How To Start A Hedge Fund? What Is The Basic Purpose Of Hedge Funds?

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How To Start A Hedge Fund

What is hedge funds?

Hedge funds are not for the faint of heart. A hedge fund manager takes a bet that something will happen, then times the purchase/sale of assets to capture any profits after the fact. This requires outstanding skill and risk management expertise which makes raising capital extremely difficult.

But if you have an excellent track record at one of the top equity long/short shops or derivatives-focused firms, this may make your life easier since LPs (limited partners) are looking for managers who know how to generate returns.

First step would be to determine whether you are interested in managing money for large institutions or wealthy individuals. Managing money via a private fund has different tax implications and legal/regulatory oversight.

Managing large pools

Most hedge funds try to raise a lot of money say $200 million from a large pool of LPs. While this can be difficult, it also has its merits because it removes some of the stress of performance since you have a diversified investor base that is unlikely to all walk away from your fund at once. This makes managing larger pools of money easier as well.

Managing small pools

Managing smaller pools of capital reduces costs associated with marketing and operations, but increases capital-raising difficulty and pressure to perform even more because a single LP walking means a lot more in dollar terms for a fund with only $20 million under management than one with $200 million.

Start from small and then grow

But if you want to start small and grow your fund over time, smart LPs will be much more interested. You can also try for a hybrid approach: e.g., you raise $50 million from a few LPs up front, then after generating returns for 2 years, go back to market and offer them an option to invest another $100 million as part of the same fund or as a separate vehicle that will have its performance reported via the first fund once deployed.

This has the added advantage of allowing you to hire additional analysts right away since there are extra assets in which to base them on-staff initially while laying down seed capital, instead of being forced to wait until you raise enough to support them.

A typical fund structure would be as follows:

  • Minimum investment size: $5 million
  • Management Fee: 2%/20% on all assets under management. Typically waived for first year or two, or prorated.
  • Performance Fee: 50% of profits on amounts over a high-water mark, usually 4 to 5 times the initial investment
  • Carried interest: Typically 20%, but could vary based on structure of LP agreement
  • Incentive fee is accrued monthly and payable on quarter or year end depending upon fund structure.  It can be paid in cash, shares, etc.

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First Year Bonus

A bonus equal to 1/2 of management fee on first anniversary date is typical. It’s subject to recoupment if certain returns are not met during first two years (usually 0%-10%), though this clause varies widely by manager, LPs, and geographic location (e.g., UK managers tend to forego this entirely).

Management Fee Waiver

A certain level of assets under management is required in order for the manager to waive his fees.  This threshold can be negotiable, with some LPs requiring more (e.g. $250 million), and others allowing for smaller levels (e.g., $100 million).

  • Lockup Periods are typically 1-2 years after initial close on fund raising, but could be more.  
  • Redemption Rights vary widely by LP agreement depending upon type of stake being held (passive vs active). 10%-50% per year usually on quarterly or annual basis is typical range. 10%) Other Fees – There can be a number of additional fees to consider:
  • For instance, late reporting/cure periods could be negotiated and can vary widely. Many managers charge 1% per month after due date for all missed reports and expenses not previously reimbursed. Others waive this fee and only charge 1% if investor withdraws without cause once the lock up is lifted (usually 1-2 years).
  • Other “one-time” fees such as $25,000 special servicing charges on certain assets, legal fees, etc. may also apply.
  • Legal fees can vary widely depending upon the work required for setup, fund documentation, etc.

Operational Costs

You should budget an initial allocation to cover these costs. This typically includes at least 2% of net new money allocated to operational expenses for first 12 months, plus other items such as rent, furniture/fixtures/equipment, utilities, bank fees, HR related expenses, travel & entertainment (T&E), internet access charges etc., software licensing fees if using third-party platforms for any back-end processing needs etc.

How to start hedge funds?

There are several ways for an individual to start a hedge fund. Most of the below requires that you have access to existing fund managers, rich individual investors or other professionals. Starting directly with investing your own money is one option but it carries huge risk.

Here are the options:

  • Go find a reputable asset manager/hedge fund firm and ask them if they will give you seed capital. The success rate of this approach is low, even if hedge funds do open up their doors to new talent because their main concern is not necessarily finding good people but just keeping up with the hotshots.
  • Attend conferences and meetups to get in touch with fund managers, asset managers, prop traders etc. The hedge funds that attend conferences are usually the larger ones that can afford it or already have a presence in the area where the conference is held.
  • Network with other individuals who may be interested in starting or investing in a new hedge fund. Networking is important for two reasons: one, you will likely need seed capital from you know; secondly, you are likely to need his or her advice.
  • Find an investor who is interested in the space that your hedge fund will focus on. The idea here is that if an individual has significant money already invested in certain companies or industries (i.e., Google (GOOG)) they may be inclined to let one of their employees invest some of their own money too.
  • Make your own money (i.e., get very rich by starting a business or working at an investment bank) and then start your own hedge fund.
  • The success rate of this strategy is low because to make one’s way up the totem pole, people usually need connections that will give them access to highly sought after trading opportunities.
  • Go work for an existing hedge fund, asset management firm or prop trading firm and break off on your own.
  • A person only needs $250000 in liquid assets (or $5 million in net worth that can be converted into liquid assets) under his/her name to get into this game; most reputable hedge funds do not take on any more than 5 to 10 new people a year.

 Frequently Asked Questions

  • How much money is required to put in hedge funds?

Approximately from $25,000 to $100,000 money is required to put in hedge funds.

  • What is the profit of hedge funds?

The profit is 20% profit on managing the assets.