Making the Jump

So you want to start your own hedge fund? Read what a hedge fund manager says from his experience

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Feb 24, 2011
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The internet has been a great leveler in terms of demonstrating how many talented investors there are out there. There are a number of fantastic value-oriented blogs maintained by those that have "real" jobs aside from managing their own capital and value-oriented websites like GuruFocus that bring like-minded investors together to discuss various investments. It's sometimes startling and humbling to read the forums on some of these sites and see just how many good investors there are out there that can present well thought out investment ideas.

Consequently, it's not a surprise that many that love investing consider stepping out on their own to make it their profession. I've received a lot of emails since I got started a few years ago from people worldwide and of varying ages and career stages considering going out on their own. Some had a bit of a value mindset while others focused on other strategies. In either case, they wanted to pick my brain on what considerations to make when evaluating the idea of being out there on their own. In fact, I'd say that it's probably one of the most common inquiries I've received so I thought sharing some of the insights I've learned over the past few years may be of value.

Please note that for regulatory aspects, I'm speaking from the perspective of someone operating out of CT. Each state has different rules and if you are close to getting your firm/fund off the ground, you'll need to be talking to the right legal/compliance folks.

The Boring but Important Stuff: Before your next appearance on CNBC touting your next big stock, you need to make sure you're in compliance with your regulators. This stuff is very boring but can get you in some serious trouble if you're not up to speed on it. I operate in CT and the state requires that you register with the CT Banking Commission, even if you were to run a private limited partnership (hedge fund).

To register as a Registered Investment Adviser ("RIA") at the state level, you need to take the NASD Series 65 exam. If you have the problem of having a lot of capital and wanted to register with the SEC instead, you can generally be exempted from the Series 65 if you are a CFA Charterholder. I am a CFA and was when applying with the CTBC but the CTBC still requested that I take the test so it's really at the discretion of your state's regulators. It takes about three weeks to register from what I remember and you get your results immediately after the test.

Once you pass that and have submitted your compliance manual, Form ADV and related documents (ADV Part 2), and interviewed with the CTBC, you're pretty much good to go. This was the same process I had to take when running my hedge fund so it's likely that this process, at least in CT, would be the same for someone managing just a hedge fund and/or managed accounts.

Hedge Fund vs. Managed Accounts: While you're going through the registration process, you'll want to consider what investment vehicle to offer to investors. When I started, I went solely with the hedge fund route. My "advisors" were mostly friends at larger institutional-level hedge funds and my professional background was banking so I didn't have that entrepreneurial insight that a smaller fund manager could have provided so I went through the hedge fund process. In 2010, I started to offer separately managed accounts ("SMAs") that mirror my fund so as someone that has both a fund and SMAs, I think I can give some perspective on what to consider.

Going the hedge fund route is costlier compared to SMAs. My hedge fund requires three legal entities, the limited partnership (the actual fund), the general partner ("GP"), and a management company (the RIA). Some lawyers combine the GP with the management company. I used a large, well known Chicago firm and the rationale with separating the GP from the management company was (surprise) limiting your overall liability. You will need an offering memorandum, subscription agreement, and limited partnership agreement drafted by a law firm. These can run from $20k-$50k but I think you can also get it done for much cheaper by finding fund documents and paying an attorney to review those files and make the minor adjustments to match your fund's needs (fees, lock-ups, etc. tailored to your fund).

In addition, you need to pay taxes for each entity in the state you register as your organization's "home" or domicile. CT requires that if you operate in CT, CT is basically your organization's home so your entities pay annual taxes here even if you register in a state like Delaware. DE requires that you have a Registered Agent too. So assuming you were to operate in CT and have DE registration for three entities (fund, GP, mgmt co), each entity would have about $250 in annual CT tax, $300+ in DE tax, and then $100-$300 for the Registered Agent in DE for each entity. This total is not material for most funds but again, it's something to consider.

With a hedge fund you will also need to conduct an annual audit along with tax returns for your investors. Audits can run from $20k-$50k depending on the firm you use and $20k is considered a "deal." So if you have about $1MM in your fund to start and get an audit for $20k, that's 2% in performance that your investors get dinged on. I didn't want my investors to pay for my career goals when the drag on their returns would be that material so I have covered the audit out of my own pocket.

You will also need an administrator for your fund. Most charge a flat fee and then some percentage of your AUM on top of that. An administrator handles your investor subscription process and basically fulfillment process (distribution of statements, audits, etc.). It's sort of the middleman between your investor, your fund, and necessary entities (prime broker, auditors). These fees can range from $10k-$50k+ depending on the fund size and often have a flat fee combined with a percentage of AUM.

You also need a broker/prime broker which is where your fund executes its trades. You can use discount brokers and I know plenty of funds that are very happy with firms like Interactive Brokers or go with smaller prime brokers. One big trend in recent years was what were called "introducing" prime brokers whereby the prime broker would manage all of the reporting and interface for the fund but custody the fund's assets at a big firm like Goldman Sachs or UBS and then offer the fund manager access to the specific trading platform offered by the bank (i.e. REDIPlus is what GS uses). I think this is still how a number of them operate.

With prime brokers, it once again comes back to cost. It depends on the prime broker but some may charge you a monthly fee for using their trading platform. Small hedge funds are loss leaders for prime brokers. Even if the fund trades a lot, it won't generate much for the prime broker unless the fund can grow, turning into a more meaningful relationship for the broker. Some prime brokers also expect a certain level of monthly trading to occur so if you are a bit more value-oriented with low turnover, then you could be even less attractive to the prime broker.

Another factor to consider is that the custodian is usually a large bank. If they alter certain aspects of their relationship with the prime broker this can impact your fund. I think the smaller prime brokers are better funded and have probably learned a lot from the past few years but I had my fund with a small introductory prime broker that shut down in 2008. It was run by experienced people and used Citigroup as a custodian but when all the hedge funds it had as clients shrank, its income dropped significantly making it difficult to pay their vendors. While there was no impairment of any hedge fund assets, it was a huge nuisance to transfer the assets over (especially in 2008) and the transfer from brokers made the accounting process that year a bit more of a hassle.

That pretty much covers the major costs to consider with a hedge fund. You'll have that one time hit of getting the legal documents up and running but as I mentioned above, there are ways to save on that. However, every year you'll have your administration, audit, and prime broker costs (assuming they charge you for access to the trading platform). As a fund manager you'll need to figure out what you pass on to your investors through the fund and what you absorb personally. If you have a $5MM fund out of the gates, then even $50-100k in annual fees (excluding the one time legal doc fees) is 1-2% in expenses before any possible management fees you may impose for running the fund. The good news is that these costs can be leveraged as your AUM grows.

This brings it back to having an idea of what your time horizon is for your venture to work. If you have a five year plan and are starting with a modest level of assets and you don't want to have your investors fund your career dreams/goals, you will need to be prepared to front a fair amount of costs for several years.

In comparison to a hedge fund, SMAs offer a pretty cost efficient way to give yourself a shot at running capital without needing as large of a personal war chest. For SMAs you basically need to register as a RIA in your state along with the necessary paperwork (Form ADV, compliance manual) that that entails. You are likely to only need one legal entity (your management company) and you are pretty much good to go. Keep in mind that this is my knowledge from being in CT, other states can vary.

With SMAs your firm is granted limited (of full) power of attorney over a client's account so you invest that client's capital as you see fit. My SMAs and fund mirror each other so there's little tracking error between each SMA and the fund. I bill each client on a quarterly basis and it's pretty straight forward.

Your costs for being an RIA on an annual basis would be about $300 for your management company (the RIA) registering with FINRA/IARD and then the same fees for CT and DE (if you dual register). I'd also recommend using a third party compliance company which can run under $5k per year. These firms are in some cases run by former securities attorneys and they keep up with any regulatory changes you need to keep track of. They also know the key people within your state's regulatory bodies and what to expect with certain regulatory processes so it can be well worth it. Overall, your costs on a shoe string budget could be below $10k per year.

I have advised some that are starting off to go with SMAs because it's easier and less costly. In addition, as an RIA with SMAs you can market your performance much easier compared to marketing (really not allowed) with hedge funds. That makes it somewhat easier to raise capital. If you can make the SMAs "work" from a business perspective, where you have say $10MM in AUM where you charge say 1.5% and generate about $150,000 in annual revenues, then you can deploy that into start up costs for a hedge fund if you want. In addition, with $10MM in AUM you'd probably have a nice little investor base/network developed that could roll their SMAs into the fund and/or provide referrals. The point is even $5MM in SMA AUM can help defray the costs of running a hedge fund for the first few years.

The downside of SMAs is that it can be a pain to trade each account without the right brokerage. I have heard Interactive Brokers is very good, if not the best, at making trading multiple accounts easy. Another downside is that a hedge fund provides more flexibility. As the general partner of a hedge fund you can do anything you want within your fund's documentation. My background is in leveraged finance and I would consider deploying some capital in take privates if the opportunities arose with small businesses. You don't have that same option with SMAs. However, the chances of investing in one small business is pretty low so overall it's not a huge issue.

Another downside with SMAs is that it can be difficult to leverage trading costs and certain portfolio positions would not be worth establishing. If someone invests in a pooled vehicle like a hedge fund, it doesn't matter if it's a $25k investment or a $250k investment from the aspect of what positions you can establish. However, if you offer SMAs, a $25k SMA may not work if you have ~30 positions and/or short because the frictional costs could be an obstacle.

Another potential issue is that SMAs are fully transparent to your investor. This is more related to developing the right investor base for your strategy, but an investor can see what you are buying/shorting/selling and could ask why or pester you. That is not the case with a hedge fund. From my experience, my investors have largely not asked about what transactions are made.

Be an Original Thinker: I always find it interesting that so many value investors can quote Buffett and tell you what he had for breakfast but then when you talk about portfolio holdings, they all hold BRK and a bunch of investments easily mooched off 13Fs. If you are managing $1MM, what incentive does an investor have to take give you capital versus just using something akin to some service that GuruFocus offers or investing with a large cap value fund? The bottom line is generating returns, but if the business component succeeds or fails, it's usually more satisfying to succeed or fail with your own picks.

I think being able to think critically and not deify every big time fund manager helps one develop as an investor and can also avoid some big mistakes. When Pershing Square invested in Target Corp ("TGT") in 2007, I took a look at it and was able to pick it apart fairly quickly. I posted a few thoughts on it on my blog and the most curious thing was I got a lot of critical emails from what should be independent minded value investors. I also sold Sprint-Nextel ("S") a little after Q3 2010, only to hear about Greenlight Capital establishing a stake in it. I've received a few "you moron" emails but I think investors, particularly those fund managers starting off, can benefit from developing their own, independent view, uninfluenced by fund managers with big names.

Get a blog going: You don't need to give up the family china but putting out some public analysis of some of your holdings and/or investment philosophy can be very helpful. It's a good marketing tool and also helps you outline your thoughts with a particular investment.

Network: This is a bit of a "duh" comment that you hear with almost any profession but one thing to note is that for value investing, there's a bit of a captive audience. People either get it or they don't and you don't want the investors that don't get it. So it helps to get entrenched within the broader value investment community. Also network and reach out to various fund managers. A lot of fund managers are willing to help and give advice to aspiring investors and sometimes if you get a fund manager on the right day, he/she can help stake you.

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