Launching a new fund can seem like an insurmountable task at times. The legal, regulatory, and operational considerations are indeed daunting, and navigating the maze that is the alternative fund formation process is a challenge. Based on Grassi’s extensive experience with hedge fund start-ups, our Financial Services team has summarized a few key components for new managers to focus on when launching a new fund.
The Right Service Providers
The first step toward achieving your goal is matching the right service providers with the fund’s needs. The four most important service providers for any hedge fund are:
- Prime Broker
SEC registrants may also need to appoint a compliance specialist. Together, these providers allow the manager to leverage their expertise by providing them access to information and offering economies of scale that the manager would not be able to obtain alone.
While these providers form a critical part of the internal control and risk management environment, just as important is the reputation validity derived from the manager’s association with high quality service providers. A good fund administrator will extend a manager’s reputation, give potential investors confidence, and have a positive effect on the brand, which ultimately boosts the manager’s ability to raise capital.
Service Provider Cost
When hiring outside service providers, managers must understand whether the providers can grow with the fund as it grows, and at the same time, maintain a semblance of cost discipline. While every manager wants every service provider to be “best of breed,” the manager must decide if a national brand name is immediately required or whether the same level or better service can be obtained at a more cost-effective price point.
Managers should try and avoid constantly changing service providers as the fund grows. A variable fee arrangement, which provides for fees to grow as assets under management increase, allows both parties to feel invested in the relationship. The best business deal is always the one where both parties are satisfied.
While service provider cost is an important consideration, it is second to understanding the unique qualifications of the service team to be sure that they truly understand the Fund’s investment strategy and will provide the manager with the correct level of technical experience.
The Proper Set-up
Most emerging hedge funds do not launch with a fully staffed back office. Moreover, the fund manager may not have the experience needed to oversee many administrative or back-office functions. Just a few of the considerations a fund manager should be concerned with are:
Decide on Structure
Side-by-side, Master Feeder or Mini-Master
Draft Fund Document Review
Understanding that an emerging manager probably makes a substantial payment to professional fund formation attorneys, it is imperative that the manager fully understands the agreements and is aware of those sections that pose the most risk to investors and the fund manager. Having an “experienced set of eyes” review the documents while in draft form can save a great deal of heartache down the line.
Managers should consider asking themselves questions on tax implications related to the structure of the Fund, General Partner and/or the Management Company. What are the potential tax issues faced by non-US taxpayers investing in a US domiciled fund? Has the manager considered UBTI consequences of having IRA capital invest in the Fund? Would a master-feeder structure be better?
Is there a need for third party valuation specialists? How does this tie in with potential audit-related issues?
Cybersecurity and Data Protection
Most managers will depend upon their fund administrator for the protection of their data. To that end, managers must satisfy themselves that their providers have established procedures as well as the necessary infrastructure to handle most sensitive information.
Pricing Your Product
The “old days” of a standard 2 and 20 pricing structure, which was applied across different funds regardless of their ability to generate Alpha, are no longer. Today, emerging managers need to utilize more non-traditional fee structures. This could include creation of a Founders class with a discounted fee structure or even a piece of the management company, tiered management or performance fee percentages based upon amount of subscription or hurdle rate. The manager needs to show pricing flexibility in meeting market demands.
Being able to efficiently connect the service provider and the tax preparer from the perspective of data flow can be a tremendous time saver. Obviously, a service provider who can also handle tax return preparation would increase efficiency and reduce costs even more, especially if the emerging fund does not require an audit in its first year or two of operation. Having the appropriate infrastructure offers the manager the best opportunity to attract assets from sophisticated investors.
Every service provider has a unique set of strengths and weaknesses that may make it a good fit for some funds but not for others. If you are an emerging fund manager seeking professional hedge fund start-up services, please contact John Zoraian, Fund Administration Principal, to schedule a complimentary consultation.