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 ¡*()*=JFKLQGMF?DDH& =jfklQgmf_j]^]jklgY_dgZYdgj_YfarYlagfg^e]eZ]jÕjekg^=jfklQgmf_?dgZYdDaeal]\$]Y[`g^ o`a[`akYk]hYjYl]d]_Yd]flalq&=jfklQgmf_DDHakY[da]fl%k]jnaf_e]eZ]jÕjedg[Yl]\afl`]MK& J]Y\q^gjY[`Yf_]7 Afmf[]jlYaflae]k$`goqgmj]khgf\lgeYjc]lmhkYf\\gofk[gmd\eYc] Yddl`]\a^^]j]f[]&O][Yf`]dhqgmja\]l`]klgje&Oal`YkkmjYf[]$lYpYf\ Zmkaf]kkY\nakgjqhjg^]kkagfYdkY[jgkkl`]_dgZ]\]\a[Yl]\lgl`]`]\_]^mf\ af\mkljq$o]Ìj]hgkalagf]\lg`]dhqgmlY[cd]ngdYlad]eYjc]lkalmYlagfko`]f]n]j Yf\o`]j]n]jl`]qYjak]&9f\afYfmf[]jlYafogjd\$l`YlÌko`YlallYc]klg`]dh qgmjZmkaf]kkY[`a]n]alk^mddhgl]flaYd& O`YlÌkf]pl^gjqgmjZmkaf]kk7 ]q&[ge'Ykk]leYfY_]e]fl 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 Published by Pageant Media Ltd LONDON Suite L, 1 East Poultry Avenue EC 1A 9PT T +44 (0)20 7029 4000 NEW YORK 240 W 37th Street , Suite 302, NY 10018 T +1 (212) 268 4919 REPORT EDITOR Jon Yarker T: +44 (0)20 7029 4066 j.yarker@pageantmedia.com REPORT WRITER Vincent Huck T: +44 (0)20 7029 4025 v.huck@pageantmedia.com HFMWEEK EDITOR David Beattie T: +44 (0)20 7029 4038 d.beattie@hfmweek .com PRODUCTION EDITOR Claudia Honerjager SUB-EDITORS Rachel Kurzfield, Eleanor Stanley DESIGNER Matt McLean EDITORIAL DIRECTOR Gwyn Roberts MANAGING DIRECTOR Charlie Kerr COMMERCIAL MANAGER Lucy Guest T: +44 (0)20 7029 4052 l.guest@ hfmweek .com publishing ACCOUNT MANAGER Richard Mason T: +44 (0)20 7029 4054 r.mason@hfmweek . com SUBSCRIPTIONS MANAGER Richard Freckelton T: +44(0)207 029 4017 r.freckelton@hfmweek .com CIRCULATION MANAGER Fay Muddle T: +44 (0)20 7029 4084 f.muddle@pageantmedia.com HFMWeek is published weekly by Pageant Media Ltd ISSN 1748-5894 Printed by The Manson Group © 2012 all rights reserved. No part of this publication may be reproduced or used without the prior permission from the publisher 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 mrosen@conceptcapital.com Frank L. Napolitani Managing Director 646.747.5228 fnapolitani@conceptcapital.com www.conceptcapital.com NEW YORK, NY | GARDEN CIT Y, NY | GREENWICH, CT | CHICAGO, IIL L | B BE BERNARDSVILLE, ER E RNA AR RD RDS R DS D S NJ 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. +HGJHDQG3ULYDWH(TXLW\)XQG)RUPDWLRQ_7UDQVDFWLRQDO&RXQVHOLQJ &RPSOLDQFH6HUYLFHV_5HJXODWRU\5HSUHVHQWDWLRQ_/LWLJDWLRQ_'HULYDWLYHV 7D[(5,6$DQG(VWDWH3ODQQLQJ_5HDO(VWDWH )LIWK$YHQXHVW)ORRU 1HZ<RUN1< &DOLIRUQLD6WUHHW 6DQ)UDQFLVFR&$ ZZZKHGJHIXQGZRUOGFRP 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 &RPSOLDQFH6RIWZDUHWR.HHS<RXU%XVLQHVVRQ7UDFN 2YHUEURNHUIHHGV :<9=0=(3.,(9 -69(+=0:69:05;/0: 5,>9,.<3(;69@>693+ $XWRPDWHGSHUVRQDO WUDGLQJUHYLHZ ,QWHUDFWLYHFRPSOLDQFH FDOHQGDUUHSRUWLQJ %XLOWVXSSRUWHG E\FRPSOLDQFH SURIHVVLRQDOV $ ', 9, 6 21 2) ZZZHYHQZKHHOVROXWLRQVFRP 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, scastree@equinoxeais.com, global Chris Foy, cfoy@equinoxeais.com, usa Rod White, rwhite@equinoxeais.com, bermuda Alan McKenna, amckenna@equinoxeais.com, ireland Irfaan Hossany, ihossany@equinoxeais.com, mauritius $WRSUDQNHG OHJDODGYLVRUWRWKH LQYHVWLQJZRUOG )RUPRUHLQIRUPDWLRQSOHDVHFRQWDFW *HRUJH-0D]LQ JHRUJHPD]LQ#GHFKHUWFRP .HYLQ36FDQODQ NHYLQVFDQODQ#GHFKHUWFRP 'DYLG$9DXJKDQ GDYLGYDXJKDQ#GHFKHUWFRP :LWKDSSUR[LPDWHO\ILQDQFLDOVHUYLFHVODZ\HUVLQWKH8QLWHG 6WDWHV(XURSHDQG$VLDRXUWRSUDQNHGWHDPKDVWKHUHDFK UHVRXUFHVDQGH[SHULHQFHWRSURYLGHFRPSUHKHQVLYHFURVVERUGHU VHUYLFHVWRWKHZRUOG·VODUJHVWKHGJHIXQGDQGHPHUJLQJIXQG PDQDJHUV ´7RSSLQJWKH6XSHU/HDJXHLV'HFKHUW7KHEUHDGWKRILWV UHFRPPHQGDWLRQVDFURVVWKHNH\PDUNHWVRIWKH86(XURSH DQG$VLDFHPHQWVLWVSRVLWLRQDWWKHWRSµ 3/&,QYHVWPHQW)XQGV6XSHU/HDJXH 7LHUIRULQYHVWPHQWIXQGVKHGJHIXQGV´'HFKHUWKDV RQHRIWKHPRVWKLJKO\UHJDUGHGKHGJHIXQGSUDFWLFHVLQ WKHZRUOGµ &KDPEHUV8. 7LHUIRULQYHVWPHQWIXQGVUHJLVWHUHGIXQGVIRUWKHWK\HDULQ DURZ´WKLVVWHOODUJURXSHQMR\VDWUHPHQGRXVUHSXWDWLRQLQWKH PDUNHWDQGUHJXODUO\DGYLVHVVRPHRIWKHFRXQWU\·VODUJHVWIXQG FRPSOH[HVµ &KDPEHUV86$ 'HFKHUW·VVWURQJFURVVERUGHUFXOWXUHPDNHVLWZHOOSODFHGWR KDQGOHFRPSOH[IXQGV &KDPEHUV*OREDO 7LHUQDWLRQDOO\IRUSULYDWHKHGJHIXQGODZDQGPXWXDOIXQGODZ 861HZV²%HVW/DZ\HUV´%HVW/DZ)LUPVµ GHFKHUWFRP $XVWLQ%HLMLQJ%RVWRQ%UXVVHOV&KDUORWWH'XEOLQ)UDQNIXUW+DUWIRUG+RQJ.RQJ/RQGRQ/RV$QJHOHV/X[HPERXUJ0RVFRZ 0XQLFK1HZ<RUN2UDQJH&RXQW\3DULV3KLODGHOSKLD3ULQFHWRQ6DQ)UDQFLVFR6LOLFRQ9DOOH\:DVKLQJWRQ'&