Beyond designing an investment strategy is the important task of setting up your firm infrastructure, and that includes how to budget the costs of starting your hedge fund.
To outline cost estimates of what it takes to start a hedge fund, here are six of the major Start Up Services using a hypothetical hedge fund:
Great Example Capital Management, LP has been prop trading for the past three years and is in its first year operating as a hedge fund. The company has 10 investors, $5 million in assets under management, and has a fully automated strategy. Initially, the firm will consist of only its managing principal.
1. Legal Costs
Year 1 Estimate: $15K-$50K
First, you’ll need to do to is create the fund’s legal structure, including setting up your limited partnership and any other additional entities required. Consider where you’ll incorporate your fund, i.e. in your home state, Delaware registered, or offshore in say, the BVI or Caymans–your legal council will advise you on the best fit for your strategy.
The costs of setting up a hedge fund can vary from approximately $15,000 to $50,000, and likely more if you use a “silk stocking” law firm. The biggest cost variable in the setup process is if the manager wants to go with a master-feeder fund structure. Doing the master feeder fund structure means adding two to three more entities, and with the additional entities customarily formed offshore.
Formation offshore generally is more costly than forming a US entity. It also usually means paying director fees along with fund administration and an audit for each entity. So, compared to a simple US domestic hedge fund, your setup and annual costs can double or even triple. “To make an offshore feeder fund structure worthwhile you need to be able to either afford to come out of pocket at the outset to cover the additional structure costs until a critical mass of AUM is obtained, or launch with significant AUM. Otherwise, it is going to weigh down on the fund’s ROR,” notes hedge fund attorney Mark Ruddy of Ruddy Gregory, PLLC in Washington, DC.
Additionally, your legal counsel will assist with the creation of your operating memorandum/disclosure documents/private placement memorandum. As part of this, you will discuss your investment strategy and any potential legal issues in the preparation of your documents.
2. Back Office & Administrative Costs
Year 1 Cost Estimate $5K-$20K
Working with the right fund administrator provides you with the insight to allow you to grow, and helps keep you focused on your primary tasks of trading and raising assets. Fund administrators often utilize large software packages designed to connect and receive data from various third parties making the management of your daily/monthly numbers more efficient, cost effective, and accurate.
“When selecting a fund administrator, it can be very beneficial to the emerging manager to find a provider who will provide pre-launch support, from reviewing offering documents to providing valuable referral networks for additional needed services,” according to Eric Warshal of Fund Associates in Atlanta.
The administrator should not only provide you with portfolio and partnership accounting services, but should also provide you with guidance respective of the practical and operational aspects of running the fund. Above all, you should find an administrator you feel will aid in your success and growth as a fund, as this hopefully will be a long term relationship.
Back office and administrative costs will grow as a hedge fund grows, but they can be kept under control by selecting a fund administrator with the right technology, staff, and your needs in mind.
3. Investment Compliance Costs
Year 1 Cost Estimate: $5K-$20K
The importance of adhering to the latest investment compliance rules cannot be understated. Rely on a compliance expert to put together your initial rules and regulations, and to ensure your processes meet all of the compliance requirements. Because these rules often change, you’ll want to look for a compliance service provider that is proactive in ensuring you are compliant with the latest changes. The firm also can make sure you are properly registered under the correct regulatory bodies i.e. if the fund is eventually going to trade futures, there may be a registration requirement under CFTC and NFA rules.
4. Tax and Audit Costs
Year 1 Cost Estimate: $5K-$20K
A third party audit of all results and reporting is a requirement for all alternative investment firms if it is outlined in the private placement memorandum or if the fund trades futures and does not qualify for any exemptions. Align yourself with a reputable firm that is recognized as an industry specialist to ensure that all of the procedures are followed. An ideal situation in choosing an auditor for the fund is to find a firm that works well and is familiar with your other service providers. An auditor that is familiar with the work of your attorney as well as your fund administrator can help keep costs low as well as expedite the entire audit process.
The cost of an audit depends on many factors the fund manager must keep in mind. The cost will depend on how many partners are in the fund, how many accounts are at different brokerage/investment firms as well as diversity of these investments. Additionally, the cost of an audit can be affected by the accuracy of the monthly accounting. If an auditor has to take time to figure out accounting, this adds time to the audit process, and therefore, money. Engage an auditor familiar with the industry and you will more than likely receive an accurate estimate.
Another aspect to keep in mind is INDEPENDENCE. Your auditor cannot be your monthly accountant. No exceptions. The firm must be a third party CPA that does not keep your books. Moreover, in certain states, they may follow SEC independence guidelines that restricts the third party auditor from compiling financial statements, footnotes, and other required disclosures. Your auditor should know which states follow such guidelines.
“Selecting a seasoned auditor that has established relationships and a solid reputation will greatly benefit new fund managers, helping to reduce fund administration costs and expensive consequences down the road, as an auditor may be able to make recommendations on how to improve record keeping efficiency early on–helping improve a fund’s profitability,” Mike Coglianese, CPA, Michael Coglianese CPA, PC.
Similarly at tax time, you’ll require a specialist familiar with the taxation issues relating to a fund. Using a CPA without these qualifications can cost you more money and, more importantly, open you up to potential legal issues.
5. Technology Costs
Year 1 Cost Estimate: Dependent on Type of Fund
Technology costs will vary from firm-to-firm depending upon the strategy of the fund. However, there are a few basics that have to be covered. The core technology items include having solid internet connectivity, professionally hosted and archived email (to remain in compliance), and a secure location for storing documentation with backups (either in the cloud, locally, or both), and that your office (whether home based or in a dedicated location) has the proper cyber security protocols in place.
Additionally, if you manage an automated trading strategy, rely heavily on real-time data and research, or have a solid communication infrastructure–you want to strongly consider redundancy, regular backups, and as possibly mandated by regulatory agencies, have a back-up procedure in the event of an outage or disaster. There is no mandated level for most of these items, and like any new business, you need to balance risk with what you can afford–but keep in mind if this is the backbone of your business, an outage can create severe and detrimental consequences.
6. Marketing Costs
Year 1 Cost Estimate: $4K-$20K
One of the most overlooked items in establishing a new fund is setting a marketing budget. As a new fund, you are competing with thousands of hedge funds of all sizes and strategies. Having a professional image, a clear message on your fund’s strategy, and a process for getting in front of potential investors is critical to your success.
“Professionally produced marketing materials including a logo, business cards, tear sheet/pitch book, and website (even a simple one) help define your business, deliver your message, and create an ongoing impression with a potential investor,” says Shane Stiles of Gate39 Media, a financial services marketing and technology agency.
With your professional marketing materials in hand, set an annual budget to visit key contacts and service providers in person and attend investor conferences where the potential to meet capital allocators is high. You have created an investment product that you believe investors will be interested in. Now you have to go out and spread the word and that cannot be done from your office.
While the above list of services and costs are relative standards, actual costs will vary relative to the size of the hedge fund startup, level of risk, and general setup. Additionally, several items (such as marketing and technology) require an initial investment with lower maintenance costs. Moreover, you must consider general monthly costs such as rent, equipment, staff, and miscellaneous services and goods that should be accounted for separately.