Considerations for Launching Hedge Fund: Investment, Legal and

Technology
**This article is for general informational purposes only and does not constitute legal or
investment advice as to any particular set of facts.
Launching a hedge fund is a major undertaking that requires a methodical approach and
experienced partners in various industries. Investment, legal, and technological
considerations are essential to the development of a successful fund. The entire process
takes an average of 6 months and requires an extensive amount of planning and
preparation. A solid business infrastructure, substantial legal organiation and document
development, and secure, efficient technolog! are the foundation of a successful hedge
fund. This article "ill outline the ke! considerations for launching a hedge fund including
investment, legal, and technolog!.
Initial Fund Development
The first step to starting a hedge fund is clearl! articulating !our investment opportunit!.
This means hiring legal council to begin development of !our legal structure "hich
consists of dra"ing up essential documentation and tax planning. #ocumentation is a
primar! concern in the creation of a fund because specific documents are necessar!
before moving further. A fund cannot secure a prime broker or even acquire office space
"ithout the proper legal literature. This process often takes longer than expected,
another reason it must be one of the first actions taken.
After the legal process is initiated, a fund manager must attract talent and begin
the development of a business plan. It is sometimes difficult for fund managers to create
a thorough business plan because, "hile the! are often familiar "ith the investment side
of the operation, the! do not consider smaller tasks such as pa!roll and benefits "hich
are essential to a functional business. $ften times funds "ill choose to outsource these
duties rather than dealing "ith them on their o"n.
Thorough documentation is necessar! "hen a manager begins developing a
marketing plan and hiring talent. It is essential to have "ell documented policies for
things such as compliance, valuation, and emplo!ee training and to ensure that
emplo!ees are a"are of and follo" these policies.
%ack office operations have recentl! become a top priorit! for investors. A
manager must evaluate "hat he needs to put in place for order management,
accounting, and risk management s!stems to create efficient business operations. A
chief operating officer &'$$( should be hired to oversee the development and
coordination of these s!stems. A '$$ is initiall! responsible for areas including trading
operation, investor relations, legal, accounting, finance, and IT) once the fund gro"s,
specialists can be brought in to pla! more specific roles.
A hedge fund manager "ill traditionall! "ork "ith a prime broker in the initial
stages of fund development and throughout the life of the fund. The primar! purpose of a
prime broker is to provide financing to the hedge fund. There are several "a!s for a
broker to do this including margin lending, derivatives trading, and securit! lending.
*argin lending is the simplest, most straightfor"ard financing method. #erivatives
trading allo"s the portfolio manager to express his vie" "ithout dedicating the capital
that "ould be required if the trade "as to ph!sicall! take place. +ecurit! lending permits
the broker to borro" securities for use in short selling.
'ustod! and clearing are also ke! services provided b! the prime broker.
'entralied custod! allo"s the hedge fund to trade "ith an! counterpart! "hile holding a
centralied position and use the position as collateral for financing.
Working with a Prime Broker
,rime brokers also provide value added services to funds. These services include
capital introduction, business consulting, talent identification and human resource
consulting. 'apital introduction teams "ill introduce potential investors to hedge fund
managers. %usiness consulting "ill assist managers "ith the business details of starting
their fund, tasks the! are usuall! unfamiliar "ith and sometimes overlook. Talent
identification and -. consulting can help find qualified individuals to join the fund and
"ork on developing emplo!ee/related requirements, such as benefits.
0hen choosing a prime broker, managers must consider "hether the! "ould like
to "ork "ith one or multiple. Traditionall! hedge funds operate "ith one prime broker, if
onl! for the advantage of maintaining simple, streamlined operations. .ecentl! ho"ever,
funds are beginning to prove that the benefits of having multiple prime brokers out"eigh
the operational challenges. -aving multiple brokers allo" for additional financing, price
discover!, additional borro"ing of multiple securities, and helps to mitigate risk. The
majorit! of hedge funds "ith 1233 million assets under management or greater consider
having multiple prime brokers a necessit!.
rgani!ation of the Fund
A hedge fund manager "ill likel! decide to organie his fund in one of t"o "a!s, a
limited partnership &L,( or a limited liabilit! compan! &LL'(. Investors in an L, are called
limited partners "hile those in an LL' are members. The manager of an L, is a general
partner and in an LL' he is a managing member. A significant difference bet"een the
t"o is that a general partner has unlimited liabilit! "hile a managing member has the
same liabilit! as other members of the fund but possesses more authorit! and decision/
making po"er. Investors in both of these fund structures have limited liabilit! and pass/
through tax treatment, features that are essential to a hedge fund. Limited liabilit! means
investors can onl! lose as much capital as the! put in. 0ith pass/through tax treatment,
the entit! itself is not taxed, but profits and losses are taxed through the individual
members as personal income tax or as an entit! on the entit!4s tax return. Limited
partnerships are more common, presumabl! because the! have been around for a
longer period of time. Limited liabilities ho"ever have a more flexible structure "ith
greater negotiation bet"een the managing member and the other members of the fund.
Another decision for a fund manager to make is "hether the fund "ill be
domestic &L, or LL'( or offshore. An offshore fund is attractive to non/5nited +tates
investors "ho do not "ant to enter the 5+ for an! number of reasons. Tax/exempt
investors are also interested in offshore funds in order to avoid unrelated business
taxable income. 0hen starting an offshore fund, one must consider the proper place to
launch. Areas such as the 'a!man Islands, the %ritish 6irgin Islands, Ireland, and
%ermuda are all favored locations but each one features different tax requirements and
costs of business. It is necessar! for interested mangers to research locations to find the
jurisdiction that best meets their needs.
*anagers "ill sometimes choose to launch an on and offshore fund
simultaneousl!. The! can either allo" these t"o funds to filter into an offshore master
fund, *aster 7eeder structure, or keep them separate, +ide/b!/+ide. In a *aster
7eeder, there is essentiall! one set of returns and one performance number as both
funds combine into one. A +ide/b!/+ide is slightl! more complex. It requires a greater
compliance structure due to the greater regulator! risk resulting from running these t"o
funds at once. *anagers must consider "hether the risk and cost is "orth using a +ide/
b!/+ide structure. If a +ide/b!/+ide seems too difficult or too costl!, and a *aster 7eed
structure is not desired, a manager can start "ith a domestic fund and later expand their
portfolio offshore.
"arketing a #edge Fund
There are several documents and regulations to consider "hen marketing a fund.
*anagers "ill t!picall! create a ,o"er,oint presentation to bring in front of investors
and legal advisors. Legal council "ill then be able to understand their strateg! and goals
and dra" up essential documents such as the ,rivate ,lacement *emorandum, the
Limited ,artnership Agreement, and the +ubscription Agreement &possibl! multiple, one
for each t!pe of investor 8 5+, non/5+, tax exempt, etc.(. *anagers are also advised to
register "ith the +9' b! submitting the 7orm A#6. Although this is not a requirement,
investors often look to see if a fund is registered "ith either the +9' or the state and
prefer to invest "ith one that is. A standard due diligence questionnaire is also
traditionall! completed at this time.
.ule :36&;(/< "as adopted in response to the =oldstein decision "hich
prohibited the +9' from forcing hedge funds to register as investment advisors. :36&;(/<
prevents the fund from engaging in an! fraudulent or manipulative practices "hether it is
intentional or a result of a simple mistake. This rule covers all communication from the
fund, not onl! to investors but to potential investors as "ell. To ensure compliance "ith
this rule, it is advised to create a schedule describing "hen to update documents and to
update all documents together to keep them consistent.
There are several "a!s for a fund manager to sell their fund4s interest. $ne
method is having the principal of the fund, of "hich he is a general partner, sell
securities. -e must have a preexisting relationship "ith those he is approaching in order
to do this "ithout registering as a broker dealer. The principle should not receive
commission for the mone! that he brings in to the fund.
A second method is hiring a third part! marketer, or broker dealer, "ho "ill sell
securities for the fund. Third part! marketers "ill often "ant to be compensated for the
mone! the! bring to the fund. This can sometimes cause controvers! and affect the
relationship bet"een the fund and the third part!. It is essential for managers to maintain
a positive relationship and honor the deals the! put in place to create and preserve a
commendable reputation.
A third, !et controversial method is to use the 'ash +olicitation .ule &.ule
:36&;(/>(. The 'ash +olicitation .ule permits a registered investment adviser to pa! a
cash fee to a person soliciting clients for the adviser only if the solicitor is not subject to
court order or administrative sanction. The fee is paid pursuant to a "ritten agreement to
"hich the adviser is a part!. 7or man! !ears, the 'ommission staff held the position that
the 'ash +olicitation .ule "ould appl! to pa!ments b! registered advisers to solicitors
referring separate account clients as "ell as in cases "here the solicitor is paid a fee for
soliciting investors in unregistered funds advised b! the registered investment advisor
2
.
-o"ever, in a :336 speech, the ?ortheast .egional $ffice of the +9' announced the!
"ould no longer cite registered investment advisers for failing to compl! "ith the 'ash
+olicitation .ule.
Technology $onsiderations
9stablishing a reliable, available, and secure technolog! core is essential for a functional
hedge fund. The specific technolog! required for a firm varies depending on the
applications used, "hat the fund does, and ho" it operates. There are a fe" basic
technological requirements that all funds must consider "hen starting up@ Infrastructure,
#ata ,rotection, 6oice +ervices and Archiving.
1
'ommission indicated the 'ash +olicitation .ule could be applicable in this situation in #ana
Investment Advisors, Inc., +9' ?o/Action Letter, 2AA; 0L B2<A6< &$ctober 2:, 2AA;(
A solid net"ork infrastructure must be created in order to carr! the valuable
information that a fund uses on a dail! basis. A business continuit! plan &%',( and
corresponding disaster recover! &#.( s!stem have become essential in toda!4s industr!
"ith investors looking for funds to demonstrate ho" the! "ill be able to maintain
continuous operations regardless of external events. A voice communications s!stem
must be created to support the valuable communication that takes place "ithin the fund.
And finall!, email and instant message archiving is required to guard against attacks
from a legal standpoint. -aving transactions archived "ill make it possible to refer back
to "hat specificall! took place and ans"er an! questions that might arise.
Infrastructure
+ecurit! is fundamental "hen considering the technolog! setup and net"ork
infrastructure of a fund. A multi/tiered securit! approach is essential to protect the critical
information that passes through the s!stem ever! da!. If outsourcing IT, the manager
should verif! that their provider is considering the securit! of their data centerChosting
environment. The site should maintain ph!sical securit!, cages and :;CB "atch, as "ell
as technical securit!, cameras and digital monitoring. The data center needs sufficient
redundanc! and availabilit!. An ?D2 infrastructure should be developed through multi/
entr! fiber paths E po"er grids, multi/da! fuel suppl! onsite, and multiple net"ork
providers. *anagers should also inquire about the frequenc! of s!stem and application
monitoring to ensure that nothing goes "rong "ith the securit! in place.
Telecommunications
There are three ke! categories to consider for telecommunications@ Internet service,
phone and market data services. *ost firms vie" Internet as a critical means of
communication, "ith market data as "ell as email delivered via this route. Three
Internet options are t!picall! available@ cable modem, #+L or T/2 line. 'able modem
and #+L offer high speeds and are relativel! inexpensive but their reliabilit! is lo",
especiall! "hen compared "ith a T/2 line. Internet T/2s are high in reliabilit! and offer
efficient speeds. 7or the highest levels of reliabilit!, a firm should consider having t"o
services and a router to establish automatic failover if one of the services goes do"n.
0hen selecting an internet service provider, look for a compan! that bundles in
proactive monitoring and securit! features to achieve high levels of availabilit!.
7or voice services, a firm t!picall! purchases a phone s"itch, or ,%F, "hich is
installed in the data center. A ,%F provides man! options for routing calls and storing
voicemails as "ell as caller I#, auto attendant and integration "ith ring/do"n lines to
various brokers.
+electing a market data vendor is based on the market and product coverage a
firm requires as "ell as cost, speed, reliabilit! and client service. The cost of services is
determined b! the offering mix, the number of users, the remote access method and the
real/time pricing requirements. Ge! market data pla!ers include %loomberg, Thomson
.euters and #o" Hones.
Data Protection
The primar! objectives of a business continuit! plan and disaster recover! s!stem are to
minimie potential financial loss, allo" for continued service to clients and partners, and
diminish negative effects of disruptions on a firmIs strategic plans, operations, market
position, and reputation. Investors are becoming increasingl! more stringent in vetting a
firm4s business and IT practices) the! are expecting firms to have comprehensive and
tested plans and procedures in place and requesting to see a firm4s plans and practices
during routine pre/investment due diligence audits.
It is important to understand the difference bet"een a %usiness 'ontinuit! ,lan
&%',( and #isaster .ecover! &#.(, as the! deliver complementar! !et unique
capabilities to a fund. #. encompass the steps taken to implement and support the
infrastructure &hard"are, soft"are and sites( necessar! to make recover! of mission/
critical services and applications &e.g. e/mail, trading, voice, file, accounting, etc%
possible. The steps to access up/to/date information and applications are established
"ith #.. A %', makes use of the infrastructure addressed in the #. ,lan, but focuses
on business operations and understanding such items as@ 0hat are the mission/critical
processesJ 0ho are the ke! personnelJ -o" are the! going to be notified of an
emergenc!J 0here C ho" "ill the! continue to operateJ
An effective %',C#. solution takes approximatel! :/> plus months and@
i( +upplies an understanding of "hat processes and personnel are essential)
and
ii( Addresses #ocumenting, ,lanning, Implementing, Testing and *aintaining
the policies, procedures and infrastructure to ensure these mission/critical
processes and people can continue to operate or quickl! return to operations
after an unexpected outage
0hen dealing "ith %', and Cor #. there are man! practices that should be used
and man! that "ill seem appropriate to a fund manager but in fact are ineffective. +ome
of these methods include rel!ing solel! on ph!sical tapes for back/up or hosting a #.
site at an emplo!ee4s home. The man! requirements, such as redundant po"er, -6A'
s!stems, fire suppression s!stems, diesel generators, etc, make running a #. server out
of a home impractical. Another ineffective method is hosting a #. site in the same
geographic region as the firm4s primar! office 8 this approach does not protect the data
from regional outages, such as flooding or po"er outages that "ould likel! affect both
environments.
9ffective practices include having actions based on business and application
availabilit! 8 firms must determine the acceptable level of do"ntime for an application
and then design the #. s!stem to achieve that level of availabilit!. 7irms should also
back up all essential documents and data offsite in an electronic format, at least dail!, if
not in near/real time. 9stablishing a means to access critical information and
applications in a remote manner could prove useful "hen an outage occurs, b! reducing
do"ntime and enabling business to remain running at near full capacit!. 7inall!, firms
must test and update plansCs!stems regularl! to ensure that all personnel kno" their
roles and that the technolog! is sufficient. This "ill guarantee that "hen the time comes,
a firm4s s!stems "ork and emplo!ees kno" ho" to get the business back up and
running.
&rchiving
9mail and instant message &I*( archiving is essential in order to prove compliance "ith
the man! rules and regulations to "hich hedge funds are subjected. The 7ederal .ules
of 'ivil ,rocedure relating to 9lectronicall! +tored Information requires hedge funds to
be able to suppl! things such as 9/mail, I*, %loomberg *ailCI*, documents,
spreadsheets, and ,#7s if requested. 9/mail and I* data should be saved for the
amount of time prescribed b! la". #ata should be stored in 0$.* &0rite $nce .ead
*an!( format so that nothing can be changed or deleted. .ecords need to be indexed in
searchable files to aid in providing onl! the information that is requested. The most
recommended "a! to store data is on its o"n offsite server accessible via "ebsite.
$onclusion
Launching a hedge fund is a formidable task that requires methodical planning and a
team of experienced service providers to help streamline the process. %! understanding
the road ahead, hedge fund managers can align the necessar! resources and focus on
devising a successful investment strateg!.
SIDEB!: Start"u# Chec$list
Fund Structure
Legal@ onshore, offshore, master feeder
Accounting@ audit, tax
Administration@ internal or outsourced
,rime %rokerage@ custod!, clearing, finance
%ar$eting
%usiness plan
Articulate strateg!
*arketing materials
Investor recruitment
Infrastructure
$ffice space
9quipment
Technolog!
#isaster recover! provisions
-uman resources
&#erations %anagement
,ortfolio accounting s!stem
.isk anal!tics
Trading &rder %anagement
Trade execution
$rder management
Trade allocations
.eal/time ,EL