Starting a Hedge Fund as an Emerging Manager
Emerging managers face various challenges in their pursuit to start hedge funds. There are a multitude of issues to consider, from planning how to raise capital to choosing service providers to support the business. With a limited history to rely on, managers need to demonstrate an ability to generate returns for potential investors whilst meeting the ever-changing demands of the regulatory environment.
Table of contents:
Raising Start-up Capital
Capital raising has drastically changed over the years and is proving to be increasingly challenging for emerging managers. Although attracting investors and raising substantial amounts of capital may seem like an overwhelming process, there are various alternatives that they can explore.
|Raising Start-up Capital|
|Friends & Family||Seed Investors||Founders' Class Shareholders||Capital Introduction Groups|
|One of the first places that emerging managers look to raise money from is friends and family.
As with any other type of potential investor, managers should be ready to discuss in detail the fund's structure, investment strategy and service providers.
|Seed investors (or "seeders") provide emerging managers with early stage capital and in some instances may also provide additional support services, such as marketing, in exchange for an agreed-upon percentage of the fund's revenue (which may include a share of both management fees and incentive fees).
In some arrangements the seeder may acquire a portion of the management company and/or general partner entity. This may contain a provision for the fund manager to buy out the seeder's interest in the future.
|Funds frequently offer a separate class of shares with preferential terms and reduced fees to their initial investors.
Funds typically adopt a '2 and 20' compensation model under which the fund manager charges management fees equal to 2% of the total net asset value, and is allocated incentive fees in the amount of 20% of any profits earned by the fund. Founders' class investors are instead charged reduced management and/or incentive fees.
Generally, this share class is closed after a certain period of time has passed or once a certain amount of capital has been raised.
|Capital introduction groups help emerging managers market themselves and aid in better aligning the fund to the most suitable investor demographic based on the fund's structure and investment strategy.
Prime brokers and third-party marketing services often take the form of an intermediary by linking emerging managers to potential investors.
Emerging managers can make use of capital introduction groups to gain access to investors that would otherwise be hard to reach, such as retirement and pension plans, trusts, endowment funds, and other large institutional investors.
Under the Investment Company Act of 1940, private funds, which are excluded from the standard registration requirements of the SEC, are commonly categorized under two sections of the Act: sections 3(c)(1) and 3(c)(7) ("3C1" and "3C7" funds). Initially, since an emerging manager tends to attract friends and family to their fund, they generally set up a 3C1 onshore fund. As a 3C1 fund grows, the manager can form a 3C7 fund and transfer those partners that qualify to the 3C7 fund so the total number of investors is able to grow. As tax-exempt and offshore investors are attracted to the fund, the manager would then consider opening an offshore fund (either 3C1 or 3C7). U.S. tax-exempt investors typically subscribe to an offshore fund, as the corporate form of the offshore fund enables the blocking of any unrelated business taxable income (UBTI) from flowing through to the tax-exempt investors. A fund manager may then consider opening a master fund and have both the onshore and offshore funds as feeder funds as each begins to mature, which would eliminate the need for two separate investment portfolios.
Management Structure Considerations
- The fund manager also has to decide the structure of the general partner (GP) and the management company, which are usually set up as pass-through entities. The structure chosen may have tax implications with regard to self-employment tax and net investment income tax.
- Inception may be the best opportunity for estate planning as business valuation is typically at its lowest point.
- There might also be tax ramifications if the GP and management company are not set up separately. For example, if the fund operates in New York City, it is important to set up different legal entities for the GP and the management company so the incentive allocation received by the GP (usually 20% of income) is not tainted by the management fee earned by the management company (usually 2% of capital), which is currently subject to a 4% tax in New York City (net of operating expenses).
Being able to clearly articulate a well-defined investment strategy is paramount to capital raising, and may also influence the ultimate fund structure and selection of service providers.
Understanding the tax implications to a fund's stated strategy is another significant step when starting out. Whether the fund is classified as a 'trader' or 'investor' can have deep tax ramifications. Different financial products or trading strategies may generate significant book/tax differences. Further, certain types of investments are potentially subject to state and/or local taxes and may have additional tax consequences for foreign investors.
Service providers play important roles in the various life-cycle stages of a fund, as they provide the advice and expertise which shape the fund for its lifetime. Below is a glance at some of the appointments an emerging manager needs to make to help provide for the needs of investors.
Operational due diligence has continued to grow in importance and has become a key element during the decision-making process of investors.
When an investor is considering investing in a fund, they are giving consideration to historical performance, investment strategies, how the manager operates their business, and the organization's ability to provide information. Key areas that an investor will consider while conducting operational due diligence include:
By concentrating on these areas, hedge funds managers are able to demonstrate transparency, reliability and alignment of interests with their investors.
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