SF Managers Talk About Starting a Hedge Fund

On September 16, members of the San Francisco investment management community gathered at the Ritz-Carlton to listen to four hedge fund managers talk about their experiences starting a hedge fund.  The event was sponsored by the San Francisco CFA society.  The event sold out prior to the event and the attendees seemed to be mostly CFA charterholders and other future hedge fund managers.  The moderaters, two CFA charterholders, asked pre-prepared questions to the managers and opened the panel up to questions from the audience at the end.

The following are some of my notes from the event.  Each bullet point is a talking point from an individual manager who I have chosen not to identify as I do not have their direct permission.  Since these are notes, I am paraphrasing the thoughts of the managers and I may have modified the comments slightly so they make sense in the context of this post.  Many of the points below are quite good and focus on the business and operational matters of running a fund which are very important.

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Is there a certain background that is helpful to be a hedge fund manager?

• MBA and CFA charterholder are good designations to have, but it is also about experience and attitude – being able to jump into a new and difficult situation is important.
• Being a manager is about differentiation and having a distinct strategegy.  Whatever is different in your background is what you should emphasize (e.g. Ph.D).  You should put out your qualifications and background.
• A CFA is not a necessity, but you should differentiate yourself because there are so many funds out there.
• A manager does not need to have a cookie-cutter background.  Managers should emphasize what will help them to outperform other managers.

It is common for successful hedge fund managers to start at a large firm, build a reputation and then start a fund – what are your thoughts?

• It does help to go that route because investors know the manager and have worked with the manager previously.
• Most people who are very successful do come from large firms.  However, launching a hedge fund now is different than it was in the 90s post market crash and Madoff.

What motivated you to start your own hedge fund?  Was it the glamour, money, challenge?

• Professional challenge – liked the work but thought that “I could do better.”  It is also fun to run a company and be an entrepreneur.  Glamour is irrelevant.
• Glamour is irrelevant.  The personal challenge is a central part.  Being able to make your own schedule and be your own boss is important.  Being able to determine the course that the fund will take is important.
• There is no glamor in being a start-up fund manager.  Motivation came from knowing that you can offer something to investors that they can’t get from other groups.
• The motivation was that it is intellectually challenging and it is rewarding to run your own business.

How do you transition from being an employee to being an employer?

• For one manager, it was easy because they cam from a small firm (6-7 people).  The key is that you need to be the master of everything – trading, researching, marketing, etc.
• For another manager who came from a larger firm, he had a range of duties at the previous firm so it was a relatively easy transition.

What is your investment process, edge and benchmark?

• Long/short absolute returns.  Don’t benchmark.
• Benchmark against the HFR Long-short equity index.  However, the index is not always a good indicator because of survivorship bias.  The HFR is also usually long-biased.
• Benchmarks usually provide an idea of what would be a low-cost beta for investors.  For the particular stategy, it would be the Goldman Commodities Index.

Did you go it alone as a manager or do you have a team?

• It really depends on your situation.  For us (team with 2 principals), we worked together for 10 years and liked working together so it was natural to start the fund together.  We started as two persons at my house planning things out.  We slowly started hiring people we knew previously and gradually built out the team.  We needed help on the business and operations side.
• I went alone by choice.  Other people didn’t have the capital to go 2-3 years without a salary.  You need to know if you can afford to be in a start-up.
• I went out on my own because of the investment process – it is systematic so there is not a need to have other people.  About 9 months in, I had to hire someone to do marketing and investor relations.
• I stated on my own and then hired people.  You have to hire people you like and want to work with.  Other hires came later and for various reasons.

With respect to compensation – how do you divide profits with the team?

• There is a certain percentage which is devoted to profit-share with the employees.  Profits outside of that are divided by the two principals of the management company 50/50.
• It is difficult to figure out the compensation because the principal is the one who really puts everything on the line.  Generally you would give a small portion of the management company to employees and then let that grow over time.
• Compensation depends on the facts of the situation.  Each negotiation is different.

Did you invest your own capital in your fund?

• Yes
• Yes.  Also had investments in the beginning from the father and father-in-law.
• Most start-up manager have their own capital invested in the fund in addition to family and friends.
• Yes – about 70% of non-retirement assets in the fund.

Who do you get to invest in your fund at the beginning?

• Friends and family; those who know you well and trust you are more likely to invest.  Also, people in the industry who know you and your background are usually good groups to help.
• People who you have worked with in the past.  Also, talk to everyone including capital raisers.

How do you get high net worth investors to invest in your fund?

• There are two routes – (1) find large institutions to invest large amounts or (2) be really good at shaking hands and developing personal relationships.  If you can develop good personal relationships this is great because the money is usually sticky.  Institutions are tough – you’re checking boxes, on phone calls, etc.  Also, the people who work at institutions move from allocator to allocator so you can get into the situation where you are talking to an institution for a while and then you essentially get dropped because your point person moves jobs.  One reason LinkedIn is such a good tool is that you can always keep up with where a person goes.

How do you get in front of investors?

• Beg, plead, try to get others to vouch for you, cold call.

Follow-up:  what is the batting average for cold calls?

• Very low – 1 out of 50.  If you do get money, it is a process.  My two biggest clients came from short meetings with the right people.  It was serendipitous, but perseverance is key.

How much time do you spend trying to raise assets?

• 30 to 35% of the time.
• It is tough to do everything.  Portfolio management takes say 60%, sales and marketing takes 60% of your time.  Now I hired a marketer to take weight off.  There are a ton of investors out there – probably 100 people in Silicon Valley with a million or more – but not all will invest…
• Maybe 20% of the time is devoted to fundraising.

What about 3rd party marketers?

• You should be aware of the selling agreement.  You want to be careful with respect to scope – you don’t want them to send you a phone book of potential investors.
• 3rd party marketers are good because they are doing something that I cannot do or do not have the time to do.
• With respect to how much you pay these groups, it will usually be 20% of all revenues that are attributable to the assets they bring in – it is better to get 80% of something instead of 100% of nothing.
• I’ve had both good and bad experiences with these groups.

The common statement is that if an investor doesn’t bite in 2 days then they won’t invest – is this true?

• No, I’ve had a group that has been receiving my monthly statements for a long time but eventually they invested.
• Some institutional investment cycles take years.  If you are a new firm they are not just going to invest right away.  It is worth it to keep up the communications with these groups.
• Sometimes you have investors who say they will invest and then get sidelined.  Sometimes you have someone who pops up out of the blue.

What is the length of the investment cycle for a high net worth investor versus an institutional investor?

• Yes, high net worth investors will likely invest sooner.  RFP (request for proposal) – if you don’t know what this means – learn it.
• With respect to institutions, they look not only at return risks, but the persons who make the investment decisions are also concerned about losing their job.  There is an asymmetrical risk-reward system for these people.  No one gets fired for buying IBM and this is why some managers will continue to get money (e.g. the guys from LTCM and Brian Hunter).

Dedicated sales person?

• I am not a good salesperson so I needed someone who could do this for me – I took it too personally.

Do you have thoughts on seed money?

• We thought about it and in this environment, it is helpful.  Right now you are competing for capital with funds which are now open (and which have traditionally been closed to new capital).  Having a seed investor allows you to get on the radar and the seeder can be a reference, provide credibility and also do initial due diligence (which will also be completed by institutional investors).  It is similar to ventural capital where it is worth giving up some economics for a change in the trajectory of your group.  With respect to fees, it will really depends on the facts of your situation and there are no standard terms.  Some seed deals range from 20-30% of revenue.
• Different seeders have different economics.
• Generally a good rule of thumb will be 1% (of the management company equity) for each million they invest in the fund, but again it depends.
• The market is in the seeder’s favor, not the manager’s.

What is the hardest question you’ve been asked when raising money?

• The big issue that many managers have when raising money is that their presentation is too long – manager’s need to sharpen their focus.

Where are you domiciled, what are your fees?

• Standard fee structure and organizational structure.
• Started with a stepped or graduated performance fee where the investors benefit, but it was too complicated.  The investor actually wanted something standard.
• We went with a standard fee structure and have a Cayman master-feeder.  Terms are standard.  Managers sometimes spend too much time with structure – just go with the standard.
• In addition to a fairly standard structure, the manager also does separately managed accounts (SMAs) for investors who want increased liquidity and transparency.  The common saying is that the manager will charge what the market can bear.

Audience Questions

Would you be affected if Congress changes the tax rate on the carried interest?

• For us it is not a big deal because we do not have long term capital gains in our structure.
• For our program (futures/commodities), there is 60/40 taxation so tax on the carried interest is not really an issue.

With respect to due diligence, has it changed recently?

• People take due diligence seriously and it can take a long time to complete.
• Watch out for the “toxic allocator” that asks for way too much information.  Be careful with your time and ask yourself if what is being requested is reasonable or just wasting your time.
• The allocators who say that they “meet with everyone” are probably not worth your time.  Many institutions require the person who is making investment decisions to meet with a certain amount of managers – many times these persons know who they are going to allocate to, but need to meet their meeting quota.
• One good issue that was discussed during the due diligence process was the succession plan.  For a one-man management company, having a succession plan in place makes good business sense and makes investors comfortable.

What is the minimum amount you take in a separately managed account?

• 5 million.  You’ve got to take into account the hassle associated with SMAs and your bandwidth.  Other institutions will also ask you how many SMAs you are managing.
• Smaller amount, but that is because economics and business are different.

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Other related hedge fund law articles:

• Hedge Fund Articles – this is a compilation of some of the more important articles on this site with respect to structuring a fund, operational matters and fund raising.
• How to Start a Hedge Fund
• Summary of Hedge Fund Laws

Cole-Frieman & Mallon LLP, a hedge fund law firm, sponsors the Hedge Fund Law Blog.  Bart Mallon, Esq. can be reached directly at 415-868-5345.