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So you want to start your own hedge fund? Top tips from hedge fund seeders

Date: Wednesday, December 5, 2012
Author: Parin Shah, ProHedge.co.uk

The biggest challenge when starting up a hedge fund is capital raising. This year marked a period where fewer seeding deals than ever before were undertaken. At the Bloomberg Hedge Fund Start-Up Conference, industry experts reveal that they really have to see a comprehensive package from the perspective of strategy and due diligence before they can even consider allocating money into a new venture. As Pierre-Emmanuel Crama of Signet Capital Management stated “we look for institutional quality with managers where we can also provide support.”

A good way for hedge fund start-ups to evaluate their own “institutional quality” is to look at the AIMA Due Diligence questionnaire and simply mark which issues you can address at the moment and which you cannot, advises Tushar Patel of HFIM. This represents a great way to get into the mindset of allocators who have a fiduciary duty. “Remember this is starting a business from scratch. You can have the best idea but there needs to be infrastructure to take it somewhere,” says Patel. Jeroen Tielman of IMQubator considers seeders to be an “enhancer” for hedge funds that can stand on their own two feet but might require optimization on issues such as investor base targeting, domiciliation and operational aspects. “We are not a hedge fund hotel,” says Tielman defiantly but “giving each other success is one of the elements of partnership.” IMQubator bases its seeding on true partnership, being fully aligned with the managers to the extent that it will support the expansion into another strategy by a manager within the same seeded entity if it feels that there is real potential.

So, crucially, what are seeders looking for from hedge fund start-ups? Size is an important issue. “It should be lean and mean. There is a minimum size and of course it should not be below the minimum,” says Tielman. There is no magic number although general consensus is at around the $100 million mark for a modern start up. Starting up a hedge fund requires characteristics such as persistence, conviction and staying power not just for individual managers, but for the team. Crama states that there is often a preference for a team who has worked together in the past for this reason. As a minimum, hedge fund start-ups should be able to demonstrate good quality operational infrastructure from administrators and custodians, through to lawyers. This helps to test the scalability of the proposition. Transparency is of great importance to Crama: “we want to discuss the portfolio at any moment”. Hedge fund start-ups should also be aware of the softer elements to the selection process too and Tielman says that he often looks to establish how “logical” the start-up is in fitting with what managers have done before and whether entrepreneurship is part of their character. The question Tielman asks is “are there signs in the past that you really want to do this?”

As expect, capital allocators pay a great deal of attention to hedge fund strategy. Patel urges hedge fund start-ups to gauge demand and consider how crowded a particular strategy really is. “There are a lot of “me to” type products that find it difficult to find shelf life,” he adds. According to Crama “timing is very important. Sometimes it is better to reposition for 1 or 2 years. Every strategy has a life cycle and you may have a great idea, but the market may not necessarily be prepared.” In an environment of incredibly low interests rates where there exists huge incentives to keep this rate low, picking a strategy that can weather the storms posed within this “new normal” is very important; hedge fund start-ups can act as portfolio diversifiers and create diversification within the hedge fund space itself. Potential strategies offered up by Tielman to be in favour are systematic strategies that are fast reacting, discretionary strategies playing ahead of events and volatility dependent strategies that take advantage of behaviour in risk-off markets.

While seeding offers a great way to develop a lot of traction for hedge fund start-ups and a method through which to develop solid infrastructure, there are alternatives. Seeding can as Phillip Chapple of KB Associates commented “feel a bit like going on the X Factor in some cases”. Crama suggested that discounted fees up on an initial $100m allocation with a lock up of between 6 months to a year could represent a great way to boost capital early on while only conceding revenue for a defined amount. Patel also points to the fact that many larger hedge funds are looking to diversify. Many may allow you to work in-house initially and allow you to work off pre-existing infrastructure using their capital. Even approaching pension funds directly such as the likes of CalPERS who are always looking for high quality early stage managers could be a very good way to kick-start a fund in its early stages by increasing AUM significantly.

For managers, the risk is when the fund is not live. Fund managers need to be in a position where they can incentivize investors to allocate capital from day 1. And while there are no short cuts, seeing things from the perspective of seeders can help fund managers address the key concerns around strategy and due diligence in order to get their start-ups off the ground.