- July 5, 2017
- Posted by: Vincent Sarullo
- Category: Hedge Funds
Hedge Fund Management – Budgeting
Let’s look at what you can expect to invest to get your fund launched. Typical costs include legal formation, Form D and “blue sky” filings, branding, jurisdiction filing fees and a huge investment in time focused on developing a plan of action.
Let me start here by addressing an issue that prospective managers have asked about when trying to keep costs down: do not use someone else’s or a prior fund’s set of legal documents and “tailor” them for your new fund! Besides the fact that those formation documents were created by a law firm that you are now plagiarizing from, the disclosure requirements and laws change on a regular basis. Even a six-month difference in timing will require you to make new disclosures. It’s not what’s in those older fund documents; it’s what’s not in them.
You may think that you have the same strategy and contemplated structure as the fund the old documents were written for, but it is very unlikely that they are the same. Moreover, there are probably many things you can build into your new fund that the industry hadn’t thought of previously; why miss the opportunity to build a better mousetrap?
Your fund offering documents are the “law” when it comes to how you run your fund, what your investing program is, and most importantly, the rules for how your investors are to be treated and how they should expect to be treated. Follow the letter of the “law” and you have done right by your investors. The number one source of SEC and other regulatory actions are from deficiencies and departures from fund documents by the managers. Later on we cover some of the more egregious penalties.
If you do not follow the fund documents and something goes wrong with the fund, the investors could be eligible to have all their invested capital returned to them. Yes, even if their account went down to zero because of the market and there was no negligence on your part, if you did or did not do something in accordance with the fund documents (even in good faith), investors can recover their invested capital from you. Are you ready to write that check?
You don’t have to spend a small fortune on creating your legal documents and structures, but these pieces of paper are ultimately what you will rely on to protect yourself and your investors. No fund strategy has ever failed because of the fund documents, but if something does go wrong (or even without something going wrong), you should have solid legal documents to stand behind.
Many new fund managers have built their careers at large banks, brokerage firms or money managers with deep pockets, and large institutional investors used to seeing big-ticket law firms’ names on all the documents. These are great law firms and they do have the capabilities to build fund structures that span the global markets and can ensure that investment strategies are legally structured for optimal tax efficiencies and global regulators. For 99% or more of new managers, this is not needed at all.
With fund launches of $25 million dollars being major industry news, your new funds are not of a size that must deal with complex investment structures and multi-jurisdictional regulatory regimes that mandate the use of these large law firms.
Instead, use one of the many excellent law groups that cater to the emerging fund manager. You can find a well-recognized firm in this industry that will construct a great fund for you for a fraction of the cost of the large firms’ fees. We commonly see these firms charge under $20,000 for all legal documents and filings, compared to the large firms’ services starting at five to ten times that amount. This is for a basic fund structure; if you have any complexities, prepare for the meter to be rolling with the large firms.
Many attorneys in the US will be large enough to have an office in offshore jurisdictions in order to finalize offshore fund structures. Others will have a relationship with law firms in offshore jurisdictions that can serve as the attorney of record for the fund.
In both situations, it is very common for the US attorney to draft all US and offshore fund documents and then send them to the offshore attorneys for review and comments. Expect to have a nominal offshore attorney fee added to your legal costs. This fee can be anywhere from $5,000 to $10,000 for the review and filing by the offshore attorneys.
Form D Filings and Blue Sky Filings
In addition to the federal securities laws, every state has its own set of securities laws—commonly referred to as “blue sky laws”— that are designed to protect investors against fraudulent sales practices and activities. While these laws do vary from state to state, most state laws typically require companies making offerings of securities to register their offerings before they can be sold in a particular state, unless a specific state exemption is available. The laws also license brokerage firms, their brokers, and investment adviser representatives.
The filing fees are about $150 per state. You don’t have to file in every state in the Union on day one! For most managers, filing in two or three states will more than suffice. You only need to file in the state where you are currently offering the fund to investors.
If you meet someone in another state, file there if it becomes evident that they will invest. You can file at any time.
Branding – Logos, Business Cards, Website and Online Reputation
You may not think that you are selling a product that needs brand recognition, but you are. Even the simplest things, like selecting a color scheme or text font that represents you, are important. Make sure that all your marketing materials – including your pitch book – match your business card and website, as this builds client and prospect recognition. I’ve seen thousands of fund names, websites and marketing materials that affirm my belief that imaginative and creative fund managers are few and far between. Many seem to have given more thought to their tattoos than they have to their business identity.
There are professional branding and marketing firms that work with investment fund managers and can help you develop your brand so you stand out from the piles of presentations sitting on an investor’s desk. These firms are incredible at what they do and have a suite of services that you can leverage, ranging from branding concept, marketing collateral, and website development and hosting. This does come at a price, with services ranging from $5,000 to $25,000.
If you have a creative side, there are online tools you can use to create your brand and logo. My own company and many of our clients have used www.logotournament.com. For as little as $250, you can set up a competition in which graphic artists from all over the world will submit designs for you to rank and ultimately select as your company logo. The website has some simple questions to answer about the industry you work in, how you view your business (“artsy” or “corporate”), colors you like, and so on. Based on this simple profile, the artists will create and post their drafts for comments. After a few weeks, you finalize your selection and the winning artist sends you the logo in all the file formats you need for printing business cards and stationery, and for use on a website.
Have a presence on the web. A simple “splash” page that has your contact information is a good start. One of the first things that we do today when we meet a new person or business is jump on the Internet and see what we can learn about them. Since the Securities and Exchange Commission (“SEC”) lifted the ban on advertising, you can use your website to let people know who you are and what you do. You don’t need an elaborate site, but do use a simple site as a way to let the world know who you are, and more importantly, that you actually exist.
While we’re on the topic of the Internet, another bit of advice: don’t underestimate its power. Do a Google search on yourself and dig a few pages into the search results. Make sure there is nothing negative about you or anyone in your firm. If there is something negative, especially if it is unfounded complaints, get those moved! Even simple gripes from an old employee you let go can be damaging and many of those complaints are posted anonymously. There are companies that specialize in repairing online reputations and can “push” positive content about individuals and entities higher up in the search results and push negative listings far, far down. These firms cannot remove any negative posts; to do that you must contact the host of that information and get them to remove it. These companies can do this for both individuals and entities.
Jurisdiction Filing Fees
The most common US jurisdiction for forming a fund structure is Delaware, but funds can be formed in any state that the manager wishes. These original filing fees run from $500 to $1,000. Most managers starting their funds may require an offshore investment fund to accommodate foreign investors and/or US tax-exempt investors such as Individual Retirement Accounts (“IRAs”). The Caribbean is the usual place to go and not just for the warm waters and sandy beaches. With over 70% of offshore funds domiciled in the Cayman Islands, it is a good place to go as far as investor recognition is concerned, but there are other options that are just as good and, quite frankly, less expensive. These include the British Virgin Islands (“BVI”), Curacao, and Bermuda.
Depending on the jurisdiction, you can expect initial filing fees to range from $4,500 in BVI to $9,000 in the Cayman Islands. Ongoing annual fees range from $3,000 in BVI to $7,500 in the Caymans. This would include the law firm’s registered office fee, because the jurisdictions require you to have a listed address in that jurisdiction.
Your fund will need to cover a variety of ongoing costs, including administration, audits, directors, tax preparation, compliance, and outsourced trading desks. Let’s take a closer look at each one.
Budgeting – Not For the Faint of Heart
It’s time to take a hard look at your living expenses and see what you will need for the next two to three years to live on. Let’s be honest, the management fee you collect from the fund is supposed to be all you need to keep the lights on and run your business. This is what you should expect to draw from to take care of yourself on your own home front. Do not bank on making a performance fee that’s sufficient to cover those things.
When considering your budget, there are of course two sides of the equation, revenues and expenses. Expenses can be quite manageable and you can work on a bare-bones office setup: computer, Bloomberg, and cell phone. The revenue side of the equation will be a fight right from the get-go.
Everyone will be trying to push to reduce fees and we all know that most of us start with the “Friends and Family Plan” members as your first investors. We also know that Uncle Bob and good old Dad-in-Law are expecting a good cut in fees. The management fee is a set amount and while the performance fee is a little more unpredictable. Investors are more than happy to share in the profits and you get to eat what you kill on that fee. So expect a harder push on reducing the management fee versus the performance fee.
A good guide for what you will need to have a well-supported investment management firm is the Alternative Investment Management Association’s (AIMA) due diligence questionnaire (DDQ). Besides covering all operational and infrastructure aspects of what investors are concerned about, it gives you an insight into concerns that firms like yours should be thinking about as you grow. Obviously, a new fund manager with limited capital and human resources cannot address all the questions in the DDQ, which is quite all right, but you can use the DDQ as a road map to see what you should be implementing over time.
I have always recommended to the managers I work with that they should start with the DDQ and keep updating it as they grow. It should be a living document that also shows potential investors you have given thought to establishing yourself as an institutional-minded firm and has acknowledged the areas they would (or should) have concerns about and how you will address them. It can also save you valuable time when meeting prospective investors. When they receive this before your meeting and can go through the operational aspects addressed in the DDQ, this frees up meeting time that can now be dedicated to discussing your strategy and allowing them get to know you personally.
The DDQ is meant to cover key points about the investment manager and the details of all the funds you have under management. In addition to the fund’s performance details, the DDQ delves into very specific qualitative aspects of the fund such as portfolio construction methodology, specific investment types, cash deployment, leverage, and risk management.
From my discussions with various investors, the DDQ offers the background information they use to determine where pitfalls may lurk for them. More importantly, it helps them determine from the very start the most important facet of the manager; namely, does the manager’s product (the fund) have a differentiating edge that is repeatable and manageable? And, does that product fit into the investors’ portfolio?
Management Fees and Operational Budget
It has been an unofficial standard or expectation that hedge funds charge a 2% per annum management fee. I’ve seen a variety of fee arrangements that work for managers. Managers like to look at their management fees and performance fees as related fees that are dependent upon each other. There really should not be any correlation between the two fees. I tell managers that the management fee should be what you need to keep your infrastructure up and running so you can do your job and work for your investors. The performance fee should be all but forgotten, as it is a bonus that you cannot rely on in any way. I know, I know, your models and back-testing have been incredible and you will be making a fortune for your investors which will give you your big pay day every year in performance fees. A word to the wise: don’t count on it.
When thinking about your management fee, start with the 2% and ask yourself the question that investors will ask, “What do I get for this 2% fee?” Your answer should be derived from your business plan and operating budget. What is the cost of running your firm? Is there a need for specialized trading programs and analysts? You need to keep the lights on.
Some investment strategies that require boots-on-the-ground work, such as real estate or tax lien funds, have structured fee arrangements that incorporate a lower periodic management fee with an acquisition fee or a cost absorption component. With the cost absorption component, make sure you have a clearly defined scope of expenses that the fund may absorb. The regulatory agencies are paying close attention to these expenses to ensure the managers are charging back items that are appropriate.
As your fund grows, you can expect some larger investors to focus more on your management fee. That’s because they often see managers of large funds getting paid huge management fees that more than cover the cost of running the firm, and the managers have been dis-incentivized to produce returns because they are getting a big fat check every month. They’ve become asset gatherers versus asset managers. If this describes you, expect a demand for reduction in fees or at least a cap that covers your costs.
What about fee concessions for allocators, seeders, and founder shares? Do you take a large allocation ($25 million to $50 million) at zero fees and performance? Hell, yes! Get those assets under management!
Costs Involved – Start Up and Ongoing
Compared to other businesses, the cost of starting a hedge fund, private equity fund, or other alternative fund structure is significantly less than you would expect. The chef who starts his culinary quest with a food truck has costs a lot more than creating a fund. Food truck industry reports show costs for a food truck setup to run upwards of $250,000 to get your wheels rolling; getting your fund on the road can be a tenth of that cost.
The costs for a US fund manager looking to start a US-domiciled fund are significantly lower than those for managers in other parts of the world. The entrepreneurial spirit is greatly supported and promoted in the United States when it comes to the investment community. The old adage of hedge funds being started with “two guys and a Bloomberg terminal” is not too far off from reality, although a bit simplistic.
Technology has made it easy for managers to set up shop and run their strategy from wherever and whenever.
The primary cost to open up shop is the creation of the “product” that you are selling: the fund structure. The Start-up manager will eventually recover even this cost, as these legal formation costs are ultimately borne by the fund and its investors. The fund manager will be reimbursed by the fund.