How to Start a Hedge Fund … and Buy that House with the Pool and the Pond

Several years ago, back when the real estate market was booming and I was just an analyst, I was eating breakfast at the New York Palace hotel.

I found myself seated next to two well-dressed fellows who couldn’t have been older than 35. They were talking about how the one man’s new house search in Greenwich, Conn. was going.

After nonchalantly throwing around some home prices that approached the 8-figure range, the discussion about specific houses revealed a unique set of amenities at one particular house:

Fellow #1: “Does it have a pool?”

Fellow #2: “A pool and a pond.”

I couldn’t hide the smile on my face. Who was this guy? Ty Webb?

Nope. He was a hedge fund manager.

Starting your own hedge fund is the ultimate buy side exit opportunity, and it’s also the quickest route to the 8-figure house with the pool and the pond, or the yacht, or maybe even your own island somewhere.

So let’s get started and start our own hedge fund in three simple (but not easy) steps …

All About Alpha

If you want to succeed in the money management business, then you have to deliver alpha. Outperform and you will be handsomely rewarded. Underperform and you will be ruthlessly cut and thrown to the street.

This is especially true in when it comes to hedge funds as everything gets amplified.

If you outperform, you get to take a share of the profits. That’s what makes billion dollar years possible for hedge fund managers. However, if you underperform, you won’t see another dime in incentive fees until you regain your high water mark.

Even worse, underperform and your investors might start calling for redemptions. This means you’ll be selling your longs and covering your shorts ,which can hurt performance even more. This leads to more redemptions, more underperformance, and the death spiral ensues until your hedge fund has imploded.

There goes that mansion mortgage payment.

Step 1: What’s Your Investment Strategy?

When it comes time to sell your fund to potential investors, the first question you will face is to explain how you will make the investors money.

Right now you are probably thinking to yourself, “That’s easy: I buy stocks that are cheap and I short expensive stocks.”

While the money management business really is that simple in theory, it is extremely difficult to put that theory into practice. Investors need to understand how you their manager is going to outperform the other thousands of hedge funds out there.

Some tips to developing a sound investment strategy and process:

Define the Strategy: Describe the process you will go through to identify the stocks you will buy and the stocks you will short. The process must be easily repeatable in different market environments and be simple to explain. You might have the most sophisticated black box financial modeling ever invented, but you won’t attract any investors if you can’t explain how it works.

Some common hedge fund strategies:

• Global Macro: Micro, company specific issues be damned to the global macro fund. These funds take positions on macro issues only, such as whether the Australian Dollar is going to appreciate against the Euro or whether the Brazilian Bovespa is going to outperform the S&P 500. George Soros’s famous attack on the pound in 1992 is a classic example of a global macro strategy.
• Relative Value: Most hedge funds fall in the relative value category. While there are many possible types of securities that you can invest (equity, credit, convertibles, asset-backed, etc.), the process remains the same: buy undervalued securities and short overvalued securities.

Whatever strategy you choose, you will need to explain to investors your competitive advantage. Think you will be a top global macro manager? Well, how will you explain to investors that they should give their money to you and not George Soros?

That brings us to our next task:

Test the Process: Find a way to test your process, either through actual results or through backtesting. You need to provide evidence that your theory (i.e., investment process) will work to deliver alpha in the real world. While past performance does not guarantee future results, potential investors still want to see good past performance.

Having a sound strategy and process that has demonstrable results will go a long way toward convincing investors to trust their money with you.

Step 2: Establish Your Infrastructure

The highly publicized cases of the Madoffs of the world have resulted in a premium being put on the soundness of the back office. Investors want to be certain their money is safe. Just as with the investment process, you need controls that are both sound and easily explainable.

Among the back office tools you’ll need:

Legal & Compliance: When it comes to dealing with other people’s money, the legal standards are high and only going higher as the regulatory environment continues to expand. This is not an area where you want to be cheap. You need to make sure your hedge fund legal documents are properly completed and filed and you also need someone looking over your shoulder so you don’t do anything stupid.

The legal entity of the fund, the domicile of the fund, and the regulatory issues of the fund will vary depending on your location in the world and are, unfortunately, beyond the scope of this article. Go hire yourself a lawyer.

Some of the more well-known hedge fund law firms include Davis Polk, Ropes & Gray, Said & Goldberg, and Schulte Roth.

Risk Management: Another biggie in the eyes of investors. How do I know you aren’t going to get your face ripped off from some derivatives play gone bad? You need checks and controls to ensure you don’t end up losing billions because of one fat-fingered trade.

Typically, risk management involves monitoring fund exposures, through software such as Barra, and setting limits on the exposures the fund can take.

Another part of risk management is business risk. Hedge funds implode every year, how will you convince investors that your fund has staying power? Are you profitable at your current AUM, or do you need to raise another $20 million just to keep the lights on?

Prime Brokerage: You need someone to handle your trading needs and be the one to supply you with the stocks to short. This is where a prime broker enters the picture. The prime broker will be like a partner to your fund, so choose wisely.

JPMorgan (the result of acquiring Bear Stearns) and Goldman Sachs are among the largest prime brokerage providers.

Administration: Hedge fund administrators handle the unsexy back office responsibilities like calculating fund NAVs and handling investor relations. The investment banks that act as prime brokers are getting into the administration business, but independent administrators are still the most common. Citco is a big name in the hedge fund administration arena.

Step 3: Attract Capital

Once you have the strategy and the structure in place, it’s time to raise some money. After all, a hedge fund is nothing unless it has the AUM to collect 2-and-20.

While it’s easy to form a hedge fund, it’s just a legal structure, it’s a lot harder to form a profitable hedge fund.

Some facts and figure to illustrate:

Let’s say you are able to hit up friends and family for $1 million to invest in your hedge fund. That may seem like a good amount of seed money to start, but it won’t be paying any of your bills anytime soon.

Assuming you are able to generate a 20% return and charge the standard 2-and-20, you just made a whopping [sarcasm] $60,000 for the whole year. And guess what, that’s before expenses. Add in legal, compliance, risk management, and marketing expenses and you’ll be lucky if you can make a take home pay that’s above the poverty line, if you have a take home pay at all.

Unless you enjoy managing money for practice, the aiming for $10 to $20 million in seed capital is a good start where you should be able to cover most expenses, but you’ll need to quickly ramp that number to $100 million if you expect to have any long-term staying power.

There are many sources of capital available to start a hedge fund, but you will need to cast the money net far and wide to attract that critical mass of AUM.

Among the more common options for raising capital:

Friends and Family: Obviously, if you have friends and family with excess capital reserves like a bank, you need to hit them up for some startup capital. For the rest of us …

Fund of Hedge Funds: Fund of funds are like aggregators of capital. They take in capital from smaller investors and allocate to various hedge fund managers. While fund of funds can be a quick way to raise capital, the downside is they will also charges fees which might eat into your fee structure. Money is never free.

HNWs (High Net Worth Individuals): If you can network your way into the financial advisor network, you might be able to convince some FAs to allocate a small portion of their investors’ portfolios to your hedge fund.

Third-Party Marketers: Similar to a fund of hedge funds, third-party marketers raise capital for hedge funds from outside investors. The upside is that these third-party marketers typically have the network and relationships that you do not have. The downside is they sometimes only work hedge fund managers with existing assets and track records.

Hedge Fund Backers: Hedge fund backers provide the seed capital necessary to get a new hedge fund up and running. These are a bit like private equity or venture capital funds that invest in startup hedge funds. Among the well-known “seeders” include Blackstone, Reservoir Capital, and Tiger Management (that of the famous Tiger Cubs).

Easy as 1-2-3?

While it now might seem simple to start up a new hedge fund, rest assured it isn’t easy. Steps #1 and #2 are actually fairly simple and easy if you have the money to outsource to the right firms. After all, setting up a hedge fund is really just about filing some paperwork and setting up a legal entity.

Step #3 is the hardest. Raising money is one of the hardest business aspects of the money management business. With all the hedge funds and asset management firms out there chasing investors’ money, it can be a difficult endeavor.

If you are still early in your career and hope to one day start your own fund, it’s never to early to start seeking out and networking with potential capital sources. Most of the top hedge fund managers got their start through the help of some early investors, the same way regular companies get their start.

When the time comes, will you have the network to successfully raise the millions of dollars necessary to become a legitimate hedge fund?

If you can answer “Yes” to that question, it might be time to give Sotheby’s a call and see what houses they have on the market in Greenwich. Tell them you’d like to see one with a pool and a pond.