatory compliance
• Adequate capitalisation
• Trading/Investment strategies
• Risk management
• Talent Acquisition
• Operational infrastructure
• Investor relations

Regulatory compliance

As discussed earlier, hedge funds are subject to a wide range of legal and regulatory requirements. It’s essential to carefully research and understand these requirements before starting a hedge fund. Failure to comply with these regulations can result in significant fines and penalties, as well as damage to the fund’s reputation.

Adequate capitalisation

Hedge funds typically require significant amounts of capital to start and operate successfully. It’s important to ensure that the fund is adequately capitalised from the outset to cover startup costs, ongoing expenses, and potential losses. Insufficient capitalisation can lead to financial difficulties and even bankruptcy.

Trading/Investment strategies

Hedge funds use a variety of investment strategies to generate returns, but not all strategies are equally effective or appropriate for all market conditions. It’s important to carefully consider the fund’s investment strategy and ensure that it’s well-suited to the current market environment. And you should also have plenty of trading strategies.

Risk management

Hedge funds typically take on greater investment risks than traditional investment vehicles, but it’s essential to have robust risk management policies and procedures in place to minimise potential losses. This includes monitoring portfolio risk, setting risk limits, and implementing hedging strategies.

Talent acquisition

The success of a hedge fund often depends on the quality of its personnel, including portfolio managers, analysts, and other key staff. It’s important to recruit top talent with relevant experience and a strong track record of success.

Operational infrastructure

Hedge funds require robust operational infrastructure to support their investment activities, including IT systems, accounting and reporting systems, and compliance monitoring tools. It’s essential to invest in high-quality infrastructure from the outset to ensure the smooth operation of the fund.

Investor relations

Hedge funds rely on attracting and retaining investors to generate capital and support ongoing operations. It’s important to establish strong investor relations and communication channels to keep investors informed about the fund’s performance and address any concerns or questions they may have.

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Costs in general and capital required

Hedge funds are heavily regulated by the Securities Exchange Commission (SEC). There are numerous requirements for registration and disclosure to regulatory bodies and investors. You will need to hire a legal firm that has expertise in compliance requirements.

Let us now take a look at different costs for owning a hedge fund, they are:

Fund administrator costs

The hiring of a fund administrator will be needed to handle the accounting and reporting of both domestic and offshore entities. The fund administrator will generally be an organisation. The organisation will also provide a piece of extensive advice and guidance on running fund operations.

The trained staff members and software packages help the administrator with the process and operations. As the hedge fund grows and acquires more assets under management (AUM) and investments, the work of an administrator becomes more of a challenge.

Audit and tax costs

Regulatory requirements often require hedge funds to undergo a private audit. You will need to work with an auditor who is familiar with hedge fund operations.

The audit cost depends on –

• The number of investments as well as the amount of the same.
• The number of domestic and offshore entities.
• The need for organising accounting records.

Equipment and technology costs

The fund will need to invest in the furnishing of the premises, the equipment including a computer set up, the software etc. It must also be noted that the software services or the technology related services can be quite expensive.

The fund is also required to be able to professionally host the communications as well as the trading services. Moreover, it is a must that the encryption and backups are done in an adequate and appropriate manner.

Also, there must be compliance measures for security purposes which is a must if the company employs software to undertake automated trading.

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Conclusion

We discussed various aspects of starting a hedge fund such as the step-by-step process as well as the costs associated with the same. Starting a hedge fund surely brings a lot of wealth to the owner but, at the same time, the hedge fund owner must remember that a new hedge fund might fail. The reasons may be that the investors do not fund your strategy anymore because they had a bad year, or it could be anything else.

Nevertheless, keeping a backup plan is always the best!

Originally posted on QuantInsti blog.