Tag Archives: hedge fund formation

Hedge Fund Incubating and Seeding

Syndicated Post on Hedge Fund Seeding

As I mentioned in a previous article about hedge fund compensation, I have recently come across a very good blog called Ten Seconds Into the Future by Bryan Goh of First Avenue Partners, a hedge fund seeder.  Bryan’s posts are very insightful and I recommend all managers take a look at his writings.

The post below discusses hedge fund incubating and seeding platforms which offer managers a turn-key solution to getting a fund up and running.  As I point out in this blog from time to time, many managers neglect to really create a detailed business plan which addresses many of the business aspects of running a fund.  In this respect incubation and seeding programs are often good places for a manager who is looking to just focus on the trading.  The article below discusses some of the aspects of these programs and includes considerations for managers contemplating such an arrangement.

Please feel free to comment below or contact me if you have any questions or would like more information on starting a hedge fund.  The original post can be found here (ephasis and bolding in the original).


Hedge Fund Incubation and Seeding. A perspective for 2009.

by Bryan Goh

In the interest of full disclosure, First Avenue Partners of which I am a partner, runs a hedge fund seeding and incubation business. I generally don’t talk my own book and I don’t intend to start now, but I will speak generally about the industry without specific reference to what we do. So please read this with a skeptical eye, and if seeding sounds like it makes sense, there are a range of seeders besides FAP out there. Talk to as many of them as you can, and please feel free to tell me if I am out of my mind. With that out of the way, let’s begin:

In 2006 if someone suggested that it was a good idea to be seeding and incubating hedge funds, I would have been highly skeptical. Managers who were any good were raising large amounts of capital on their own on day one, mediocre managers were able to start with credible amounts of day one capital and even managers who while talented had no idea how to run an investment management business could get into business. The hedge fund seeder faced insurmountable adverse selection problems.

Hedge fund managers willing to give away either a share in their management company or a share of their fees tended to be of lower quality. You didn’t want to be seeding them.

Hedge fund managers of good quality but who understood the business development support role of a seeder and were happy to work with one were labelled as poorer quality and found it difficult to raise capital, so also were from a business perspective, less attractive to a seeder.

Seeding was simply a negative signal to the market all around.

In fact, seeders play an important part in the hedge fund industry. They provide all kinds of support that the fledgling hedge fund manager simply doesn’t want to bother with such as infrastructure, business development and marketing, a stable base of capital, corporate governance, risk management and a host of intangibles such as a sounding board for trade or business ideas.

Of course until the adverse selection problem was resolved, none of this really mattered. And well it should be. The adverse selection up until the middle of 2007 was severe.

2008/2009. What’s changed? Investors risk appetite has been drastically reduced. The number of new funds starting up is down drastically, the number of fund closures is up drastically. The size of the hedge fund industry has halved in size by assets under management according to several of the usual industry sources such as HFR, Eurekahedge and surveys conducted by the major prime brokers. Hedge funds which were previously closed to new investment with multiples of billions of assets under management are reopening their funds (after losing big chunks in losses and redemptions) and finding it hard to raise new capital. This it should be said, in an industry which managed to lose 20% in 2008 while the long only world lost double, and only in the second half of the year when regulated banks failed and regulators decided it was a good idea to ban short selling.

Investors are more discerning. Quality of the hedge fund manager matters. Quality of the strategy, idea generation, execution and trading, mid and back office, systems, counterparty management, liability management, corporate governance, investor management, all matter and matter more than they ever did 2 years ago when investors were happy to fund a business plan with two phone lines and a credit line.

That’s a lot of considerations for a hedge fund manager striking out on his own. What is my strategy? Will it sell? How do I represent it? Who should my counterparties be? Ditto service providers. Who should be on the board of the fund? My best mate’s uncle or an industry professional? Who are my potential investors beyond my partners and I, our best mates’ uncles and aunts? Should there be lock ups, gates, side pockets, NAV suspension rights, what are the right terms? And how do we divide the spoils?

A seeder can help. There are different seeding models to suit different manager objectives and immediate needs. Do I give up fees? Do I give up equity? What control does the seeder have? What services beyond capital can the seeder provide? Often the advice and structuring are worth as much as the capital. And if I brought all this in-house, what would be the cost of it all? Would it be cheaper than a seeder?

The raison d’etre of a seeder has never before been clearer; the value that the seeder brings never been greater.

2009 and beyond: For the prospective investor in a seeding fund, what is the opportunity?

First of all, the investor must want to invest in hedge funds. No amount of incubation economics can make up for a bad investment. Over the last 10 years, hedge funds have done better than long only equities (MSCI World), bonds (Barcap Global Bonds, the old Lehman bond index), commodities (CRB), and real estate (UK IPD all sectors) for example. In 2008, hedge funds lost less money than real estate, equities and commodities. In fixed income, depending on credit quality, you would have lost as much in credit (high yield) as in equities, or lost low single digits if you were in guvvies.

Second of all, smaller, newer funds tend to do better than the big funds. Its not always true but there are various academic studies that seem to indicate that this might be the case over a large sample of managers across the gamut of strategies. The truth is that in some strategies size is an advantage. Nothing like an 800 pound gorilla of an activist or distressed debt manager. For trading and liquidity constrained strategies, beyond a certain size the fund begins to behave like a beached whale. The real advantage with smaller funds is that they haven’t yet accumulated the arrogance that comes with multi billion dollar success to deny the hapless investor transparency, clarity or airtime. Beyond the transparency necessary for the proper monitoring and risk management of a fund investment, being in constant touch with the manager and being involved with their business and playing a part in their success is a highly rewarding activity. It is certainly why I love it.

If one is to invest in start up and new managers, there are of course additional risks. With less money to manage there is also less money to spend on systems and people. Shorter track records also make an econometric assessment harder to do. Risk of failure is higher than for a large fund, but surpringly lower than for a mid sized fund. Anecdotal and some albeit stale studies have found that while the big multi billion funds may have very low mortality rates, medium sized funds’ mortality rates can be substantially higher than that of small funds. Why is this? Big funds are well resourced and have the financial viability to maintain their resources. Also, big funds often have defined succession planning. The founding portfolio manager rarely abdicates but does take on a Presidential role rather than as lead General of the Campaign. Small funds may be thinner on resources but are likely fuller on resourcefulness and the drive to succeed. Medium sized funds exhibit high mortality probably because of lack of succession planning so that even a great track record may not survive beyond the management of the founder. Whatever it is, investing in small funds needs to be compensated over and above the returns they generate. Some seeders take a stake of equity in the investment management company, some take a share of the fees charged by the fund manager, and some take some combination of both. Some seeders provide only investment capital, some provide working capital as well, and still others provide infrastructure, risk management, marketing or other business advice.

Seeding and incubation, like so many things, is a highly cyclical business. A couple of years ago, the managers entertaining seed deals were mostly those who could not raise day one capital on their own. The number of hedge fund managers cognisant of the complexities of running a hedge fund business and saw the logic of partnering up with a seeder were few and far between. Today the landscape has changed. The pipeline of managers is supplied by both types of managers. Seeders are spoilt for choice. Where once capital went in search of talent which was relatively scarce, the world is relatively well supplied with talent. It is capital which is scarce.

Of course the competitive landscape for seeders has changed as well. The number of seeders has diminished significantly, as has the capital available for seeding. Why? It was a highly cyclical business and it was victim not of the bust but of the boom of the last 5 years. Too much money was chasing too few deals. Manager quality times deal terms equals a constant. In the good times, that constant was rather low. But the pendulum has swung the other way. Many of the deals struck in good times broke and incubation as well as incubated funds performed poorly, not always for lack of talent. More often than not, talent was abundant but non-investment support was not forthcoming or deals were structurally unsound and failed to align interests. As the tide of risk and capital ebbs, it leaves many stranded, but as it flows once more the opportunities in seeding appear brighter than ever.

In that context hedge fund seeding and incubation is a recovery play, one that if structured well, keeps paying for years to come.

Hedge Fund Law – State Law Issues

Dealing with Ambiguous State Securities Laws

An issue which often arises during the planning phase of the hedge fund formation process is whether certain state securities or investment advisory laws or regulations apply to a certain fact situation.  Many times these issues arise in the context of investment advisor registration (especially with regard to “custody” and net worth requirements), but they can also apply to less common issues (such as spot forex registration and matters involving commodities and futures licensing).  The problem is not only that the laws and regulations may not apply to a specific situation (many state laws are based on a model code which was written over 50 years ago), but also that there are no judicial or administrative actions which can provide valuable insight into how the state or the enforcement division would view a similar situation.

Unfortunately it can be very hard to receive clarification on these laws and regulations  and sometimes reaching out to state regulators can be an exercise in futility.  In a recent call with the California Department of Corporations (which is in charge of, among other things, administering the state securities laws) I was practically scolded by the staff attorney for first reaching out to the state to determine if they had any informal thoughts on my question.  In situations where we cannot receive informal guidance from a state, the client may choose to request a no-action letter from the state with regard to their situation.

Requesting a No-Action Letter or Interpretive Opinion

NASAA, the North American Securities Administrators Association, has provided this description of no-action letters and interpretive opinions:

Many state securities regulators have the authority issue “no-action letters” in which staff confirms that a transaction carried out under a set of assumed facts will not result in a recommendation for enforcement action.  Some states also issue “interpretive opinions” in which staff provides guidance by indicating how a provision of law applies to a situation presented.

Generally states will allow groups to submit either request.  The request letter will include a restatement of the applicable facts and laws and an argument as to why the requested relief or opinion should be granted.  The attorney will draft this letter on behalf of the manager.  The manager will also need to pay a fee to the state, usually $100-$300 to receive an answer to the request letter.  There is no guarantee that the state will agree with manager and grant any relief.  It will usually take a minimum of 30 days to receive an answer from the state.

Unfortunately the process is both expensive and time consuming.

Fixing the Problem

There are many problems with the federalism system with regard to securities regulation.  One of the biggest issues is the lack of uniformity between the state laws and the disparity between states with regard to enforcement.  I posted an article yesterday about what NASAA is doing this area.  I commend NASAA for taking this step forward – it will be a big improvement over the current system and hopefully will lead to more uniform laws (and application of those laws) throughout the states.  However, this is not a panacea and we are unlikely to see truly fair and efficient enforcement of laws unless there is a wholesale scrapping of the current system and unfortunately even then we are still left with federalism which provides state securities commissions with powers that most do not understand how to deal with.

Ultimately this increases costs to the managers and ultimately investors.

Carbon Hedge Funds

Overview of Carbon Hedge Funds

The flexibility of the hedge fund structure is the central reason these investment vehicles are so popular.  The flexibility allows funds to specialize on certain investment sectors or strategies, and they can move quickly to the hot areas of the markets.  One of the hot areas of the markets is the movement toward green investments and strategies.  With this increased focus on energy and related areas, Carbon Hedge Funds have become a popular investment vehicle to focus on “carbon” as a new asset class.  This article will overview the two common carbon hedge fund strategies and will also provide resources for more information on carbon trading and other investments.  Please contact us if you have any questions on the information below or if you would like more information on starting a carbon hedge fund. Continue reading

Hedge Fund Series LLC

The Series LLC

Most hedge funds are structured as either limited partnerships or as limited liability companies (LLCs).  Some hedge funds, however, are structured as series limited liability companies.  The series limited liability company is a relatively new statutorily created entity.  The series LLC is one entity with a group of series each of which is bankruptcy remote from each other series.  This means that the assets of one group or series of assets are protected in the event another group or series of assets becomes subject to suit or other action.  This article discusses the primary uses for the Series LLC in the hedge fund industry, the advantages and disadvantages of the series LLC and other issues involved with the formation of a hedge fund as a series LLC. Continue reading

Recommended Hedge Fund Articles for Start-up Hedge Fund Managers

Last week we posted our most popular hedge fund articles to date.  This week we are providing start up hedge fund managers with a “hedge fund manager start up guide” which consists of the most important articles for start-up (and existing) hedge fund managers.  The following article provide you with the background information you need to be prepared to begin the hedge fund formation process.

Our group has worked with over 200 start up hedge funds and hedge fund managers and we know the issues which managers are concerned about.  Please contact us if you have any questions on these articles.

Hedge Fund Presentation

  • Start Up Presentation – this voice-over presentation goes over most of the topics covered in the posts below.  The presentation is about 40 minutes long and discusses the basic issues involved in starting a hedge fund.

The Basics

Investors and Fees

Structural Issues

The Laws

Raising Hedge Fund Assets

Other Recommended

Start your hedge fund today with less than $1 million…

Can a manager lauch a successful hedge fund with less than $1 million in assets?  Yes.

While having a large amount of AUM when starting out can be helpful, start up hedge fund managers do not necessarily need to start with a large asset base to have a large, successful hedge fund.  Case in point – David Einhorn.  David Einhorn started his hedge fund in 1996 with $900,000.  His Greenlight Capital fund now has AUM of around $5 billion. Continue reading

Hedge Fund Formation for January 1, 2009 Launch – Start Today!

The end of the year tends to be a busy time for hedge fund attorneys as many managers are deciding to prepare hedge funds for launch on January 1.  As we’ve noted in previous articles it can take 6-8 weeks to get a hedge fund launched depending on the investment program.  Accordingly, this is a reminder to all potential hedge fund managers that it is time to start discussing your hedge fund launch with an attorney if you want to have the fund ready for January 1.

Some of the issues that will need to be discussed and planned include:

For more information please see our start up hedge fund timeline and please feel free to contact us if you have any questions or would like to schedule a consultation with a hedge fund attorney.

Hedge Fund Formation Legal Fees

Question: How much does it cost to establish a hedge fund?

Answer: The costs of starting a hedge fund can vary considerably depending on the manager and the manager’s circumstances.  A start up hedge fund manager will need to consider the hedge fund start up costs which will include legal costs, administration costs and set up fees, bank fees, prime brokerage fees, rent, etc.  This article will detail hedge fund legal fees.

Hedge Fund Formation Legal Fees

The central legal fees for a start up hedge fund manager are the costs associated with preparing the offering documents for the hedge fund.  Most law firms who provide these services will charge on a flat fee basis, depending on the novelty and scope of the project.  The cost breakdown is, generally, as follows:

Large brand name New York based law firm: $35,000 – $75,000

Midsize law firm with known hedge fund practice: $25,000-$45,000

Small or boutique hedge fund law firm: $15,000-$30,000

The above are very large fee ranges, but for managers with very basic hedge fund strategies (say a long-short large cap investment strategy) you are looking at the lower end of the fee range.  If the strategy is more esoteric or if there are many structural issues (especially liquidity and valuation issues), then the costs will be more.  Additionally, if the strategy has certain ERISA or tax issues then the cost is going to be more.

The costs above generally do not include filing fees for entity incorporation, fees for investment advisor registration, or any blue sky filing fees.

Please note that you may find groups out there which provide hedge fund offering documents for lower prices.  As when selecting any attorney, price should not be the only determining factor.  There are also offering document software sources out there which purport to create offering documents for your fund for under $5,000 – do not use such services.  The legal documents provided by hedge fund lawyers are designed to protect you as the manager and any off the shelf solution is not going to be able to provide the customized legal advice you will need to be properly protected.  I have personally seen some of these documents and they are woefully inadequate.

Please contact us if you have any questions or would like to start a hedge fund.  Other related hedge fund law articles include: