Practus LLP Hedge Fund Services 

Hedge funds have always attracted investment professionals looking to go out on their own. What’s not to like? It offers an escape from the confines of a larger corporate entity and a chance to run your strategy, not theirs. Many hedge fund managers started their careers at other hedge funds or mutual fund companies. They hit the ground running with available funding, a portable track record and ability to scale. This doesn’t sound like you? That’s because being so well-equipped out of the gate is rare. We call them unicorns. If you’re not a unicorn keep reading.  We’ll line out what you need to think about in creating and marketing your own hedge fund. 

What you need to consider in forming a hedge fund 

At Practus LLP, we counsel and work with many aspiring and existing hedge fund managers, to guide them through the process of forming one. Although every client is unique, and we create solutions specific to their goals and interests, there are basic issues every prospective hedge funder needs to consider.  

1. You’ve been told wrong. You need licensing 

There is a misguided perception that if you are managing a private fund and catering only to accredited investors, you have little or limited obligations to register. Wrong. It is vital that would-be managers ensure they comply with federal, state and SRO regulations regarding initial registration and disclosure.  This is why we strongly suggest you consult with counsel while laying out your business plan, before forming a fund. 

2. Which comes first, investors or the hedge fund?

Do you incur the time and expenses of forming the fund and then look for investors and seed capital? Or do you lock down a few investors to ensure you can scale and manage separate accounts for those clients while you form the fund? The reality is that most aspiring hedge fund managers walk away from their previous existence with a few crucial investors. And that transfer of client assets is often a battle with your prior fund. So, in most situations it makes sense to seal the deal investor by investor. You would manage their accounts separately, until you have enough assets under management to scale into a hedge fund.  

3.  Make friends with Separately Managed Accounts 

We see many advantages of using the Separately Managed Account (SMA) process for smaller managers looking to eventually form a hedge fund.   SMAs differ from pooled vehicles like mutual funds in that each portfolio is unique to a single custodial account. This allows cost control while you are accumulating assets under management.  

• SMA help establish track record
  • SMAs also provide a path  to establishing a track record for your strategy. That’s key to attracting more investors. The best marketing pieces in the world and most persuasive sales pitch will not attract capital without verifiable investment performance. This track record also allows prospects to look at holdings and risk factors across the portfolio. Most institutional investors, allocators, or consultants will not even look at a manager without a 24-to-36-month track record and a reasonable number of assets under management. 

4. Begin with an end date for transitioning to a hedge fund 

We suggest would-be hedge fund managers continue the formation process with a defined end date in mind for transitioning to a fund. This way, you can earn fees while you and your service providers are doing the fund formation work.  

• Inform clients of plans to convert to hedge fund   
  • We also think it’s a good idea to inform prospects and your initial clients of your longer-term plans to convert to a fund structure. As you build your client base, you will manage them individually as SMAs. Yes, it’s unwieldy, but the investment strategy stays the same either way. The only major difference is how the custodian holds the assets. 

• Multiple accounts, one strategy 
  • With proper portfolio modeling practices, you can manage a strategy as one process regardless of where the assets are held. Keep in mind this approach requires enhanced oversight and disclosure. You’ll need to provide documents such as the Adviser’s Form ADV to assure that investors are aware of possible conflicts. 

5. What are you going to be?  

Hedge funds can take on many legal and ownership structures, whether that is a corporation, limited liability company, or a limited partnership. One of the most popular forms is the master-feeder structure. This can be advantageous when a fund is intent in taking on clients from multiple jurisdictions, most often the United States and non-United States investors. Your Practus lawyer can guide you toward the structure that best suits your organization. 

6. Where are you going be? 

Will your hedge fund be based onshore or offshore? Onshore entities are the most common and can be incorporated in any state, although Delaware is a popular jurisdiction. But there are many offshore venues for fund formation as well. Most of these, such as Cayman Islands and Guernsey provide tax havens for the fund and underlying investors. Absolutely consult a Practus tax expert to be sure your clients can reap any tax advantages. 

7. Vendors: You are who you choose 

Think of your vendors as your business partner. Their reputation is going to be yours, so do the due diligence in selecting the service providers for your hedge fund. When investors are mulling over whether to hand you their money, they will look at your vendors. And if they have a spotty or unproven reputation, investors may perceive you the same way.  

The reverse is true too. When a fund is associated with a well-respected auditor or Law firm, potential investors take comfort in that fact.    

• Choosing your Prime broker 
  • A prime broker that caters to large institutions will understandably be most responsive to to the clients that provide the most revenue.  Larger prime brokerage firms may not be that excited to work with emerging managers and may not offer the same high level of service they would to a larger fund. The key here is to look for a prime broker that has a reputation for delivering exceptional customer service to emerging and mid-sized managers. You won’t be emerging or mid-sized forever. You want a technology-forward team of advisors that will support and help you grow your business.   

8. Minimizing Risk

A key factor for many investors in assessing a possible hedge fund investment is risk, and not just investment risk. Investment risk can be measured quantitatively and there are tools available to assist. What’s not as simple: how does the hedge fund manager minimize other risks internally? 

• Consider outsourcing your CCO
  • Most emerging hedge funds cannot initially afford to hire a full-time chief compliance officer (CCO) But compliance is key. Think outsourced CCO.  An outsourced CCO can assist with tools and guidance  
• Reality is perception  
  • There are firms that will roll the dice and fold CCO duties into the role of a staffer with a different day job. The danger with this is two-fold – perception and reality. Investors may perceive that the CCO could be conflicted and distracted by the disparate obligations. It’s not a good look. And there’s a huge danger because this is likely the reality. The CCO must be seen by clients and regulators as having the necessary independence, focus, and power to make tough decisions.  

9. Coming to Fund Terms

An emerging manager must make a number of small yet vital decisions that can make or break a fund’s long-term success.  

• What fee structure works best? The immediate inclination is to use performance fees but there are other considerations for start-up managers. Accredited investors are the only people that can be charged a performance fee.  
• What limitations will the manager place on the ability of investors to redeem assets?. Whereas a mutual fund generally has daily liquidity, a hedge fund may impose instructions on redemptions.  Many managers feel that ‘gates’ that limit redemptions allow managers to best serve all clients and improve overall gains. Contrarily, investors may have concerns about the same gates putting them at significant risk if they ever needed to raise cash. 

More hedge funds fail within 5 years than succeed. The initial set of decisions you make determine whether your fund becomes are relevant to large investors (think institutions) allowing you to survive the lean years. 

Practus LLP offers a variety of services to prospective clients and more specifically investment management clients. We also offer a variety of billing structures including hourly and fixed fee arrangements for projects.  Feel free to reach out to discuss your legal needs.