All too often start up hedge fund managers do not realize that starting a hedge fund is really starting a business and that considerations need to be given to managing the business as well instituting the trading program.  In a perfect world the hedge fund manager would be able to simply implement his program and have all of the back office, IT, compliance and other services outsourced.  One option obviously is a hedge fund hotel which provides this type of support to beginning managers.  For those managers who do not use hedge fund hotels, greater emphasis needs to be placed on understanding the business they are getting into.

While the offering documents (private placement memorandum, limited partnership agreement and subscription agreement) inform potential investors about the hedge fund’s investment program (the product), it is not a business plan for the hedge fund management company which is in charge of implementing the hedge fund’s investment program.  Most start up hedge fund managers do not have a business plan and I have always wondered why.  Even an outline of the expected costs and income would help many managers understand what exactly they are getting into and it will also help them to understand how they will make money – if the expected costs exceed the expected management fee then the manager is relying on the performance fee to stay in the black.  This may be fine during bull markets, but we’ve seen recently that even the best hedge fund managers are down this year.  This makes having a strong business plan even more important.

Besides drafting a business, I recommend that hedge fund managers take a close look at expected costs during the first year.  After the first year the hedge fund manager may want to talk with a hedge fund consultant on ways to grow the business, from a structural as opposed to asset raising perspective.  Survey’s, like the survey described below, will help a hedge fund manager to realize the drag that costs can have on the management company’s profitability.

Hedge Fund Survey on Costs

KPMG just released a survey on hedge fund costs.  A description of the survey can be found here and states:

Hedge Fund Cost Survey — A U.K. Perspective explores the cost base structure for small to medium-sized hedge fund managers, looks at managers’ appetite for outsourcing and where costs are expected to change in the future. Participants in the survey were London-based; with US $13 billion in total assets under management, with a significant proportion under US $1billion. Twenty hedge fund managers took part in the survey, which included hour-long interviews and completion of a questionnaire.

This survey points out that understanding costs is important for two reasons.  First is profitability.  Second is because investors are becoming more active in asking questions about the manager’s infrastructure, including costs.  As we’ve detailed in other articles, increased due diligence is a trend which should continue.   The survey outlines three driving forces in the hedge fund industry in the near term, they are: (1) the current credit freeze, (2) potential future regulation, and (3) increased middle and back office support from hedge fund service providers.

Increased support from hedge fund services providers may be the most important for the hedge fund manager.  To the extent that the manager can outsource many of the functions which take time away from the trading desk, the manager will.  As stated in the survey,

“Increasingly managers are looking to move to a more variable cost model, geared to activity or performance. The services and technology offered by service providers have expanded from monthly NAV calculations to ‘full office’ support including daily valuations, compliance, risk management, front-to-back office processing, premises and IT. Managers are able to outsource more of their operations, providing flexibility and leaving them free to focus on performance. The high fixed cost elements of operations, particularly for small to medium sized firms usually make a clear business case for outsourcing in financial terms alone.”

The full report can be found here.  Please contact us if you have any hedge fund start up questions.  Other related HFLB articles include:

• Hedge Fund Managers
• Hedge fund management fees
• 5 challenges to raising institutional assets
• Hedge Fund Hurdle Rate
• Hedge Fund Due Diligence
• Due Diligence 2.0
• Hedge Fund Prime Brokerage
• Start Up Hedge Fund Timeline
• LP and LLC Fund Taxation
• Hedge Fund Structure: LP and LLC Issues
• Advantages of Hedge Fund Structure
• Hedge Fund Auditor
• Hedge Fund Administrator
• Hedge Fund Attorney