How to launch a hedge fund or boutique investment firm
How to launch a hedge fund or boutique investment firm Author: Clinton Joyner Sea Analytics Pty Limited Sydney, Australia Web: www.seaanalytics.com.au Email: info@seaanalytics.com.au Last Updated: 10 March 2014. How to launch a hedge fund or boutique investment firm How to launch a hedge fund or boutique investment firm This paper is intended for anyone considering launching their own hedge fund or boutique investment firm. As you can imagine there are myriad matters to address when launching a new firm (start-up) and this paper aims to address the important aspects, particularly those that can lead to costly consequences if executed poorly. We appreciate that everyone is busy so we have tried to avoid waffle and keep each topic brief. We have endeavoured to tailor this paper to an Australian audience although many of the challenges and considerations apply to start-ups all around the globe. Since the global financial crisis (GFC) the economics for investment firms has changed significantly. Specifically, management fees and performance fees are lower, operating expenses are higher due to ongoing compliance and regulatory costs and there is a greater expectation for transparency, sound operational systems and robust processes. If you choose to only read this page, the top 10 thoughts to take-away are: 1. Don’t underestimate the importance of a live track record; 2. Everyone claims they offer low correlation to market so differentiate yourself from the pack; 3. Poor systems and processes will cost you money; 4. The wrong service provider reflects badly on you; 5. You can outsource a function but you can’t outsource your responsibility; 6. Make a realistic fund raising plan, then double the timeframe and halve the expected flows; 7. Perception is reality in the world of marketing; 8. Generally speaking 2%/20% is a thing of the past; 9. Find a reasonable balance between minimal information and complete transparency; and 10. Invest time in documentation and streamline the ODD process with a virtual data room. We hope you find this paper instructive and we welcome the opportunity to work with you on any of the matters discussed herein. Please email any constructive feedback and let us know if there are any future topics that you would like us to write about. Clinton Joyner Director Sea Analytics Pty Limited Copyright 2014 Page 2 of 24 How to launch a hedge fund or boutique investment firm Table of Contents Why do people launch their own firm? Investment Process Team Development Obtaining your Licence Investment Structure Risk & Compliance Insurance Service Providers Investment Operations: In-House Versus Outsourcing Technology Raising Funds Marketing Fees Investor Reporting Due Diligence 4 5 6 7 9 11 13 14 16 17 18 20 22 23 24 Disclaimer: These materials have been prepared solely for information purposes and must not be considered tax, investment or legal advice. If you are interested in any subjects discussed in this document we encourage you to contact us or seek independent advice. Sea Analytics Pty Limited disclaim any and all liability relating to these materials including without limitation, any express or implied representations or warranties for statements or errors contained in, or omissions from, these materials. These materials must not be used for the purposes of avoiding penalties that may be imposed by any law. Sea Analytics Pty Limited and its employees and officers shall not be liable for any loss or liability suffered by the use of any information contained in these materials. Sea Analytics Pty Limited Copyright 2014 Page 3 of 24 How to launch a hedge fund or boutique investment firm Why do people launch their own firm? Many successful firms have been launched by professionals who spent many years establishing a distinguished track record managing other people's money, perhaps in equities, commodities, currencies, fixed income or indeed a combination. A handful of prominent examples within the Australian market include: i. Kerr Neilson (ex-BT and founder of Platinum Asset Management); ii. Anton Tagliaferro (ex-BNP and founder of Investors Mutual); iii. David Paradice (ex- Mercantile Mutual and founder of Paradice Investment Management); iv. John Sevior (ex-Perpetual and founder of Airlie Funds Management); and v. Morry Waked (ex-BGI and founder of Vinva Investment Management). According to the 2013 ‘BRW Rich 200’ list, the first 3 names above were estimated to be worth a staggering $2.43b, $240m and $235m respectively. Numerous other successful firms have been established by lesser known rising stars with the ambition and conviction that their distinctive investment proposition will deliver superior returns. It is also not uncommon for start-ups to be established by a spin-off from their investment bank, hedge fund or proprietary trading desk. These firms tend to gain traction early as they already have a team in place with a proven track record. Their departing firm may also provide seed capital and access to existing infrastructure which can greatly enhance their journey towards break-even. Regardless of how a start-up is formed, these entrepreneurs seek longevity rather than focussing on their next bonus cheque and they are committed to having ‘skin in the game’ by investing a large portion of their personal wealth alongside investors. Most successful fund managers from large investment firms are sheltered from operational matters and are therefore unaware of the complexities that can occur behind the scenes. For this very reason it is critical that start-ups surround themselves with a team of talented individuals to navigate through the numerous operational and business challenges that will be uncovered throughout this document. Sea Analytics Pty Limited Copyright 2014 Page 4 of 24 How to launch a hedge fund or boutique investment firm Investment Process An investment process typically starts with an objec- Minor tweaks to your investment process can tive such as adopting a fundamental, bottom-up demonstrate your willingness to fine tune and furapproach to identify a basket of strong companies ther polish your process based on experience, with compelling prospects for future growth. missed opportunities or changing market conditions. According to the Basis Point Consulting, Australian Risk management should also be a core component Investment Managers Directory 2013, “there are of your investment process as investors will want to 138 investment managers investing predominantly understand how you intend to navigate your fund in Australian equities” and therefore the key to mak- through periods of extreme volatility. ing your fund attractive to potential investors will be your ability to differentiate your offering from the pack. On a separate note, extensively back testing your investment process can provide you with confidence that your investment approach is working but this Since the GFC, more investment firms emphasise to means very little to investors as they want to see investors that their fund has low correlation to the real results before investing. You should consider market and due to the frequent use of this state- the cost-benefit of prolonged back testing given the ment; it is no longer a differentiating factor. consequent delay to collecting your first manage- In simple terms an investment decision to buy, sell ment fee. or hold is commonly determined following the outcome of several components/criteria being satisfied. Articulating these components in the appropriate sequence with a combination of illustrations, text and real examples will go a long way to breakingdown the steps. If an investor doesn’t understand your investment approach they won’t invest, nor will they be confident it can be replicated successfully in the future. Being able to articulate your investment process verbally is equally important and your success will impact the ability of others to convey your message in an accurate manner to their superiors and potentially other investors. Sea Analytics Pty Limited Copyright 2014 Page 5 of 24 How to launch a hedge fund or boutique investment firm Team Development Building a team of experienced individuals is critical Hiring a part-time or full-time Chief Operating Ofto the success of a start-up as investors aren’t just ficer (COO) can save founders a tremendous amount buying the founder’s experience but the complete of time otherwise their attention is diverted to dealpackage. Most start-ups tend to hire past colleagues ing with operations, compliance, reporting, technolor people that come with strong recommendations ogy, service providers, due diligence questionnaires because they can’t afford to choose the wrong can- and various administrative tasks. Many investors will didate. not consider a firm unless they have appointed a It is not uncommon for founders to draw a zero salary for the first 2-3 years and therefore rely on their savings nest-egg and investment returns as income COO because without one the founder will be distracted by business matters rather than focusing on generating performance. received by the firm tends to go towards rent, sys- Start-ups with only 1 or 2 people should consider tems and other staff. hiring part-time resources as required because you Start-ups generally require additional research, administration or technology staff but they are unable to match salaries paid by more established investment firms. Instead they might offer a reduced base simply can’t manage everything. Remember, mistakes in the early days of a start-up can not only be costly but destroy your reputation and hence your ability to succeed. salary (often 50%-80% less than market) but allocate Firms should also leverage from their broad industry some equity in the firm. This carrot provides key connections and strive to build a strong Board of staff with skin in the game as they will ultimately Directors and Investment Advisory Committee of share in the firm’s success. talented individuals to challenge and debate issues. Prior to joining a start-up, individuals tend to calculate the opportunity cost of accepting a below mar- Close associates may even be willing to donate their time gratis. ket salary and set themselves a timeframe by which When marketing your team, it is obviously wise to they expect their equity component to start gener- highlight your stars but it is equally important to ating a return. Therefore, although an equity stake emphasise the team to limit the perceived reliance can help to retain staff this is only meaningful while on key players. Although challenging for small firms, the firm is profitable and/or while a positive outlook you will also be expected to appease investors by for the future remains. demonstrating the existence of succession planning. Sea Analytics Pty Limited Copyright 2014 Page 6 of 24 How to launch a hedge fund or boutique investment firm Obtaining your Licence When you are involved in the provision of financial People Proofs for each Responsible Manager (RM) services in Australia, you must hold an Australian financial services licence (AFS licence). The Australian Securities and Investments Commission (ASIC) is the regulator that issues AFS licences and they describe a financial service as: RM’s are the people you nominate as being responsible for significant day-to-day decisions about your business. ASIC generally expect that a licensee will have at least 2 RM’s. For most start-up entities, ASIC will also require at least one of the RM’s to be iden- i. providing financial product advice; tified as a Key Person under the AFS licence. This ii. dealing in a financial product; means that if the Key Person no longer works at the iii. making a market for a financial product; licensee, the AFS licence could be cancelled unless iv. operating a registered managed investment another appropriately skilled person is identified. scheme; v. providing a custodial or depository service; or vi. providing traditional trustee company services. This proof helps ASIC to assess the organisational competence and the good fame and character of RM’s. AFS licences are regulated under the Corporations ASIC also require a national criminal check which Act 2001 and when ASIC assesses a licence applica- can take up to 6 weeks to obtain so this should be tion they seek to ensure you are competent, have arranged before commencing an application. sufficient financial resources and that you can meet all AFS licensee obligations. The AFS licence application form (FS01) is electronic and can be completed online. Your application must also be supported with proofs (sent to ASIC via email), of which the quantity and type will depend B1 Organisational Competence This details the experience and qualifications of each RM. This helps ASIC to assess whether there is adequate organisational competence to provide the desired financial services and products. on the complexity of your services, products and B5 Financial Statements & Financial Resources business in general. Serves to demonstrate how you will comply with the The core proofs required are: financial requirements to satisfy ASIC that you have adequate financial resources. A5 Business Description Provides an overview of the financial services you intend to provide, whether your clients will be retail and/or wholesale clients and an organisational chart. This helps ASIC to understand your business. While assessing an application, ASIC may request additional proofs to gain a greater understanding on a particular matter in which case these need to be completed and returned to ASIC within 10 business days. Sea Analytics Pty Limited Copyright 2014 Page 7 of 24 How to launch a hedge fund or boutique investment firm Should you wish to vary your AFS licence at a later date to modify a service, product or RM, a similar process to the above is required. Some firms rely entirely on lawyers to manage an AFS licence application thereby leveraging their experience gained from previous applications. While this approach can save time and effort, you will still need to be actively involved to ensure the proofs are accurately tailored to your business. Considering the AFS licence application is generally a significant start-up cost, others choose to manage the process themselves and engage lawyers on specific matters as required. AFS licencees are subject to financial resource requirements. This includes being solvent (being able to pay your debts as and when they are due and payable), cash flow and net tangible asset requirements. At a base level these are not overly onerous however depending on your activities, these increase quite significantly. Recent changes coming into effect on 1 July 2014 will have particular impacts on trustees of wholesale schemes and responsible entities. Amongst other things, these entities will typically be required to hold at least 10% of the last 3 years gross revenue as net tangible assets. Sea Analytics Pty Limited Copyright 2014 Page 8 of 24 How to launch a hedge fund or boutique investment firm Investment Structure Determining an appropriate investment structure skills and experience to comply with these enhanced will depend primarily on the tax requirements and obligations. risk preferences of your investors. This section is not intended to be exhaustive but rather provide some general information on the commonly used investment structures. Offshore investment vehicles are typically established as a limited partnership (LP) or a company. Under the LP structure the investment firm operating the fund assumes the role of general partner An Australian unit trust structure is a prevalent in- (usually a limited liability company or LLC) while investment vehicle when investors predominantly re- vestors are limited partners in the sense that they side in Australia. Each investor receives units in the are only liable for their investment amount. Under trust which rank equally among other investors. the company structure, a board will have to be apTrusts are created by a trust deed or constitution pointed and investors will hold shares in the comwhich outlines the purpose of the trust, rights and pany. obligations of the trustee and powers of the trustee, amongst other things. Offshore funds are usually domiciled in jurisdictions to avoid adverse tax consequences for foreign and These unit trusts are generally referred to as man- tax exempt investors. The Cayman Islands has been aged investment schemes which are subject to cer- the most popular registration location for a number tain regulatory requirements. If you intend to pro- of years because: mote a trust to retail investors then the scheme is required to be registered with ASIC whereas a scheme that is only promoted to wholesale investors is not required to be registered. i. Funds can be established quickly and cost effectively; ii. There is an established and stable legal system; Firms licensed to deal solely with wholesale inves- iii. There are few obligations on Cayman Islands tors may nevertheless opt to register their scheme Monetary Authority (CIMA) regulated funds as this serves to demonstrate a commitment to- (annual audited financials and Cayman based wards the more onerous compliance regime. For administrator); and registered schemes the trustee is known as a re- iv. There are quality service providers. sponsible entity which must be established as a public company, have at least three directors and maintain certain net tangible assets. Care should be exercised before establishing an offshore fund structure. For Australian based managers, there is a risk that the structure could be Australian law provides that retail clients must be brought within the Australian tax regime due to the provided with enhanced disclosures and consumer delegation of investment management to an Ausprotections. This means that it is very difficult to tralian entity. Whilst the Federal Government’s Inobtain an AFS licence that authorises you to deal vestment Manager Regime may reduce these risks with retail clients or operate a registered scheme by providing a regulatory safeharbour, the preunless you are able to demonstrate you have the conditions to this safeharbour are quite significant. Sea Analytics Pty Limited Copyright 2014 Page 9 of 24 How to launch a hedge fund or boutique investment firm For example, the offshore fund must be widely held Now back to Australia, a listed investment company and not closely held, as defined. The European Un- (LIC) is a fund listed on the Australian Securities Exion (EU) Alternative Investment Fund Managers Di- change (ASX) and can be another attractive vehicle rective (EU AIFMD) also poses an obstacle for those for retail investors. LICs are closed-ended vehicles wishing to distribute offshore funds in the EU. The as the number of shares on issue is fixed which pre-existing exemptions allowing these funds to be tends to allow investment firms to adopt a longer marketed within the EU are being dismantled. To term investment strategy without being concerned fall within the EU AIFMD rules requires careful plan- with fund redemptions. ning and documentation. There are increased hurdles if the manager of the offshore fund is not EU based. Separately managed accounts are popular among institutions and family offices as they are literally separate from the investment firm while also ex- Pooled vehicles offer greater economies of scale and pected to perform consistently with the flagship investment firms sometimes take advantage of a fund. Investors are able to achieve greater liquidity, master-feeder structure by establishing feeder transparency and control as they usually appoint funds that comply with specific jurisdictions. These their own custodian. Some investment firm’s resist funds then feed into a larger pool of assets known managed accounts due to the additional work assoas a master fund. Hedge funds in particular take ad- ciated with trade allocations, dealing with multiple vantage of master-feeder structures to accommo- counterparties and client reporting although ignordate the tax intricacies of US and non-US investors. ing these opportunities may be perilous. Within the EU, Undertakings for the Collective Investment of Transferable Securities (UCITS) are popular. This is a public limited company that allows the investment firm to operate freely across the 28 EU membership states on the basis of an authorisation from only one member state. UCITS are more heavily regulated than offshore funds and there are restrictions on their investment strategies. UCITS are however exempt from AIFMD and can be more easily marketed in the EU, especially for non-EU based managers. Sea Analytics Pty Limited Copyright 2014 Page 10 of 24 How to launch a hedge fund or boutique investment firm Risk & Compliance Firstly it is important to highlight that risk and com- Ideally, staff should acknowledge each year that pliance are very different. Risk management refers they have read and understood your compliance to a set of processes used to identify and analyse plan and therefore it is important to avoid legal jarrisks such as operational or financial and the devel- gon, clearly describe who is responsible for tasks, opment of controls to mitigate or reduce the impact the task frequency, specify how tasks will be moniof the risk transpiring. Compliance on the other tored and by whom. A compliance plan should be a hand is the conforming of certain requirements, for living document and updated as new rules and reguexample law and regulations. lations are introduced. Alternatively, it should be ASIC expect you to identify and address all risks associated with your business and a risk matrix is the ideal tool in this regard. A risk matrix is constructed reviewed at least annually and endorsed by the Board to ensure it is integrated into business operations. by assessing the probability of a risk occurring and In addition to a compliance plan, internal policies the harm this may cause. For example, if a seed in- provide a framework for making decisions or dealing vestor was to redeem their funds, this could be cat- with certain matters which help to protect the firm, astrophic to the firm however, the likelihood of this employees and clients. These typically include a occurring might be considered low if the investor code of conduct, outsourcing, dispute resolution, IT committed to a lock-up period and/or the seed in- protocols, conflicts of interest, soft dollar guidelines, vestment is now a small portion of your total assets marketing and personal account dealings to name a under management. Once you understand your risks few. it is much easier to design controls to mitigate them. The Anti-Money Laundering and Counter-Terrorism ASIC take the view that unless you have documenta- Financing Act 2006 (AML/CTF Act) requires you to tion in place outlining your structure, key processes, have an AML/CTF Program when you provide a dessystems and measures you will apply to ensure you ignated service such as acquiring or disposing of a meet all compliance obligations, it will be very diffi- security on behalf of a person. AML/CTF programs cult for you to demonstrate compliance. help investment firms identify, mitigate and manage Developing and maintaining a compliance plan is an effective way to promote your compliance program and this ultimately serves to reduce the risk of breaching obligations, including the Corporations Act, AFS licence conditions, financial services laws, industry standards, etc. In the case of registered the risk of their products or services potentially facilitating money laundering or terrorism financing. AML/CTF programs have two key parts. Part A relates to the identification, management and reduction of AML and CTF risks. Part B addresses customer identification procedures. schemes, the compliance plan must be audited annually by an external auditor. Sea Analytics Pty Limited Copyright 2014 Page 11 of 24 How to launch a hedge fund or boutique investment firm There is no denying that compliance has added significant cost to business and this section could easily span another 20 pages if we were to discuss other regulations imposed by ASIC, APRA, the US Securities & Exchange Commission (SEC), the UK’s Financial Conduct Authority (FCA) and so on. Keeping up with regulatory changes and understanding how they are relevant to your business can be daunting so you may wish to consider the services of a part-time compliance consultant. Other ways of keeping informed are by attending industry forums and asking legal and accounting firms to include you on their distribution list for free regulatory updates. Large firms strive to achieve a strong compliance culture by ensuring clear and consistent communication and by integrating compliance across the business. This is equally important in a small firm as failing to comply may result in fines, court action and potential withdrawal of your AFS licence. Remember, a pilot can’t fly without their licence and you can’t manage funds without yours. Sea Analytics Pty Limited Copyright 2014 Page 12 of 24 How to launch a hedge fund or boutique investment firm Insurance If you are licensed to provide financial services to retail clients, ASIC require you to maintain adequate professional indemnity (PI) insurance to compensate clients for any losses they may suffer if you breach your obligations under the Corporations Act. To determine the adequate level of cover, refer to the ASIC Regulatory Guide 126: Compensation and insurance arrangements for AFS licensees. From our experience start-ups tend to seek minimum coverage of $5m but it is important to assess your own requirements. While firms providing financial services to wholesale clients are not obliged to maintain PI insurance, they often obtain coverage anyway for peace of mind. Investment Managers Insurance (IMI) is offered by some insurance firms and combines PI, Directors and Officers (D&O) and crime coverage into one policy cover. D&O insurance serves to protect management from claims that may arise as a result of actions or decisions made while conducting regular duties. Other insurances such as property (to protect your property and contents), Worker Compensation (to protect the firm in the event of an employee workplace injury) and other policies should be discussed with your insurance broker. Sea Analytics Pty Limited Copyright 2014 Page 13 of 24 How to launch a hedge fund or boutique investment firm Service Providers ASIC expects AFS licensees to have appropriate pro- v. Will a dedicated account manager be appointed cesses in place to ensure service providers are cho- to look after you? sen with due skill and care. The ongoing perfor- vi. Differentiating factors of their firm; mance of a service provider must also be monitored vii. Do they use institutional grade technology or and any issues are to be dealt with effectively. are manual processes rife? Most firms will require a prime broker/custodian, fund administrator, lawyer, auditor and will probably also need to consider an outsourced IT provider, viii. How many clients do they serve and average length of a relationship? ix. Additional services offered e.g. capital introduction, technology, discounted office space; web designer and perhaps a marketing firm. Appointing service providers that are inexperienced or have a poor reputation can reflect badly on the im- and x. Costs and timing of key service deliverables. age of your firm and therefore you should invest Before you analyse the RFP responses, build a matime and effort to avoid making errors. trix and assign a weighting to each question as this Firms often outsource functions that are beyond their core competencies which is sensible but can also make it difficult to separate the services of one provider over another so consider seeking the services of a consultant to assist with the process. Look beyond the polished presentations and compile a list of 20 questions known as a Request for Proposal (RFP) and ask your preferred 2-3 service simple approach can help you identify the service provider that ticks the most boxes and is therefore more likely to satisfy your needs. This method will also help to ensure you don’t focus entirely on cost but rather a range of factors. Also obtain a list of client contacts from each service provider and meet a few over coffee to understand the strengths and weaknesses. providers to respond. You must also describe your Prime Broker / Custodian business, product offering, instruments being traded, your expected turnover and type of investors, etc so the prospective service provider can tailor their responses. Questions are typically aimed at understanding matters such as: i. Team structure, experience/qualifications, staff turnover and ongoing training; ii. Detailed list and explanation of services offered; iii. Detailed description of specific tasks such as the corporate action process or client onboarding; iv. How the provider will service your firm/fund; The core services provided by a prime broker include financing, securities lending, custody, trade clearing and settlement, corporate action processing and reporting. Hedge funds generally borrow securities as a means of facilitating a short sale and therefore the ability of your chosen prime broker to source the stocks that enable you to implement your investment strategy is of ultimate importance. Obtaining a certain degree of leverage may also be critical so understanding the use of margin accounts, swap accounts, risk offsets and re-hypothecation limits will also be vital. Sea Analytics Pty Limited Copyright 2014 Page 14 of 24 How to launch a hedge fund or boutique investment firm Since the GFC, major investment bank prime brokers Fund Audit & Tax have become very cautious and it is not unusual for start-ups with less than $50m in assets under management to rely on the services of a non-investment bank prime broking arrangement for their initial 1-2 years or until fund raising efforts gain traction. A reputable audit and tax firm with proven expertise in your field will provide great comfort to investors that their work is reliable. Ensuring the creation of appropriate tax structures and acting as advisor to on-going tax matters is also critical. Fund Administrator and Unit Registry Legal Counsel Since the Madoff scandal, investors have increasingly demanded that firms appoint a fund administrator to protect their interests. Lawyers can assist with the set-up of your management company and the creation of fund structures that comply with the necessary regulation and legis- A fund administrator serves as an independent third lation. AFS licence applications and fund offer docparty by reconciling cash and holdings with custodi- uments tend to inspire greater investor confidence ans, independently pricing holdings at current mar- when prepared by recognised firms. ket values, calculating fund income, calculating expenses (including management and performance fees), payment of fund expenses, preparation of regular fund accounting reports and net asset values (NAVs). In practice, it is not uncommon for start-ups to engage legal consultants to draft offer documents and review agreements before passing these to a toptier law firm for final review and sign-off as this can generate meaningful cost savings. In Australia, fund administrators also maintain the unit holder registry and most importantly manage the required Anti-Money Laundering / Know Your Client (AML/KYC) checks when investment funds are received. Hedge funds typically appoint specialist fund administrators whereas firms managing traditional assets often rely on their custodian to also provide administration and unit registry services. Sea Analytics Pty Limited Copyright 2014 Page 15 of 24 How to launch a hedge fund or boutique investment firm Investment Operations: In-House Versus Outsourcing Like with all outsourcing arrangements there are The operations function is often described as the many pros and cons that need to be considered. engine room of the firm as it is responsible for runReduced overheads and the ability to focus on core ning and managing the day-to-day processes in an activities can be advantageous although you lose efficient, controlled, risk-free and timely manner. control and flexibility. This internal knowledge is invaluable to your busi- Typically the decision whether to build an in-house operations team or outsource is driven by the complexity of your business, the need for timely data ness. You can obviously play a key role in the retention of this knowledge within your firm whereas this is almost impossible when functions are outsourced. and your desire to invest in technology as poor sys- At the end of the day, there is not one correct aptems and manual processes ultimately lead to errors proach. It is best to carefully evaluate your business which can be costly to your reputation and bank desires and then identify the strategy to meet your balance. needs. It is important to remember that you can Implementing an internal operations function will require you to deploy specialist software (to be discussed further in the next section). This software outsource a task/function but you can’t outsource your responsibility so either way you will still need to understand what’s happening. can be expensive and require resources to implement effectively whereas outsourced providers tend to operate established systems that have been tried and tested by other firms. Sea Analytics Pty Limited Copyright 2014 Page 16 of 24 How to launch a hedge fund or boutique investment firm Technology Appropriate systems are another key component to Trading a successful investment firm. Historically an execution management system (EMS) Most start-ups simply can’t justify implementing expensive systems from day one and realistically it doesn’t really make sense to implement a Rolls Royce when a Toyota will probably suffice. That is, until your business becomes profitable and complex enough to require the additional bells and whistles that expensive systems offer. was used by a trading team to facilitate direct market access (DMA), algorithmic trading and access to dark pools whereas an order management system (OMS) provided portfolio modelling, trade allocations and pre/post trade compliance monitoring. Over the last several years OMS vendors have expanded functionality to include live market data and electronic execution so an OMS can now be consid- Quantitative funds tend to be more technology sav- ered a more complete package. vy compared to most other investors given technology plays an important part in their investment process. The functionality offered by system vendors can vary, however we have split technology into 4 core areas: Risk Management Risk systems enable firms to monitor risk on a regular basis, potentially both pre and post investment decisions. The type of instruments and markets that you trade will tend to dictate the type of risk monitoring required. For example, you may require Val- Portfolio Management A portfolio management system (PMS) will typically ue-at-Risk (VAR), analysis of Greeks, counterparty store trade history, interface with custodians and analysis, concentration exposure analysis and liquidfund administrators, prepare cash and position rec- ity analysis. Some firms implement off-the-shelf sysonciliations, provide automatic corporate action tems whereas others develop their own proprietary processing, value positions at end of day and possi- models when risk is a direct input into their investbly real-time, calculate accruals, calculate NAVs and ment process. enable reports to be customised. A more advanced PMS may also provide fund accounting, tax reporting, greater performance and risk analysis and the ability to programmatically access data stored in the system. petitors is the right one for you. Otherwise you might pay for expensive functionality that is not necessarily required. As mentioned earlier, start-ups are not expected to Market Data Depending on the instruments you trade and your investment approach, you might need access to real-time and/or historic market data such as price, economic releases, company financials, currencies, commodities, etc. These systems integrate data from global sources and deliver the data to your desktop or mobile device. Don’t assume the system used by one of your com- invest in institutional grade technology but rather ensure their infrastructure is appropriate given the stage and complexity of their business. It is well known that businesses need to spend money to make money in order to remain relevant and technology can certainly have an enormous bearing on the attractiveness of your business. Sea Analytics Pty Limited Copyright 2014 Page 17 of 24 How to launch a hedge fund or boutique investment firm Raising Funds Initiating a track record with real funds (as opposed According to the Australian Prudential Regulation to paper) is imperative to proving that your invest- Authority (APRA), Australia’s superannuation pool as ment process and operational framework is effec- at 31 December 2013 was worth A$1.8 trillion, an tive. Fund raising is an arduous process that requires increase of almost 20% on the prior year and a reyou to plan and set targets along the way. Once you markable A$543 billion of this belongs to self manhave developed a plan, we recommend you double aged super funds (SMSF). Further afield, only the your expected timeframe and halve the anticipated UK, Japan and the US surpass our market with inflows as this will probably result in a more realistic US$2.7 trillion, US$3.7 trillion and US$16.85 trillion outcome. respectively, as detailed in the Towers Watson Global Pensions Asset Study - 2013. Common sources of initial funding are: i. Founders are usually seed investors as this demonstrates a clear alignment of interests with other investors and increases the incentive to achieve strong performance. ii. Family and friends can be a tremendous source Raising capital from these significant assets pools (and others) can be challenging yet tremendously lucrative for your firm if you succeed. Here are a few ways to tap into these pools: i. firm/fund to their network of potential inves- of capital for start-ups as you will have already tors. They commonly operate on a monthly formed close and trusting relationships. iii. Third party marketing firms promote your retainer and receive a percentage of fee in- Fund incubators and investment partners can come from the funds raised. Some third party also provide early stage capital and in some marketers prefer to acquire equity in your cases may offer additional services such as op- firm so that their interests are aligned while erational support, marketing and corporate others don’t charge a retainer but expect a governance in exchange for a minority equity larger cut of your fee income. holding in the firm. ii. Prime brokers can also provide capital intro- It is customary to offer preferential terms to early duction services to assist with your marketing investors in the form of reduced management fees efforts although they tend to expect a mini- and/or performance fees in exchange for a mini- mum 2-3 year track record before they active- mum investment term or lock-up period. These ar- ly engage. rangements are usually maintained as a separate class of units. iii. Investment Consultants are the gatekeepers that stand between investment firms seeking Once you have raised some start-up capital you to raise funds and the large institutions wish- need to keep your foot on the accelerator by con- ing to invest. These consultants act on behalf tinuing to meet potential investors and developing of clients and can be highly influential with sound relationships with your target audience. regards to investment decisions. Most investment consultants expect at least a 3 year track record and are therefore generally re- Sea Analytics Pty Limited Copyright 2014 Page 18 of 24 How to launch a hedge fund or boutique investment firm luctant to invest time investigating start-ups Family offices are also frequently targeted because unless pushed by their client so maintaining there are fewer bureaucratic hurdles to leap but pressure will help to ensure consultants moni- these investors rely heavily on relationships and tor your progress and ultimately provide a rat- recommendations from fellow colleagues. ing for your fund. A positive rating places you on the radar and boosts your chances of raising institutional funds. High net worth (HNW) and sophisticated investors are other avenues to explore particularly if you are able to tap into the financial advisor network. When you receive an introduction from your marketing firm or prime broker, this will typically start with a phone call or meeting for a high level chat about your investment strategy. If you’re lucky, your firm might get added to a list for further review. Af- Wealth Platforms contain a wide range of investors with varying risk appetites and can generate a plentiful flow of assets if your firm/fund meets the criteria. ter 3 months or so, you might get another oppor- Regardless of your target investor market, be pretunity to present your investment process in more pared to devote major time establishing and builddetail and possibly be asked to provide some histor- ing relationships. Airport lounges will seem like a ical data for detailed analysis by the potential client. second home and your patience will be constantly This phase of discussions may continue for several tested while jumping over the countless obstacles months and possibly up to a year or more. placed in your way. Hopefully though, the process If the investor is still interested, they might com- will be gratifying and fruitful. mence operational due diligence to further assess your firm, investment process, operations, compliance etc. Assuming you satisfy all their due diligence requirements, you may then be offered an opportunity to pitch at the investment committee or board of trustees which usually meet 4-6 times a year. By this point, the investor should be close to making a decision but it only requires one committee or trustee member to have reservations for the deal to blow-up in your face. Sea Analytics Pty Limited Copyright 2014 Page 19 of 24 How to launch a hedge fund or boutique investment firm Marketing Obtaining a professional looking company logo can Although we naturally want to focus on our winning promote instant recognition of your firm and there trades, it is also important to describe some of the are many online sites now that offer this service at a losers as this helps potential investors understand reasonable price. Your company branding will also what you learned and how your risk strategies have become essential for all of your documents and been modified to mitigate future losses. Presenting marketing material. a mixed bag of stories can demonstrate how your There is no standard approach to marketing although we encourage you to invest considerable time and effort into ensuring the following 3 key marketing documents are of high quality: process takes advantage of market opportunities, risk management, hedging and/or leverage techniques. Developing your pitch book will consume a significant amount of time and you need to balance some Pitch book of the granular details without overwhelming or This is usually developed in Microsoft PowerPoint confusing investors. You will probably also find (or Keynote for the Mac users) and in essence is a yourself constantly fine-tuning your pitch book. ~20 page presentation. One or two page flyer A pitch book serves to describe the firm, biographies of the team, investment strategy and process, risk management, trading examples, service providers, performance history and why you believe the pro- This is a lighter version of your pitch book and provides a flavour for your investment offering and ideally promotes a desire to learn more. cess can be successfully repeated throughout all Offer Documents market cycles. Quite often the pitch book includes visual aids like flow diagrams, charts and tables as these help to enhance your message. Offer documents formally outline the terms and conditions of the investment offering including a description of the various risks and a fee summary. Most firms favour walking potential investors Offer documents are usually also prepared in a through each slide to ensure their message has been manner that complies with regulation and/or indusunderstood although some investors prefer to ab- try standards so will require a legal and tax sign-off. sorb the information in their own time before deciding whether to meet the firm. For this reason, it is important to ensure the pitch book is comprehensive otherwise essential characteristics will be easily overlooked. Sea Analytics Pty Limited Copyright 2014 Page 20 of 24 How to launch a hedge fund or boutique investment firm Depending upon your investment structure the offer Social media is ubiquitous and has become a powerdocument might be termed an Information Memo- ful low-cost medium by which to engage a large aurandum (or IM for unregistered unit trusts), Product dience. Blogging and tweeting allows you to convey Disclosure Statement (or PDS for a registered unit a message to an audience who respect and admire trust), Private Placement Memorandum (or PPM for your work and are likely to promote your words of LP/LLC structures), Key Investor Information Docu- wisdom to an even wider audience. ment (or KIID for UCITS), Prospectus (for a listed investment company (LIC)) or an investment management agreement in the case of a managed account. On a separate note, as you work towards expanding your investor pipeline it would be wise to consider a Client Relationship Management (CRM) System which may initially be managed in Excel. A CRM can Other effective ways of marketing your firm include: Websites are open 24/7 and are a cost effective way of marketing to attract new clients. Existing clients can also benefit when fund information and performance history is available via a secure login feature on the website. Whitepapers can be authored internally or externally and are most effective when the topic relates to the investment strategy employed by your firm. be very useful to track your marketing success, manage your various communication distribution lists and remind you to follow-up leads. For an added personal touch, you can also record the preferred tea/coffee order of your client so that it’s ready upon their arrival. Finally, perception is reality in the world of marketing so a professional looking website, pitch book and offer document can change the way a start-up is perceived and inspire confidence. Presenting at industry conferences where your audience is likely to include competitors and potential investors can be a useful way to gain new contacts and stimulate interest in your firm. Sea Analytics Pty Limited Copyright 2014 Page 21 of 24 How to launch a hedge fund or boutique investment firm Fees Domestically there has been substantial pressure Investors can still redeem before the expiration of placed on investment firms to reduce fees as indus- the lock-up but, the firm would be entitled to levy a try super funds in particular actively seek to reduce specified exit fee. The fund directors have the power costs on behalf of members. to waive the fee at their discretion. In September Devising an appropriate fee structure is ultimately achieved by balancing your revenue needs with the competitiveness of your investment offering. Some firms successfully charge more than others but generally speaking 2%/20% is a thing of the past. A management fee is usually a monthly charge paid by the investor to the investment manager and is calculated as a percentage of the NAV. Some institutional investors believe that investment firms should charge a management fee sufficient to cover the operational costs of running their firm. Performance fees are intended to reward an investment manager for the performance (or alpha) they generate above a specified benchmark/hurdle. Most investors are willing to give up 10%-20% of their net gains to incentivise the manager when they outperform which in turn can generate significant profit to the investment firm. 2011 the Supreme Court ruled that Military Superannuation and Benefits Scheme were required to pay a 5% exit fee for redeeming $150m from the Agora Absolute Return Fund II so it cannot always be assumed that the fee will be waived. Some firms specify in their offer documents that the management company will pay for certain fund related expenses such as fund administration, audit, tax, legal, etc and in these cases it is not uncommon for the manager to levy an administration fee to contribute towards fund expenses. When operating pooled investment vehicles it is also common to charge a buy/sell spread to contribute towards transaction costs associated with the buying/selling required for applications and withdrawals. Thus buy/sell spreads are for the benefit of investors rather than the firm. You should also consider your redemption terms. In order to level the playing field, most firms also incorporate a high watermark which means the firm must recover prior losses or underperformance before they collect any further incentives. Depending on your investor base, clients may require daily liquidity otherwise hedge funds typically permit redemptions following 30-90 days notice which allows sufficient time to raise cash to fund withdrawals. Typically, start-ups impose a 1-3 year lock-up commitment to prevent investors from redeeming until after a specified period. This allows time for the start-up to properly implement their investment strategy but also secures a certain level of management fee income which is critical to their financial survival. More established firms also seek to impose lock-ups but investors may resist. Sea Analytics Pty Limited Copyright 2014 Page 22 of 24 How to launch a hedge fund or boutique investment firm Investor Reporting You can expect investors to demand a newsletter Open Protocol Enabling Risk Aggregation (OPERA) is outlining your performance each month. Generally an industry initiative to standardise the reporting of those investing into an existing fund will receive the hedge fund exposure and risk information. Many same material as all other investors unless they in- large international firms are supporting the initiative vest via a separately managed account in which case and a handful of software vendors have already dethe investment terms may stipulate additional re- veloped reports to comply with the OPERA requireporting. ments so you can expect this initiate to rise. Hedge funds have traditionally been accused of lack- Most firms aim to find a reasonable balance being transparency although pressure from institu- tween minimal information and complete transpartional investors has led to greater transparency. In ency otherwise the administrative burden becomes addition to reporting fund and benchmark perfor- too great. It is also important to verify the contents mance, investment firms are increasingly providing before you distribute your newsletter and ensure it additional information to investors such as, top contains the appropriate disclaimers. holdings, top/bottom contributors, long/short/net/ gross exposures, the use of derivatives, risk statistics and a detailed commentary describing the prior period and future outlook. The Global Investment Performance Standards (GIPS) outline the best practices for calculating and presenting investment performance although in Australia start-ups tend not to follow these due to the lack of performance history and adequate systems. Sea Analytics Pty Limited Copyright 2014 Page 23 of 24 How to launch a hedge fund or boutique investment firm Due Diligence Due diligence is the process whereby potential in- Staff: Bios, qualifications, compensation structure vestors seek to gain a comprehensive understanding and leaving notice periods. of your firm and investment proposition. The 2 main due diligence practices are Investment Due Diligence (IDD) which focuses entirely on your invest- Investment: Legal structure, offer documents, risks, fees, valuation methods. ment process and Operational Due Diligence (ODD) Operations: Segregation of duties, demonstration of which focuses on all non-investment matters. trade confirmations and automatic trade alloca- Due diligence has become a key component of an investor’s decision making process and they will walk away if unsatisfied. Despite the greater focus, tions, daily reconciliations and the age of outstanding items, adequate resourcing, NAV calculations, collateral management, cash transfers. the information gathering process can seem ineffi- Service providers: Legal agreements, process docucient. menting how/why the service provider was ap- Some investment firms attempt to streamline the pointed and evidence of on-going monitoring. process by using virtual data rooms. Once you have Compliance: Compliance manual and internal poligranted on-line access to your virtual data room, the cies, copy of your AFS licence, details of any authorpotential investor can download your documenta- ised representatives, breach register, procedures, tion as opposed to you feeding the information. This pre & post trade monitoring, committee minutes, approach helps to demonstrate transparency alt- AML/KYC and corporate/fund governance. hough on the flipside you need to ensure the content remains current. Performance: Track record, attribution, liquidity management, counterparty management, portfo- Inconsistent questioning can also be a source of lio/market risk reporting. frustration and to this end The Alternative Investment Management Association (AIMA) and Financial Services Council (FSC) have developed a standard investment management questionnaire for investment firms. The due diligence process involves a questionnaire, supporting documentation, on-site interviews with key staff, a demonstration of certain tasks, reference and background checks of key staff and intro- Technology: Determine adequate/recognised software or the extent to which the firm relies on Excel. Also data protection, network backups, virus protection and BCP/DRP are covered. Due diligence can be intrusive and much of the information may be considered confidential so you may wish to consider executing a Non Disclosure Agreement (NDA) with the potential investor. ductions to service providers. Some of the investigation areas will include: Firm: Ownership structure, financials, insurance arrangements and board minutes. Sea Analytics Pty Limited Copyright 2014 Page 24 of 24
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