With over 10,000 hedge funds out there managing about $3 trillion in investments, many managers don't know where to begin.  While some will spend countless hours just trying to launch their fund, others choose to let professional consultants do most of the ground work.  At Hedge Fund Tools, we will chart the course together.  Here are a few of the steps we will need to take:

Finding the Right Attorney 

With all of the special licensing requirements associated with hedge funds, it is important to find an attorney that specializes in the industry.  The first thing you will do with your lawyer is devise the master plan.  The location of the fund, investment adviser registrations, and any areas that need further planning will be addressed.  Once the plan is charted, the attorney will construct several documents.  The first is the Offering memorandum, also referred to as the Private Placement Memorandum.  This document is appoximately 60-70 pages and is essentially the heart of your hedge fund.  The offering memorandum lists all of the fees associated with the fund, outlines the fund’s strategy, lists the services providers, and is the basic operating manual for your hedge fund.  These documents must be written in a clear, concise manner, and all terminology must be defined so that the investor may make an educated investment decision. The second set of forms that your attorney will produce is the Subscription Documents, usually about 20-30 pages.  Since there are many requirements for an individual to invest in a hedge fund, the investor must sign these documents asserting that he/she meets the prerequisites.

Constructing the Business

General Partnership

Also called the Investment management firm, this entity is set up to form and advise the hedge fund.  The general partners will control the investment strategy.  These partners get to collect all the fees and bonuses associated with the hedge fund.  Usually an incentive fee of 2% is collected, along with a performance fee which ranges anywhere from 20-40%. 

Limited Partnership

This is the actual fund itself.  A limited partnership is set up so that the investors are only liable for the amount of money they have in the fund.  Limited partners may include individual investors, pension funds or endowments, brokerage firms or investment companies, or other corporations formed to manage investments in hedge funds.

Hiring the Service Providers

The Prime Broker

Since the broker is the person who executes the actual buying and selling of the securities, it is important you find someone who is trustworthy.  Having a prime broker with a stellar reputation also can increase the attractiveness of your fund.  Goldman Sachs, Bear Stearns, and Morgan Stanley are among some of the big players in the Prime Brokerage industry.  In addition to dealing with the day-to-day operations of the fund, brokerages also may try to find qualified investors for the fund.  They also may run a risk-analysis of the fund, or provide consulting services.

Independent Auditor

An audit is done on an annual basis to review the fund and its strategies and provide all of the necessary documentation.  The auditor will prepare all of the tax documents needed including K-1s to investors, federal, state and local fund income tax returns, and the 1065 for the partners of the fund.  The auditor may also provide year-end estimate letters to investors, assist in the taxes of the managers and partners, and provide representation before the IRS.  The audit is crucial because many times, hedge funds work with multiple prime brokers.  Because the capital and assets are distributed among these prime brokers, it is up to the auditor to combine all of this information in a way that makes it easy for investors to view.  The auditor may also provide consultation, review of partnership agreements, along with investor contributions and withdrawals.    

The Administrator

Having a hedge fund administrator for your fund is extremely important in today’s constantly changing hedge fund environment. A hedge fund administrator does not manage your portfolios, trade or research, develop products, raise capital, or manage client relationships. These functions are the core functions of your business that tend to be out-sourced infrequently. A hedge fund administrator services your clients and investors; supports you administratively and operationally; and provides you financial, tax and compliance reporting. This includes audits and tax coordination; compliance services such as anti-money laundering and know-your-client procedures required by the Patriot Act, and middle office services. These functions are critical to the successful daily operation of your fund and investment adviser.

When administrating their own fund, many fund managers find they are in over their head. In-sourcing requires you to hire sufficient support staff with the necessary skills and experience, pay their salaries and benefits, provide necessary infrastructure (office space, hardware and software), and supervise their work. In-sourcing also makes you directly responsible for correct and timely performance of these duties and compliance with all rules, regulations, and laws, especially the recently enacted anti-money laundering and know-your-client laws. The other choice would be to simply outsource these functions and have your fund pay a hedge fund administrator for all administrative and operational support. Out-sourcing requires the hedge fund administrator to provide necessary staff, infrastructure and supervision of the work performed. You can contract with a hedge fund administrator for correct and timely performance of these duties, and compliance with all applicable rules, regulations, and laws.

The SEC imposes strict requirements for record-keeping, and a good administrator will be quite familiar with them.  These records include typical business accounting records as well as most forms of written communication such as emails, any advice given or received, the disbursement of funds, or the execution of the buying and selling of the securities.

Your investors will appreciate the independent third-party verification of your funds’ operating results provided by a hedge fund administrator. A hedge fund administrator can also provide you custodial services to safeguard the investor monies and the assets of your fund. Professional accounting and finance individuals with investment industry experience will service your investors. These individuals bring a wealth of administrative and operational experience to the table. Hiring a hedge fund administrator increases the size of your operations by providing a virtual administrative and operations staff. Your investors will pay approximately one basis point (0.01%) of return per month for the benefits of these services, a cost, which will barely reduces the returns of your fund, but will greatly enhance the service.

Website Design Firm

Since the SEC has strict limitations regarding the advertising and marketing of your hedge fund, you have to be a bit creative when it comes to putting your funds out there.  Attracting the right audience is key.  That’s why the utmost professionalism and attractiveness must be purveyed in a way that makes people want to learn more about your investment strategies.  A website design firm will build a website for your hedge fund that is in compliance with all of the guidelines and that will hopefully attract the right investors.  Most of the time, a website design firm will even assist you in providing documentation, data analysis and statistics, to make the management aspect of your website one less thing to worry about.