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2. investing
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HFMWEEK
S P E C I A L
R E P O R T
HOW TO START A HEDGE
FUND IN THE US 2014
INFRASTRUCTURE
Choosing the right controls
and service providers
DUE DILIGENCE
Establishing a quality investor
identification process
REGULATION
Adapting to a challenging
and changing landscape
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H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 4
T
aking the leap into hedge funds can be a
daunting task for even the most passionate
start-up manager. While the struggle to raise
capital remains as tough as ever, it is not
the only challenge facing the contemporary
launch, with barriers to entry creeping up
across a range of metrics.
In the lingering shadow of the financial
crisis, and as managers try to attract institutional investors, start-ups have
to work diligently to build a robust infrastructure. Only the right internal
controls and service providers, as well as sufficient levels of transparency,
will keep potential investors interested.
In the US, the legislative landscape continues to evolve, with Fatca
and Dodd-Frank presenting challenges for the industry as a whole. The
burdensome expectations from regulators and investors alike mean
managers face a significant strain on resources.
For most start-ups, hiring enough staff to cover the demands in legal
and administrative remits is proving difficult. The need for outsourced
services and third-party administrators has become more important than
ever before.
New managers also face the challenge of deciding what kind of
structure is right for their potential investors, as well as the challenges
associated with setting up a fund onshore or offshore, from Ucits and ’40
Act offerings, to AIFs and beyond.
With these factors in mind, it is little surprise than many industry
observers have declared the launch environment as challenging as ever.
In this, the How to Start a Hedge Fund in the US Report 2014, we speak
to several key service providers to get the latest advice on how to achieve
start-up success.
Alexis Burris
Report editor
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21
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 4
06
LEGAL
SUCCESSFULLY LAUNCHING A HEDGE FUND
15
Ron Geffner of Sadis & Goldberg explains how a new launch can be
successful in an ever evolving and increasingly regulated market
09
STRENGTH FROM WITHIN
Corey McLaughlin of Arthur Bell CPAs explains the importance of
internal controls and infrastructure to managers starting a hedge
fund
ACCOUNTANCY
LESSONS FOR NEW EMERGING FUNDS
Nick Tsafos, Mike Laveman and Jeff Parker look at best practices for
forming a fund and explain how EisnerAmper can help with the
process
12
INVESTMENT ACCOUNTING
FUND SERVICES
STARTING YOUR ALTERNATIVE INVESTMENT
BUSINESS
Frank Napolitani of Concept Capital discusses the steps involved in
starting up an alternative investment fund
4 H F M W E E K . CO M
18
FUND SERVICES
A HELPING HAND
Michael Von Bevern of U.S. Bancorp Fund Services discusses the
difficulties in starting up a hedge fund
21
FUND SERVICES
MAKING THE LEAP
Jerry Wright of UMB Fund Services answers the burning questions
managers have about launching a hedge fund
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H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 4
SUCCESSFULLY LAUNCHING
A HEDGE FUND
RON GEFFNER OF SADIS & GOLDBERG EXPLAINS HOW A NEW LAUNCH CAN BE SUCCESSFUL
IN AN EVER EVOLVING AND INCREASINGLY REGULATED MARKET
T
Ron Geffner
is a partner of Sadis &
Goldberg LLP and oversees
the Financial Services
Group. He regularly
structures, organises and
counsels private investment
vehicles, investment
advisory organisations,
broker-dealers, commodity
pool operators and other
investment fiduciaries.
Geffner also routinely
counsels clients in
connection with regulatory
investigations and actions.
he hedge fund industry has matured over the
last ten years. Now more than ever, successfully launching a hedge fund is dependent
upon selecting the proper structure and complying with the ever changing 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 demographics 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.
ECONOMIC ANALYSIS
In determining whether to form both a domestic and
an offshore hedge fund, it is advisable to determine the
amount of anticipated assets which will be invested in the
hedge funds within a few months after the launch of the
funds. In short, the anticipated aggregate investment at or
shortly after the launch of the business may not justify the
formation of both a domestic fund and an offshore fund
and to create both may 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.
SIDE BY SIDE, MASTER FEEDER &
MINI-MASTER STRUCTURES
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 mini-master. In a sideby-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.
LAUNCHING A HEDGE
FUND IS DEPENDENT
UPON SELECTING THE
PROPER STRUCTURE AND
COMPLYING WITH EVER
CHANGING REGULATIONS
STRUCTURING THE 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 a 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 of 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 taxexempt investor.
”
6 H F M W E E K . CO M
LEGAL
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 tax-exempt investors and non-US
persons. Thus, a side by side structure allows the investment manager the ability to employ 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.
STRUCTURING & DOMICILE OF THE INVESTMENT MANAGER
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 nonUS 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.
Historically, federal and state regulation often impact-
ed the location at which the investment manager maintained its office in the United States. Certain states have
compulsory registration requirements which require an
investment manager with an office in those states to register as an investment adviser prior to the launch of the
hedge fund. Prior to The Dodd Frank Wall Street Reform
and Consumer Protection Act (Dodd-Frank) certain
managers chose to maintain offices in neighboring states
which did not have compulsory registration requirements so as to avoid having to register as an investment
adviser. Post Dodd-Frank, managers have accepted registration as an investment adviser as inevitable.
JOBS ACT
The US Securities & Exchange Commission adopted
Rule 506(c) of Regulation D, which allows for issuers
to use general solicitation and advertising to offer securities, provided that the issuer takes reasonable steps
to verify that all purchasers are “accredited investors” as
defined in Rule 501 of Regulation D. Managers need to
evaluate the benefits and implications associated with
engaging in a general solicitation. At this time, there appear to be fewer than 24 firms seeking to advertise. It
remains unclear as to whether hedge fund investors will
respond to advertising.
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 practicing law in this
industry, both as an enforcement attorney with the SEC
and in private practice, I have had the benefit of witnessing many successes and failures. It is important to use
law firms with corporate, tax and regulatory experience
in connection with structuring and maintaining 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. In many cases, the
costs associated with fixing a problem far exceed the
costs of doing the job correctly at the outset. In certain
cases, the problems cannot be fixed. Q
H F M W E E K . CO M 7
Jill Calton, Managing Director, Alternative Investments
umbfs.com
Accountable
At UMB Fund Services, delivering the unparalleled customer
experience means being accountable for seamless operations.
We’re focused on timeliness, accuracy and technical
Our full-service line-up for
alternative investments includes:
+ Product formation assistance
expertise—all the while, taking into account the unique
needs of each of our clients.
By all accounts, we’re delivering value to our clients
through the responsiveness and consultative approach
that comes from working with a boutique service provider.
It’s why more and more asset managers are choosing
+ Fund accounting
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+ Tax preparation/reporting
+ Investor accounting/reporting
+ Custody*
to count on UMB Fund Services.
*Custody services provided by our
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A C C O U N TA N C Y
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 4
LESSONS FOR NEW EMERGING
FUNDS
NICK TSAFOS, MIKE LAVEMAN AND JEFF PARKER LOOK AT BEST PRACTICES FOR FORMING A FUND AND EXPLAIN HOW EISNERAMPER CAN
HELP WITH THE PROCESS
L
aunching a hedge fund can be a daunting and
complicated process, with various factors to
take into consideration and pitfalls to avoid
along the way. EisnerAmper provides services
to managers forming new funds and helps
them incorporate best practices and standards. HFMWeek caught up with partners Nick Tsafos,
Mike Laveman and Jeff Parker to find out more.
Nicholas Tsafos
is an audit partner with
25 years of diversified
accounting and auditing
experience. His practice is
primarily devoted to hedge
funds, private equity funds,
broker-dealers in securities,
registered investment
companies and investment
advisers.
Michael Laveman
is a tax partner and
member of the Financial
Services Group. He is
involved in the structuring
of investment funds and
related entities, as well as
in providing advice on the
tax complexities of financial
products and investment
strategies.
HFMWeek (HFM): What are the key considerations
for hedge fund managers starting up in the US?
Nick Tsafos (NT): Most important is regulation. Fund
managers in the US need to understand the regulations
around hedge funds here, for example the ’33 Act, ’34 Act,
’40 Act, Dodd-Frank, and JOBS Act. When you’re devising a strategy for a hedge fund you
need to keep these all in mind because regulation has control over
all the operations. In addition, the
regulations are ever-changing –
and growing.
What’s even more important in
terms of raising capital is having
a business plan. A lot of advisers
who start a fund think that if they
just talk about their strategy, investors will want to invest. That
doesn’t happen anymore. It’s very
important to develop a business
plan that talks about your business strategy, how you’re going
to execute that strategy to achieve
the rates of return that you hope
to achieve, and the capital levels to
which you want to grow. By putting everything down on
paper, you’re making and documenting decisions about
the type of service providers you’re going to need, the type
of infrastructure you’re going to build to meet the regulatory requirements, and the needs of investors.
Investors also want to see that you’re capable of executing the business plan you present. It’s very important that
you can persuade your investors to buy into what you’re
doing and that you’ll be able to do it. These elements will
set you apart from other investment advisers.
and running today than it did five years ago because of the
challenging fund raising environment. Managers should
make sure they have enough start-up capital to get them
through this period.
Building an infrastructure that can grow as the fund
grows in complexity and size is very important. Many
fund managers focus on the near-term, but also need to
spend time thinking ahead to what challenges they will
face in the future. Having flexibility in the fund documents is a critical part of this. It is also important for
fund managers not to neglect allocating time related to
setting up their management companies and incentive
fee vehicles as well as considering employee compensation issues.
Finally, making sure that you’re working with the right
service providers, with the right
experience and expertise who can
grow with your business is very important.
IT’S VERY IMPORTANT
THAT YOU CAN PERSUADE
YOUR INVESTORS TO BUY
INTO WHAT YOU’RE DOING
AND THAT YOU’LL BE
ABLE TO DO IT
HFM: How can EisnerAmper
help new hedge fund firms during
the start-up stage?
ML: We’ve been working with
hedge fund managers for more than
30 years, many of which are (or
started with us when they were)
emerging managers. We have a high
level of partner involvement from
day one. We deal with all the practical implications of starting up a new
business. A lot of start-up managers
don’t have a business plan or the expertise of running a business so we
spend a significant amount of time on the structuring issues, types of entity to set up etc. It’s something that we’ve
really excelled at for many years.
We can also provide business advice on insurance needs,
assist with IT/space consulting, provide outsourced CFO
services, and make introductions to resources which may
be able to help the manager grow. Tax planning for the
manager, especially in the estate tax area, is also a very important topic we discuss.
One particular service that we are seeing a demand for,
particularly from smaller managers, is for us to review past
performance returns. Typically referred to as agreed-upon
procedures, these attestation services can provide potential investors additional comfort from the returns the managers are touting in their marketing materials.
”
HFM: What key pitfalls should a new manager avoid?
Mike Laveman (ML): These days you need to have realistic timing expectations of getting a fund off the ground. It
probably takes two or three times longer to get a fund up
H F M W E E K . CO M 9
A C C O U N TA N C Y
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 4
current and advise them on a host of issues relevant to
their ventures.
HFM: What factors do new fund managers need to consider from a tax perspective?
JP: Within a fund’s strategy there are certain tax ramifications, such as whether the fund is classified as a trader or
an investor. This has a large tax effect on the ability to take
deductions. By better understanding the rules and their
implications, managers can structure their funds to support their strategies with optimum tax efficiency.
Certainly doing business in New York City is significant
from a marketing perspective but it is also very expensive.
Managers need to understand the pros and cons and
whether it makes sense to incur the tax costs to be in New
York. Structuring of management companies has other effects as well, such as self-employment tax and the new net
investment income tax, also known as the Obamacare tax.
Another area that’s also become very important from
a tax perspective is Fatca. Fortunately we have a lot of expertise in this area; Mike Laveman is one of the co-leaders
of our Fatca initiative. The structuring and much of the
registration obligations need to be happening right now,
so funds need to make sure they have the flexibility and
understand what they need to do under Fatca.
NT: Our clients consistently rank us very high for client
service. We’re always willing to talk about and share our
knowledge.
Jeff Parker (JP): One thing that we always stress internally to our employees and partners is that the investors in
the funds are the fund managers’ clients. Whether it’s timing of deliverables or expertise, we really pride ourselves in
advising fund managers for the benefit of their investors.
HFM: How does EisnerAmper’s service stand out or
differ from the competition?
JP: One way in which we stand out is with our size. We
are large enough to have the right amount of expertise but
small enough to still be able to provide great service. With
regard to our fund practice in general, a significant portion
of our client base is funds.
At the same time, we have substantial experience in
what I would call ancillary services, such as valuations, international planning, state local planning and personal tax
services, etc. Many of our clients see value in taking advantage of these as well – and appreciate the comprehensive
perspective it allows us to bring to their ventures. We often
find that our clients may have a relationship with a smaller
accountant who has been handling their personal work
for years, but they quickly realise that they have outgrown
them and need personal income tax preparers that really
understand the fund world.
Another thing that makes us different from our competitors is that we’ve got a very high degree of partner involvement, from the initial proposal stage to servicing our
clients. Some of our competitors may bring in top-level
people for the initial meeting, but they do not get involved
in the details of the engagement.
NT: What’s also of value are our offices in the Cayman
Islands and India, which provide us an international perspective and presence. We have the kind of expertise not
typically expected of firms our size.
JP: We also provide a lot of education for our clients
through webinars, events and publications to keep them
10 H F M W E E K . CO M
Jeffrey S. Parker,
CPA, MBA, MST, JD, is a
tax partner specialising
in advising investment
partnerships, funds of
funds and broker-dealers,
including structuring and
compliance. Jeff also advises
fund managers on personal
tax returns and planning.
HFM: What standards do fund managers need to meet
to ensure best practice?
NT: Investment advisers have to be able to show that
they can meet all the regulatory requirements and provide information to investors. They need to have a good
understanding of the business environment that they’re in
and be able to showcase that understanding when they’re
speaking to investors. We ensure they not only do it right
– but can aptly discuss the issues and nuances.
The managers also need to ensure that they understand
the investors’ needs and how those needs fit into their investment strategies as well as the operational infrastructure. Because of our experience advising clients with an
eye towards their investors, we can provide insight to
those needs.
Managers also need to have an infrastructure that gives
them a platform to support many investment vehicles, not
just hedge funds. Whatever the case may be, investment
advisers need to understand the business environment,
the implication of their structure and options, and be able
to discuss them in a manner that impresses investors. Q
OUR CLIENTS CONSISTENTLY
RANK US VERY HIGH FOR CLIENT
SERVICE. WE’RE ALWAYS WILLING
TO TALK ABOUT AND SHARE OUR
KNOWLEDGE
”
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H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 4
STARTING YOUR ALTERNATIVE
INVESTMENT BUSINESS
FRANK NAPOLITANI OF CONCEPT CAPITAL DISCUSSES THE STEPS INVOLVED IN STARTING UP AN ALTERNATIVE INVESTMENT FUND
S
Frank Napolitani
is a managing director in
the Prime Services Group
of Concept Capital Markets
in New York. Frank has
spent the past 16 years in
the hedge fund industry
as an analyst at a fund of
funds, portfolio manager
at a family office and in
a managerial/business
development role in prime
brokerage since 2005.
tarting your own alternative investment fund
is a formidable undertaking, and while it can
be an exciting and lucrative endeavour, it will
require a great deal of thought and careful
planning. Concept Capital has been involved
in new fund launches for many years and has
played a key role in assisting a large number of managers
to get started as well as to navigate their various growth
phases. Our experience suggests that when investment
managers make the right decisions early on, it dramatically enhances their success rate.
As managers embark on their new venture, you’ll want
to consider the following:
DEVELOPING A BUSINESS PLAN
By writing a detailed business plan, you will increase the
odds of succeeding as an entrepreneur. It will not only
help you articulate your investment strategy and process,
but importantly also understand the financial undertaking you’ll be committing to in order to establish and manage a sound business. Writing a business plan is an excellent way to determine whether or not the idea of starting
your new business is feasible.
CHOOSING A STRUCTURE
There are a number of legal issues to consider when
deciding how best to structure your fund management
business. Complying with applicable laws is important
throughout the entire process, both prelaunch and after
the fund/business is up and running. Selecting a fund
structure is equally critical as you’ll have to consider the
costs of varying ones and the flexibility that they will afford you and the investors you hope to attract. Among
the options are the following:
Incubator hedge fund: Ideal for portfolio managers who
are looking to incubate their investment strategy with
their own personal capital for a set period of time to build
a track record.
Domestic hedge fund: Appropriate for investment by
US-based taxable investors.
Offshore hedge fund: Appropriate for investors located
outside of the United States or tax-exempt US investors
such as qualified pension plans.
Side by side structure (onshore & offshore funds): Accommodates both domestic and foreign investors, but
could result in operational inefficiencies and slippage between the two funds.
1 2 H F M W E E K . CO M
Onshore/offshore master feeder structure: Accommodates the efficient management of one pool of capital
for the investment manager as all portfolio positions are
held in the master fund, with the feeders holding shares
in the master.
Separately managed account (SMA) platform: SMAs
allow investors to allocate to hedge fund managers without commingling assets. The investor retains control of
its assets, has complete transparency into the advisor’s
activity, and enjoys the ability to disengage from the
manager on very short notice.
1940 Act – liquid alternative mutual fund structure:
Allows hedge fund strategies to be packaged into mutual
fund structures for broader distribution into the “advice
channels” of registered investment advisors (RIAs), traditional financial advisors and wire-house brokers. These
are attractive to investors unable to, or prohibited from,
investing in private placements.
Ucits fund structure: Allows funds to operate under a
set of European directives that are aimed at allowing
commingled investment pools to operate freely throughout the European Union (EU) on the basis of a single
authorisation.
Insurance dedicated fund (IDF) structure: The insurance structure allows high-net-worth individuals, family
offices and/or corporations to invest in alternative investment funds on a more tax efficient basis using insurance products as the source of funding.
SELECTING SERVICE PROVIDERS
After selecting the fund structure you will employ, you
will need to choose the service providers that will help
you execute your plan. These include legal counsel, auditors/accountants, fund administrators, and of course,
prime brokers. As a new organisation, and with a relatively low asset base, it is widely expected and accepted
in the investment community that many of the key, noninvestment related functions in your business will be outsourced. This is a less expensive and more efficient route
by which to implement best practices throughout your
organisation.
LEGAL
If you choose a traditional domestic hedge fund structure, you will need to create the following three entities:
general partner (GP), investment management company
(IM) and the fund. The GP and IM are often organised
FUND SERVICES
as Limited Liability Companies (LLC). The GP engages
the IM through an Investment Management Agreement
(IMA) to manage the fund. The IM is paid the asset
based management fee, generally 1%-2% of assets, and
the general partner receives the incentive allocation, often 20% of net new profits.
The fund’s offering documents will comprise a private
placement memorandum (PPM), limited partnership
agreement (LPA), and subscription documents. While
drafting your fund offering documents with legal counsel, there are key issues to consider when determining
the fund’s investment terms, including minimum investment, management fee, incentive allocation, founders’
class, subscription dates, lockup, redemption notice, redemption period, and gate provision.
ACCOUNTING
Your accounting firm will provide audit, tax and estate
planning services. The accounting firm you choose
should have experienced staff, thought leadership, access
to senior practice leaders, and technology expertise.
FUND ADMINISTRATION
The fund administrator is responsible for maintaining the
official books and records of the fund and performance
reporting to investors. There are many firms offering
such services, so you will want to select one whose experience and capabilities best match your needs. Many
administrators provide a comprehensive, turnkey solution, including client on-boarding, online reporting portal, shareholder services, portfolio reporting, and performance and fee calculations.
PRIME BROKER
Because an investment manager is trading securities on
a daily basis, the prime broker often is the main cog in
the wheel of the service provider relationships, generally offering custody and clearance, execution, securities
lending and financing, and portfolio reporting services.
Some offer more extensive services, including portfolio
and risk analytics and reporting and capital introduction,
while others, through affiliates, also provide middle and
back office services and IT and office support. When
considering your prime brokerage options, it’s important
to investigate each firm’s capabilities and how the respective offerings match your specific anticipated needs.
MIDDLE OFFICE SOLUTIONS
These are the daily operational solutions that will allow
investment managers to benefit from an independent
daily workflow that includes trade capture, confirmation,
settlement, and reconciliation; trade error resolution;
position and valuation reconciliation; corporate actions;
shadow books and records; and month-end reconciliation with the administrator. As an emerging manager,
outsourcing your middle/back office operations to a
high quality partner will allow you to focus on your core
competencies and generating returns. Institutional investors also tend to appreciate the value of a third party’s
review of such matters.
MARKETING/CAPITAL RAISING
Managers need to clearly articulate their investment
strategy and investment process, and summarise the
management team’s capabilities. Building a relationship
with the investment community is a key component to
an investment firm’s growth, and this will entail identifying appropriate potential investor types and concentrating on those potential investors with the highest probability of closing. Q
Concept Capital Markets, LLC offers emerging managers a comprehensive set of solutions ranging from extensive pre-launch consulting, to custody, clearing and
execution, to post-trade and ancillary operational support, portfolio and risk reporting, and office infrastructure and IT support. As our client, you will benefit from
our seasoned team, our client centric service model, our
extensive market expertise, and our top-tier technology
platform. Concept Capital Markets, LLC is a dual registered broker-dealer and registered investment adviser
with SEC, member FINRA, NFA, and SIPC.
H F M W E E K . C O M 13
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ISSU
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14
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F O R M O R E I N F O R M AT I O N P L E A S E CO N TA C T
v email r.freckleton@pageantmedia.com
Richard Freckleton at +44 (0)207 832 6593 OR
O R V I S I T H F M W E E K . CO M FO R D E TA I L S
INVESTMENT ACCOUNTING
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 4
STRENGTH FROM WITHIN
COREY MCLAUGHLIN OF ARTHUR BELL CPAS EXPLAINS THE IMPORTANCE OF INTERNAL CONTROLS AND
INFRASTRUCTURE TO MANAGERS STARTING A HEDGE FUND
I
Corey McLaughlin
is the member in charge
of audit, assurance and
advisory services at Arthur
Bell CPAs. For 16 years, he
has helped managers in the
hedge fund and managed
futures industry prepare their
operations to satisfy audit,
shareholder, and investor
requirements.
n today’s environment, managing a hedge fund
has become increasingly difficult due to evolving
regulatory requirements, a higher demand for
transparency, and more complex due diligence
processes. For managers looking to launch a fund
in the US, the task can seem daunting. One of the
biggest challenges with starting a fund is raising capital,
which is the life blood of the manager. Yet many managers overlook the importance of having the right internal
controls and infrastructure in place to attract investors.
Given the impact of frauds on the industry, investors have
increased their due diligence procedures prior to investing in a hedge fund. In particular, investors require longer
track records and focus more on the manager’s operations.
As such, managers must be committed to establishing processes, systems, and experienced teams that build investor confidence in the manager’s ability to protect investor
money, data, and privacy.
Internal controls are crucial because investors want to
know their assets are safe. Proper
internal controls prevent and/
or detect any misappropriation
of assets. Prevention is obviously
the strongest and most desired
approach. When developing
processes around controls, managers should validate that one
individual is not able to steal or
manipulate assets of investors or
the management company. Managers should also consider if any
person in control has a self interest to commit fraud or collusion.
As managers design their internal
control procedures, they should
focus on segregation of duties.
An efficient way for start-up managers with limited resources to
segregate duties over investor assets is to involve an independent
third-party administrator that is
responsible for approving cash disbursements and preparing accounting separate from the manager. In addition, as
managers document their internal controls, they should
include policies that address investor concerns around
privacy, data protection, and employee trading practices.
Nowadays, we see managers launching funds with
fewer assets under management, so they feel more pressure to make operational decisions based on costs. Even
if starting a fund with limited resources, it’s important for
managers to think strategically about how to build a so-
phisticated and scalable infrastructure that will support
their business needs and investor demands over time. As
an example, managers should ask themselves how they
can manage the trading and investor inquiries while also
avoiding regulatory, compliance, tax and accounting pitfalls. For most managers, this means hiring a chief operating officer (COO), either in-house or third-party, that
has experience with financial operations, internal controls,
regulatory requirements and vendor selection. A strong
COO also knows how to maximise the use of reputable
attorneys, compliance advisers, administrators, auditors
and tax professionals. The guidance of experienced advisers who understand the hedge fund industry will help the
manager and COO prevent issues that can be expensive to
resolve and that might damage the manager’s reputation.
Building a team of advisers who care about the manager’s success makes a big difference. These advisers devote additional time to helping the manager through the
various start-up and growing pains that occur over the
first few months and years of
launching a fund. In particular,
the manager should immediately hire legal counsel that is
familiar with hedge funds and is
willing to collaborate with audit
and tax advisers when setting up
the fund. Legal and tax planning
are critical at this stage to ensure
that the entities are structured efficiently from an operational, tax
and cost perspective. A manager
should avoid attorneys who use
standardised templates resulting
in more complex and expensive
structures that ignore the manager’s current needs, facts and circumstances. Good legal counsel
works with the manager to strike
a balance between what works for
the manager today and what provides flexibility for growth and attracting new investors in the future.
When hiring an independent auditor, the manager
should consider auditors with a good reputation in the
industry. Also, having the financial statements of a hedge
fund audited from inception will show potential investors
that the manager takes financial reporting seriously and
goes the extra mile to ensure that the financial statements
are independently examined.
Sometimes managers make the mistake of assuming
an audit is all they need to have an effective internal con-
INTERNAL CONTROLS ARE
CRUCIAL BECAUSE INVESTORS
WANT TO KNOW THEIR
ASSETS ARE SAFE. PROPER
INTERNAL CONTROLS
PREVENT AND/OR DETECT
ANY MISAPPROPRIATION
OF ASSETS
”
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 4
trol environment. However, an auditor is only required
to gain an understanding of internal controls to assess
the risk of material misstatement of the financial statements. An audit does not test the operating effectiveness
of the manager’s internal controls to identify all of the
deficiencies. Therefore, even with an audit, the manager
needs to establish an effective infrastructure and internal
control environment.
When it comes to compliance with regulatory and
tax matters, managers should always consult with experienced compliance and tax advisers. Compliance
is one area that managers should not ignore. There are
too many industry and tax regulations for one person to
follow. If a manager misses a deadline or fails to register
properly for a regulatory requirement, the penalties can
be costly and severe. Managers should avoid any missteps that could earn them a reputation for disregarding
the rules, even if by mistake.
Setting up internal controls, building infrastructure,
and hiring a team of experienced advisers – either internal or external – cost money. So managers often ask what
level of capital is appropriate for launching a hedge fund.
There is no one right answer to this question, as it can
be facts and circumstances driven; however, we typically
recommend that anyone launching a fund under the $5m
range should consider setting up separate managed accounts until they have enough capital to absorb the annual operating costs of a hedge fund. Separate managed
accounts allow emerging managers to establish a performance track record, which is important, particularly to
institutional investors, as they try to raise capital for the
16 H F M W E E K . CO M
INVESTMENT ACCOUNTING
SETTING UP INTERNAL CONTROLS,
BUILDING INFRASTRUCTURE, AND
HIRING A TEAM OF EXPERIENCED
ADVISORS – EITHER INTERNAL OR
EXTERNAL – COST MONEY
”
fund. In addition, an independent auditor familiar with
the hedge fund industry can examine the performance
history to provide comfort to potential investors, similar
to the audit of a fund.
Once proper controls and infrastructure are in place,
managers should gain a higher level of investor confidence
in their ability to handle and protect investor assets, data
and privacy. As a result, these managers are better prepared to market to a larger group of investors worldwide.
Also, as the manager becomes more established, a scalable
infrastructure will allow the manager to grow and leverage
the procedures already established. In today’s hedge fund
industry, a manager can’t afford to not invest in having
sound internal controls and a good infrastructure, especially if raising capital is a concern. Q
WE PRACTICE LAW
BUT WE LIVE BUSINESS
Sadis & Goldberg represents over 600 hedge and private
equity funds. Above all else, we value our client relationships.
Our attorneys strive to provide excellent, consistent, practical and
efficient legal services. We distinguish ourselves from other law firms by
assisting our clients in the development of their businesses. This
comprehensive approach has often earned us recognition as one of the top five
law firms in the U.S. for our hedge fund practice. Invest a few minutes to learn
what our attorneys can do for your business.
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H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 4
A HELPING HAND
MICHAEL VON BEVERN OF U.S. BANCORP FUND SERVICES DISCUSSES THE
DIFFICULTIES IN STARTING UP A HEDGE FUND
S
tarting up a hedge fund is more complex
than the emerging manager might first realise, bearing many hurdles which need to
be overcome in order to be successful. Prospective fund managers need to understand
the difficulties along the way as well as the
best resources to provide a helping hand. Michael Von
Bevern of U.S. Bancorp Fund Services gives the full story
on what they need to know.
Michael Von Bevern
serves as a head of US
operations in the Alternative
Investment Solutions
division, having joined U.S.
Bancorp Fund Services
through the acquisition of
AIS Fund Administration in
December 2012. Von Bevern
began his career in the audit
practice of KPMG LLP and
has more than 20 years of
experience in the financial
services industry.
18 H F M W E E K . CO M
HFMWeek (HFM): What main pieces of advice
would you give to emerging managers starting out in
the US?
Michael Von Bevern (MVB): Today’s emerging managers face a daunting task. The markets are challenging,
costs are increasing, and competition for investor capital
from overseas markets along with large, well-established
US funds pose a significant barrier to entry. Additionally,
as the flow of talented traders and aspiring fund managers from investment banks increases, they face many
difficult and complex business decisions that they more
than likely are not prepared for and did not have to deal
with as a member of a larger organisation.
Putting aside how difficult it is to find qualified investors, an emerging manager is faced with many issues
related to running an entire business such as corporate
real estate, payroll, legal, business continuity planning
and regulatory and compliance requirements that are
PUTTING ASIDE HOW DIFFICULT IT
IS TO FIND QUALIFIED INVESTORS,
AN EMERGING MANAGER IS FACED
WITH MANY ISSUES RELATED TO
RUNNING AN ENTIRE BUSINESS
”
part of being on your own. In most cases, picking a trading strategy and fund structure turns out to be the easy
part. Finding the right service providers and negotiating an array of legal agreements, while trying to navigate an increasingly complex operating environment
FUND SERVICES
that has matured to the point where only the strong will
survive, only adds to hurdles one must face.
Starting up a hedge fund is much more complex than
trading is; you have to be an exceptional trader, but you
also have to be a great risk manager, good at performing
operations and have the ability to understand regulatory
issues. It’s more like being the CEO of a business. Unfortunately, the barriers to entry are pretty low in the hedge
fund business. You can start hedge funds pretty much at
will, but the successful managers are the ones who understand the breadth of knowledge that is needed to survive
in this business.
I would say to emerging managers: do your homework
and your due diligence, and perform the right tests and
checklists. If you don’t have the right partner that is culturally a good fit for you, it can be very difficult to be successful in the long term.
HFM: What are the biggest challenges facing emerging managers in the US and how they can be overcome?
MVB: One of the biggest challenges facing start-up managers is the realisation that the alternative asset business
is vastly complex and that without size and scalability,
issues such as technology, middle and back-office costs,
marketing and investor relations functions and legal
costs can be a significant obstacle to overcome. All of
these hurdles have caused emerging managers to fail to
get off the ground.
As a group, emerging managers are usually pretty optimistic on their chances for success and that optimism
and drive to create and succeed has fuelled our industry since its inception. However, given the landscape
in 2014, I recommend that emerging managers avail
themselves of the many competent and knowledgeable
business partners that exist to help guide them towards a
successful launch. To that point, I would add that identifying service providers that are true partners in your business and who are vested in your success is vitally important. An experienced legal team, focused auditors and an
independent administrator that provides the same level
of services to small emerging managers as they do for
their largest clients can make the difference in the long
term success of the fund.
HFM: What are the main trends currently in the US
hedge fund sector and how do they impact start-up
funds?
MVB: At U.S. Bancorp Fund Services, we see many of
our emerging managers dealing with a variety of issues.
The most prominent are the ability to attract investor
capital, draw on investor commitments and launch a
fund with enough size and scale to cover their cost basis. Unfortunately for emerging managers, larger, more
established funds have been more successful in attracting new investor money in the past and that trend continues today.
Additionally, emerging managers now face increased
regulatory requirements that larger managers with more
robust support systems have just finished or are still digesting. Lastly, the investor community continues to
demand lower fees, increased transparency and com-
plex reporting, requiring emerging managers to invest
in state-of-the-art technology and to outsource support
functions when previously they could forgo these costs
until they had reached a critical mass. From a new business perspective, we are seeing an increase in registered
alternative funds or ‘liquid alts’ and other investment vehicles, such as business development companies and insurance dedicated funds, which indicates that emerging
and existing managers realise the key to initial and future
success is to expand the array of strategies and products
they offer to meet investor demands.
HFM: What are the benefits of the US as a location to
start up a hedge fund?
MVB: Contrary to popular belief, it is still possible to
launch a hedge fund today in the US. Recent data does
indicate that the Asian and European markets are seeing
the largest inflows of new money, but that doesn’t mean
that a new US-based manager, with a well-designed business model and dedicated and complementary business
partners cannot be successful. Every year we see many
EMERGING AND EXISTING
MANAGERS REALISE THE KEY TO
INITIAL AND FUTURE SUCCESS IS TO
EXPAND THE ARRAY OF STRATEGIES
AND PRODUCTS THEY OFFER TO
MEET INVESTOR DEMANDS
”
US-based managers launch successfully, and the common
denominator is a focused and diligent approach to building a business that will endure for the long term and not
the next three to five years.
HFM: How do you foresee the hedge fund space
evolving in the next 12 months, particularly in relation to start-up funds?
MVB: Over the next year, I foresee a steady increase in
alternative investment products and strategies, an increase in hedge funds with more private equity-like features, such as performance fees based on carried interest
models, as well as more investor transparency and access
to data and increased due diligence. All of these trends
indicate that investors are driving the future of the hedge
fund industry. Hopefully over the next 12 months we
will see an increase in the allocation to the alternatives
asset class. My hope would be that all fund managers
will be given the opportunity to focus on more desirable technology initiatives such as client-facing portals,
trading and order management systems and middle and
back-office technologies that will actually help them to
grow their business and increase margins. Q
H F M W E E K . C O M 19
FUND 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 4
MAKING THE LEAP
JERRY WRIGHT OF UMB FUND SERVICES ANSWERS THE BURNING QUESTIONS
MANAGERS HAVE ABOUT LAUNCHING A HEDGE FUND
I
Jerry Wright
has over 13 years of
accounting experience in
the alternative investment
industry, and extensive
experience helping
clients launch new funds
and resolve operational
challenges. He holds a
minor in personal financial
planning, a bachelor’s
degree in accounting, and
an MBA from Utah State
University and is a certified
public accountant.
n today’s challenging environment, investors
are looking for increasingly longer track records,
more transparency, and are placing even more
importance on the strategies and internal controls
of a fund. As a result, prospective fund managers
must focus more than ever on having a solid strategy and building a positive, three-year track record before
considering launching a fund. Developing a great track
record and reputation for strategy execution proves resilience in the market and will be crucial in attracting large
investors.
I frequently field basic questions from potential startup managers. Many of these funds will not make it to
launch because managers are not fully prepared to enter
this space. Some hear there is money in the industry, small
barriers to entry and want to make money without having
a passion for investing, which is a common mistake. Others are more prepared to make the move and quit their day
jobs. In this article, we’ll take a look at some of the most
common questions start-up managers ask. The answers
can help them determine this industry is not for them, or
fuel them to work harder to make the leap as a prepared,
knowledgeable manager.
WHAT ARE THE FIRST STEPS IN SETTING UP A HEDGE
FUND?
The first step is determining whether hedge fund management is the right career for you. If you don’t have a passion
to invest or a great idea you are willing to sell to friends
and family in order to get the needed seed money, then
there is little chance of success. Once you are committed,
you need to establish a relationship with a reputable law
firm experienced in hedge funds to help create the needed
legal documents and offerings. Excellent legal work is not
cheap, and I recommend considering a few firms and then
letting them compete for your business. Next, you will
need to find a reputable administrator who can walk you
through the operational processes and set up controls that
will enable you to develop best practices and eventually
become an institutional investor-ready firm. From there, it
is important to establish a broker account and a bank account in order to start accepting seed money from friends
and family. Friends and family should complete subscription documents so they fully understand the terms and
risks of their investments.
WHAT COSTS ARE ASSOCIATED WITH LAUNCHING A
HEDGE FUND AND HOW MUCH CAPITAL WILL I NEED
TO BE PROFITABLE?
The cost of launching a hedge fund depends on a myriad
of factors. However, attorney costs typically range from
$20,000 to $70,000 to create legal documents for a new
H F M W E E K . C O M 21
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 4
FUND SERVICES
performance and to market the fund to potential investors.
hedge fund. You will likely need to engage an audit firm
and administrator in order to have an independent company verify the existence and value of your investments. For
a start-up fund, the fees range from $15,000 to $60,000 per
annum for an audit firm and from $20,000 to $70,000 for
an administrator. Fund expenses, such as tax, also have to
be taken into consideration, which can add up to $10,000
to $20,000. These fees can be a big drain on a start-up and
can cut into performance. Therefore, the recommended
start up capital is $10m, otherwise start-up expenses will
be too much for the fund to handle and will negatively impact performance. Some managers with limited resources
opt for an incubator fund, where they scale back services.
Once they have reached the recommended $10m, they
can officially launch.
WHAT DO I NEED TO INCREASE MY CHANCES OF HAVING SUCCESS AS A NEW HEDGE FUND MANAGER?
WHAT ARE THE OBSTACLES THAT I WILL NEED TO
OVERCOME?
When it comes to building a new hedge fund, there are
three factors that can increase your chance of having success: strategy, performance and distribution. Your strategy
is critical in the growth of your fund. It must be simple and
easy to explain to investors why they should invest in your
strategy and why you are the right person to make it work
in practice, not just in theory.
Without a great strategy it is an uphill battle to get distribution, which is crucial in raising assets. Success will
require hiring the right people to help you once you have
enough assets. Until you have the needed capital, it is difficult to hire anyone to help you market your fund, therefore
many start-up managers work double, both to generate
22 H F M W E E K . CO M
WHAT ARE SOME WAYS I CAN POSITION MY FUND TO
ATTR ACT INSTITUTIONAL INVESTORS?
Institutional investors expect the hedge fund to have a robust compliance team and system. They want to know that
funds are working with a recognisable PCAOB audit firm
that performs an independent audit and that the fund has
a reputable administrator. Having the right service providers and controls in place allows investors to have more
confidence in the fund. The controls put in place by the
administrators needs to provide both prevention and detection of misuse of capital funds. Prevention is the most
important factor. An institutional investor wants to know
that controls are in place preventing money from leaving
the fund without an administrator signing for it and making sure that money leaving is in agreement to the offering
documents.
Institutional investors require a high amount of due
diligence in considering a fund. They will run background
checks on key employees, and require that there are robust
disaster recovery standards and that the investment managers are also registered with the SEC. They expect the
fund to be fully compliant with their specific standards.
After the institution is confident that operations are in
compliance with their standards and that the strategy fits
their needs, they will then look at the track record of the
fund manager. Additionally, institutional investors need
every assurance they can really trust the manager in implementing the agreed-upon strategies and that investors’
money will not be misused.
HOW WILL THE FEE COMPRESSION IMPACT MY
START-UP FUND AND WHAT ARE THE DIFFERENCES TO
CONSIDER STARTING A HEDGE FUND AFTER THE LAST
FINANCIAL CRISIS?
At the moment, management fees are being compressed
and costs of running funds are increasing. The industry has
become more regulated and with this regulation comes
increased expenses while at the same time revenue from
WHEN IT COMES TO BUILDING A NEW HEDGE FUND,
THERE ARE THREE FACTORS THAT CAN INCREASE YOUR
CHANCE OF HAVING SUCCESS: STRATEGY, PERFORMANCE
AND DISTRIBUTION
management fees and incentive fees is decreasing. Investors are coming in with more money and expect lower performance fees and management fees so the days of starting
a hedge fund with $1m from friends and family are over.
There are increased barriers of entry into the market after
the events of the 2008 financial crisis. In many cases today,
institutions or high-net-worth individuals want to know
how a hedge fund manager performed during the 2008
financial crisis, which puts newer funds without that track
record at a decided disadvantage. Q
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