In the first quarter of 2022, the general value of assets managed under hedge funds has reached almost $5.137 billion, which already exceeds the previous-year figure of $4.798.
If you’ve developed a market-beating strategy and have a good track record of outperforming the market, you may consider starting a hedge fund. Hedge fund managers receive considerable compensation for their performance, and the tax benefits are great for high earners.
Hedge fund definition
A hedge fund is an investment company where the money of private investors is managed by professional hedge fund managers who use complex and risky investment strategies to generate returns. Those strategies include short-selling, derivatives, leverages, and alternative asset classes.
Hedge funds are regarded as risky investment choices and require a high minimum investment or net worth and target wealthy private investors.
Hedge funds are often considered as easy-to-establish-and-benefit-from ventures due to the following reasons:
- Hedge funds offer an attractive earning system, often referred to as “2 and 20,” which stands for a 2% management fee and 20% performance fee. It means that a hedge fund manager gets 2% of each investor’s shares and 20% of the profits the investment brings.
- Hedge funds are less regulated, which makes it easier to start such an investment company if you have enough experience, prospective investors, and capital required for the fund to function.
Difference between hedge funds and mutual funds
Though hedge funds and mutual funds are similar in their basic structure (both are investment companies that manage money from different investors), they’re different in many aspects. Below are the main differences between hedge funds and mutual funds.
Who can invest in a fund?
- Hedge funds: only accredited investors with an annual income of more than $200,000 or a net worth of more than $1 million (institutional investors or high net worth individuals);
- Mutual funds: all investors with minimum investment as low as $1.
How the fund is regulated by the Securities and Exchange Commission (SEC)?
- Hedge funds: less regulated;
- Mutual funds: strictly regulated.
When can investors sell shares?
- Hedge funds: only in limited windows (assets are often locked for at least a year);
- Mutual funds: any time.
How does the fund earn?
- Hedge funds: management fee + performance fee (usually, 2% + 20%);
- Mutual funds: only management fee (up to 2%).
How to start a hedge fund in 7 steps
Starting a hedge fund should always begin with defining a viable and profitable hedge fund strategy that is clear to your potential investors.
Then, you’ll need to follow several regulatory steps to legally register your new investment company.
Below are 7 regulatory steps on how to launch a hedge fund in the USA.
1. File the articles of incorporation for your own hedge fund
To start a hedge fund in the US, you’ll need to create two business entities: one — for the hedge fund itself, and the other — for the hedge fund’s investment manager. The second entity will be your investment advisory company.
As a rule, hedge funds are registered as limited partnerships (LPs) or limited liability companies (LLCs). Contact the secretary of your state to get more details on what are the legal requirements to registering a hedge fund.
On this stage, you’ll also need to come up with the fund’s name to complete all the necessary legal paperwork.
Additionally, you’ll need to apply for a Federal Employer Identification Number (FEIN) with the Internal Revenue Service — it’s free. You can do it online or by filling out the IRS Form SS-4.
With this information, finalize filling out the articles of incorporation and wait for the company to be legally formed (usually, it’s pretty fast).
2. Create your corporate bylaws
To move to the incorporation of your company and registering a hedge fund with the SEC and other regulatory agencies in the state, you’ll need to create your corporate bylaws.
The bylaws solely depend on a particular hedge fund manager, but usually include:
- Manual for supervisory procedures
- Ethical code of conduct
- Compliance manual
- Advisor’s portfolio-management agreement
3. Register your investment company as an investment adviser
To make the partnership legal, you need to register your company as an investment advisor. You can do it online on the Investment Advisor Registration Depository (IARD) website.
By obtaining the status of the Registered Investment Advisor (RIA), you get the right to advise high-net-worth clients on their investments as well as administer their portfolios.
4. Register your company representatives as investment advisors
After legally registering your fund as an investment advisor, you’ll need to register yourself (and all the hedge fund managers of your company) as the Registered Investment Advisor Representative (RIAR).
You can do it online on the same website and take the Financial Industry Regulatory Authority (FINRA) Series 65 exam.
5. Write offering documents
Writing offering documents is one of the important starting a hedge fund requirements to attract prospective investors. Offering documents explain your fund’s strategy and regulations.
Regulatory bodies require offering documents, and their range depends on the state where you’re registering your hedge fund — consult professional lawyers to make sure you prepare all the needed documentation.
6. Register the hedge fund offering with the Securities and Exchange Commission
You’ll need to register the offering of the limited partnership with the SEC. For this, complete the SEC Form D in each state where your hedge fund will be operating.
This offering will have all the names of the key partners of the firm and large hedge fund investors, as well as provide a detailed hedge fund investment strategy.
7. Promote your hedge fund
This is the final yet crucial step of starting a hedge fund.
Without proper marketing, you won’t be able to attract wealthy investors. Make sure you have a viable and effective marketing strategy or at least are acquainted with enough prospective investors to form a seed capital.
It’s worth mentioning that due to the light regulations of hedge funds, they are more flexible when it comes to promoting. You can legally market your hedge fund to all the investors who satisfy the requirements.
Tips on setting up hedge fund
To make the process of starting a hedge fund even more efficient, keep the following recommendations in mind:
- Conduct thorough competitors’ research. If you want to make your hedge fund profitable, you have to ensure you have a competitive model and terms for potential investors. Study what the best hedge funds in your market have to offer before creating a strategy.
- Define your competitive advantage. Offering something that makes you stand out among other hedge funds, you enhance your chances of being noticed by wealthy investors. It can be a marketing advantage of knowing lots of potential accredited investors who could establish your fund’s capital, or a trading advantage of having a unique investment strategy — pick anything you’re good at and promote it.
- Determine a viable strategy. The accredited investors you want to attract to your hedge fund want to see a clear and viable strategy that will bring returns from their investments. Mind that strategies that were not used in the market before might discourage investors from investing money in your fund, as there is no evidence of its profitability.
- Develop a strong marketing plan. Even the best investment strategy will go in vain if no one knows about it. Investing in marketing is important since it’s the only way for you to raise capital.
- Get seed capital. Considering the fact that hedge fund managers work with wealthy clients, you’ll need a lot of seed money to establish the capital of your new investment company. To find a seed-capital provider, you’ll probably need to have a lot of professional acquaintances and a good professional reputation in the investment network.
- Ensure you have a professional lawyer. Having a good lawyer is a kind of investment when starting a hedge fund. With such a person on the team, you can rest assured that all the regulatory-required documentation is in place and that there are no pitfalls on your way.
Extra details about starting a hedge fund: Structure, strategies, and challenges
Below are the basics of structure, strategies, and challenges of hedge funds described in brief.
The structure of hedge funds can be different, but let’s distinguish the following two types:
- Domestic. This type of hedge fund’s structure corresponds to the local regulations of the country where the hedge fund is registered and might be more interesting to its residents.
- Offshore. Offshore hedge funds’ structure serves the needs of foreign investors and corresponds to foreign laws.
There’s a broad variety of Investment strategies used by hedge fund managers, but let’s define the three most common ones that depend on the investment goals:
- Long or short equity. According to this strategy, investors go short and long on two competing companies that operate in the same industry.
- Fixed-income arbitrage. This strategy guarantees investors stable returns and targets capital preservation in taking short and long positions in fixed-income securities.
- Event-driven. This strategy takes advantage of temporary volatility in stock prices that is caused by such events as mergers and acquisitions, bankruptcy, takeovers, or restructuring.
Many investors who want to establish their own funds face several common challenges on the way:
- Raising capital. For the emerging hedge fund manager, it can be difficult to raise a starting capital for his investment company to become attractive to potential investors. One of the solutions for this is a strong marketing strategy that will help your fund to get noticed by high-net-worth individuals.
- Forming a strong hedge fund strategy. A viable and understandable strategy is a cornerstone for any hedge fund. An emerging hedge fund manager should dedicate a lot of time to the competitors’ research that will help to define the most efficient investment strategy.
- Attracting institutional investors. By having a mix of characteristics that satisfy the requirements of institutional investors, your hedge fund will be an institutional quality hedge fund. This allows for attracting large sums of money to your fund.
Let’s sum up the basics of the information on hedge funds you’ve learned from the article.
- Hedge funds are investment organizations where investors’ money is managed by professional hedge fund managers who use rather risky strategies to bring returns.
- Hedge funds are very similar to mutual funds, but they come with a better earning ratio, are less regulated, offer limited windows for withdrawing assets, and are suitable only for wealthy investors.
- Starting a hedge fund, you need to contact the authorities of your country to get detailed instructions on what documentation to prepare.
- A viable strategy, strong marketing plan, and substantial seed capital are crucial when setting up a hedge fund.
- There are many types of hedge fund structures, but the most commonly defined are domestic and offshore.
- The strategy of the hedge fund usually depends on the investment goals, such as long/short equity, fixed-income arbitrage, and event driving.
- The typical challenges an emerging hedge fund manager can face are capital raising, attracting institutional investors, and forming a viable strategy.
How to start a hedge fund with no money?
This is impossible to do due to the “nature” of the hedge fund. To attract high-net-worth investors to your fund, you’ll need to present it as a solid and reliable organization. And obviously, that requires a certain amount of money to invest. Some of the starting a hedge fund costs include marketing costs, tax and audit costs, back office costs, and technology costs.
How much money to start a hedge fund do you need?
The sum will solely depend on your hedge fund’s size and structure, but be ready to spend somewhere from $10,000 to $100,000 on marketing, software, taxes and audit, back office, and legal services.
What are the key service providers of the hedge fund?
The team of key service providers of your hedge fund should at least include a prime broker, independent third-party fund administrator, attorney, custodian, and public accountant.