Article by Ian Gobin, Appleby

Want to set-up your own hedge fund? If so, you’re not alone. According to a recent report by the Financial Times, last year more than 1,100 new hedge funds launched globally, the highest number since 2007.

There are many factors that will determine the successful launch of a new hedge fund. Your hedge fund must have a competitive advantage over others in the market. You must have a clearly defined investment strategy with a successful track record (at least 2-3 years) and have a front-, middle- and back-office. You must be able to raise capital. And you’ll have to source and grow assets and run the fund as a profitable business, while simultaneously producing positive returns. Raising capital is often the stumbling block.

Seed capital is important for the following reasons:

• It demonstrates to other investors that someone has faith in the hedge fund manager;
• Initial investors need not be concerned with the total expense ratio of the fund;
• It allows the hedge fund manager to cover expenses; and
• From an investor’s perspective “everybody wants to be first to be second”.

Potential sources of seed capital include:

• Own capital and capital of friends and family;
• Seed capital providers;
• Financial advisors, wealth-management and family offices;
• HNW individuals;
• FoHFs; and
• Sub-advisory relationships.

“Seeders” like to see that your own money is a significant portion of the fund – you must have “skin in the game”.

The vast majority of top hedge fund managers got their start through seeders. Often the seeder is the management team’s former employer or former client.

An investment by a seeder is a high-risk investment, but one that can reap significant rewards if the fund becomes a sensation. Well-known “seeders” include Blackstone, Goldman Sachs and Reservoir Capital.

We’re seeing some innovative approaches from seeders to start-up hedge funds, including potentially taking an equity stake in the fund or a portion of the hedge fund manager’s 2/20 fees. Capacity rights, enhanced liquidity and transparency rights and fee discounts/rebates could also form part of the terms.

Hedge fund managers may also choose to sell minority stakes in the entity managing the fund to raise capital to seed their funds and to cover some of their start-up costs. However, in return for the provision of such seed capital, seeders may insist on certain veto or other rights to obtain a level of control over the activities of the hedge fund manager.

We have also seen funds being formed by established hedge fund managers in conjunction with start-up managers. The established manager will act as the investment manager with the start-up manager acting as the sub-advisor and the fund being branded with the established hedge fund manager’s name.

The idea being to enable the start-up manager to raise capital on the strength of the existing hedge fund manager’s name and develop a reputation as a sub-advisor to the fund. At which point the start-up manager takes over as investment manager and the fund is re-branded using their name – with the existing hedge fund manager retaining the benefit of some fee sharing arrangement.

Start-ups are also turning to seeders with back-office resources, as rising regulatory costs require compliance officers, audits etc.

Despite the challenges that exist, we’re seeing a significant rise in the flow of start-up hedge funds.

Originally published in the Hedgeweek Cayman Special Report.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.