Stories of the Institutional Past #14

Starting a Hedge Fund

Starting a hedge fund can be a thrilling and rewarding venture, yet it comes with a unique set of challenges and considerations. I will talk about my own experience and reflection as I delve into the various aspects of creating and managing a hedge fund, shedding light on the complexities involved from initial conception to operational execution.

One of the most significant hurdles in launching a hedge fund is securing investment from institutional investors, who are often called cornerstone investors. I was lucky enough to have had the commitment of another fund that gave me an initial capital to get started. These entities often seek funds with a proven track record and a certain level of experience in the market. As a founder, meeting expectations without the historical performance to back your strategies can be daunting.

I was there; you go through a lot of detail and due diligence. If you don’t have a professional track record, it will be tricky. The reality is that convincing institutional investors to place their trust and capital in your fund requires not only a compelling investment thesis but also evidence of your ability to execute it successfully over time.

That’s where some basic game theory comes in. I met hundreds of selectors and potential investors. For 99% of them, you will need at least a 3-year track record with a decent enough ticket to have credibility. Back in the day, that “number” used to be around 50 million USD. These days, the hurdle to get additional investors is way higher, around the 300+ mio USD mark. Think about it: an allocator takes a huge career risk in selecting a new fund. If anything goes wrong, he or she is going to be on the hook for it. That’s why it’s safer to go with the big boys. Life isn’t fair, but that’s the reality.

With 50 mio, you can just about break even. A Cayman feeder fund isn’t cheap and will have significant start-up costs with it. Then, there are typically outsourced operations and compliance, legal counsel, and running costs, such as for an office. I have found a spreadsheet in my files that summarises the estomated costs below. You can see that running 50 million USD with a 1.5% management fee pretty much only covers all basic costs and salaries. If performance is there, more money could be accrued. While those numbers seem large, I can tell you that the real costs creep up on you.

Most allocators also want to see you go through an investment cycle and your ability to attract more investors. I can also tell you that performance, initially, is not even an important marker. They want to see some resilience and a fund that and its founders can finance themselves for a long runway until success kicks in.

The operational setup of a hedge fund is no small feat. From appointing directors to handling the myriad of administrative duties, the costs can escalate rapidly. Navigating these operational challenges while staying focused on market and trading opportunities can be a delicate balancing act. The sheer volume of operational tasks can be overwhelming, leading to significant expenditures that must be managed wisely to prevent them from consuming too much of the fund's capital.

Another critical aspect of running your own fund is managing key man risks and protecting intellectual property (IP). The dependence on a few individuals for critical investment decisions or operational management can pose significant risks to the fund's continuity and performance. This will be picked on in any due diligence meeting.

I never regretted having started my own fund, and I was lucky enough to have been able to grow it and then sell it to another company after the burden of managing all aspects was just too much of a hassle for me to continue. It all sounds so easy, but starting your fund or, in fact, any other business will test you to the core. It's not for everyone, and you will find out a heck of a lot about yourself in the process. If you are thinking about going for it, consider all those options above and make sure you have a long enough runway through appropriate financing or a good enough starting ticket to tick you over. Otherwise, it will be exponentially more stressful.

A funny story to end with. I was in New York City many years ago on a roadshow and trying to drum up some more investors in the fund. We went to possibly one of the largest allocators that could easily drop you a 250 mio ticket if they so wish. The meeting went very well until the moment I chose to pick a little spot I had noticed on my neck. Seconds later, I started bleeding all over my crisp white shirt and had to excuse myself for a few minutes to clean up. Unfortunately, we never got the money, but I’m sure it was as memorable for them as it was for me.

Blood, sweat and tears. That’s what it’s all about.