Starting a hedge fund: How to establish a foundation for success in a challenging marketplace

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Introduction Being a hedge fund manager isn’t easy, even if it can pay well. 2015 was an exhausting year for many of the approximately 9,000 hedge funds operating in the U.S. Although the stock market has shown some improvement with the Dow Jones Industrial Average crossed the 18,000 threshold for the first time in nearly nine months, 2016 is unlikely to be much easier, judging by certain macroeconomic challenges out of the gate, such as market turmoil in China and the Greek debt crisis. This uncertainty comes on top of woes for money managers in 2015, with the devaluation of the Chinese yuan in August, and market upheaval after the International Monetary Fund declared the yuan a major global currency in November. Risk tolerance has fallen among investors as energy commodities and equity continue to decline, and the oil industry took a drubbing. One bright spot was the Federal Reserve’s slight rise in interest rates at the end of December 2015, which caused some celebration on Wall Street and among some hedge funds.

Even so, between performance pressures, competition for funds, erosion of fees, market volatility and regulatory hurdles, hedge fund managers are in a challenging spot. Many hedge funds performed poorly in 2015, posting average returns of 1.45%, the lowest since 2011. North American hedge funds posted their lowest returns since 2008, down 0.55%.

At the same time, compliance costs have soared, driven by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), signed into law in 2010 with the objective of preventing the excessive risk-taking that led to the financial crisis of 2008. Title IV of Dodd-Frank makes a number of changes to the registration, reporting and record-keeping requirements of the Investment Advisers Act of 1940. Now, advisers to most private funds (hedge funds and private equity funds) must register with the SEC provided they are above a certain threshold, a requirement from which they had been exempt in the past, via the private adviser exemption.

With SEC registration comes the many complexities of SEC control and disclosure reporting requirements. Even the SEC examinations that assess hedge funds’ compliance with these requirements are a continued source of concern and still more costs for hedge fund managers. Ensuring transparency in these funds is a high priority among the SEC examiners. Among other examination priorities are complicated fee structures that are hard for investors to understand, and complex and illiquid investments that can make it hard to measure fair value. It is important for hedge funds to regularly review and update their policies, procedures and business activities to reflect SEC priorities so they can strengthen their business practices and prepare for potential exams. For related content, see SEC, FINRA Release 2016 Exam Priorities for Asset Managers, originally published by Grant Thornton LLP on Feb. 10, 2016.

The poor performance and new regulatory hurdles drove many high-profile hedge funds to close their doors or liquidate certain funds in 2015, including JAT Capital, Everest Capital, Fortress, Bain Capital, Comac and Cargill’s Black River Asset Management. Among those winding down funds, many high net worth fund managers returned investors’ money and converted their operations to family offices, where they manage their own money and that of relatives and friends, while avoiding the regulatory requirements of Dodd-Frank and the demands of investors regarding performance and fees.

Another response to the pressures on hedge funds has been increased consolidation. Recent deals included Affiliated Managers Group purchasing a minority stake in Systematica, KKR buying a 24.9% stake in Marshall Wace LLP and Julius Baer upping its stake in Kairos Investment Management from 19.9% to 80%. Blackstone Group, Goldman Sachs and Credit Suisse have raised money and/or staffed up for future asset management acquisitions. For related content, see Plan Now: Don’t Let Your Books and Records Stall the Sale of Your RIA, originally published by Grant Thornton on Jan. 27, 2016.

Amid these many concerns and pressures, attracting investors and raising capital are harder than ever. Investors have grown ever more vigilant in delving into all aspects of a fund’s operations to safeguard their assets and minimize any exposure to operational risk. And it should not come as a great surprise that it’s a highly competitive marketplace. This paper provides an overview of three key fundamentals today’s hedge fund managers need to master:
  • Raising capital in today’s financial environment
  • Sustaining profitability in the face of increasing regulations and declining fees
  • Organizing the fund for maximum tax efficiency

Raising capital in today’s financial environment
Despite the disappointing performance and heavier compliance burden, worldwide hedge fund assets under management (AUM) continue to grow. Roughly 10% of the 9,000 hedge funds operating in the U.S. start new funds each year, while an average of 500 to 700 funds close. For example, 2014 witnessed 731 U.S. fund closures. Hedge fund closures in the first nine months of 2015 totaled 674, compared with 661 during the same period the previous year.

Performance last year was dismal, but fundraising and investments continue unabated. In fact, some hedge funds performed so poorly that they sent apology letters, at the same time asking investors to pony up for new funds. Investors poured $38.2 billion into hedge funds for 2015, compared with the $18.8 billion recorded in 2014. Hedge funds are expecting to raise a significant amount of capital in 2016 and beyond. This should be made somewhat easier by the prospect of continuing increases in U.S. interest rates, credit defaults and volatility, which make hedge funds an attractive investment option.

As always, the biggest challenge for most new funds is finding and raising capital. A startup often begins with $10 million to $30 million — not enough to make any money, but sufficient to establish an investment track record, which is key to the fund’s marketing efforts. Much of the initial capital will come from the fund manager, ensuring that the manager’s own interests align with those of other investors and the fund overall. Family and friends typically form the next ring of early investors.

At this point, many hedge funds seek out a strategic partner from a broader mass of potential investors, including high net worth individuals, family offices, institutional investors (e.g., pension funds and foundations), hedge fund seeders and funds of funds. This seed investor typically will provide an influx of capital in exchange for some sort of economic participation in the fund, whether that amounts to reduced fees or another incentive.

“A seed investor can help a startup hedge fund attract additional outside capital, but keep in mind that it comes with certain complexities,” says Michael Patanella, Grant Thornton Audit Services partner and Asset Management leader. “If that seed investor pulls out without sufficient warning, it can be disastrous.” He advises fund managers to make sure the terms of the seed investment are viable. For instance, how long is the seed investment locked up? What revenue share is the hedge fund expected to pay to the seeder, and for how long? What is the buyout clause? Patanella says: “These are important issues to address upfront. It’s also important to address confidentiality expectations with seed investors, since future investors often want to see the terms of the seed investment. If these terms are bound by confidentiality, it’s problematic.”

Institutional investors contribute a larger share of hedge fund investments than ever, which also brings different challenges. For the industry as a whole, about 60% of its capital now comes from institutional investors. Consequently, many hedge funds are rethinking their products, fees and fund strategies to attract these institutional investors, particularly pension funds. At the same time, pension funds are changing their investment criteria and objectives, creating new demands on hedge fund managers.

Unfortunately for new funds, tapping institutional investors is something of a Catch-22: Funds have to have substantial capital to get institutional money, but institutions won’t invest with those funds unless they have substantial capital. Smaller funds that are exempt from SEC registration especially face an uphill struggle to attract the interest of institutional investors.

Kunjan Mehta, Grant Thornton Asset Management partner, says: “Due diligence is still extremely cumbersome and time-consuming, with no guarantees of additional money to fund managers after the process is complete. There are extensive background checks and a significant amount of paperwork. A process that used to be two or three months now often takes six months to a year.”

Potential investors are closely examining hedge funds before they invest, examining their business plans, strategies, exposures (both investment and operational), policies and procedures. And they’re also taking a long, hard look at the team the fund has in place, both internally and externally, to do the job. It’s helpful to prepare by obtaining one or more due diligence questionnaires and be ready to answer all the questions.

Patanella says: “Fund managers need to be prepared for close scrutiny from investors. Transparency around exposure to risks and sources of returns will be more important this year than ever. Investors will want to understand the economics of your business. What is your plan beyond trading? Who are you going to hire? Who is going to do your compliance?” He adds that institutional investors, in particular, are going to be looking for pedigreed managers and top-tier service providers, including accounting, legal and prime brokers.

An outstanding investment track record, of course, offers a big boost. But historical performance, no matter how stellar, is not enough to convince investors that a firm’s strategy works long term. It will be dissected to determine whether its past successes can be duplicated in different economic and regulatory environments, and whether it will continue to perform for that fund as it grows and changes. Moreover, most hedge funds haven’t performed optimally over the past few years, making this a harder sell.

In addition to the business plan, a well-conceived marketing plan is also a must. This plan must address a number of questions:

  • What types of investors is the fund going to approach?
  • How will the fund reach these investors?
  • What is the story that the fund will tell them?

Advertising is also an option. The ban on general solicitation and advertising for hedge funds was lifted in September 2013 as part of the Jumpstart Our Business Startups Act. The SEC now allows funds to advertise through a wide range of media, including print publications and TV. A company’s website, which had been a mostly password-protected tool for current investors, has been positioned to become a much more robust promotional medium.

Given its ability to reach a greatly expanded universe of potential investors, advertising is certainly something startups will at least want to consider. One challenge for hedge funds is that advertising requires a set of marketing skills and capabilities that is unlikely to reside at most smaller funds. Another is that most of those reached through advertising will have far fewer assets than traditional hedge fund investors. That means a lot more of them will be needed to achieve a critical mass of capital.

Eager to ensure that the new investors are indeed high net worth individuals, the SEC has issued stricter guidance for determining investor suitability; self-certification by the investor through simply checking a box is no longer sufficient. The fund now bears the burden (and associated costs) of ensuring that all the money it gets comes from accredited investors or qualified purchasers. (There is grandfathering for existing investors.)

The investors attracted by advertising are also more likely to be new to hedge funds. They will ask more questions and need more personalized attention, which raises administrative costs, or at least increases the burden on current staff.

Finally, firms must file a Form D before a general solicitation begins, and an amended Form D when it is completed. The raised profile that advertising brings to the fund may come at the price of increased regulatory scrutiny. The firm must be careful to avoid making statements of material fact that could be perceived as misleading, because performance results are especially likely to receive close examination.

Sustaining profitability in the face of increasing regulations and declining fees
Hedge funds are under margin and performance pressures. They’re squeezed between reduced fees and higher costs, especially when it comes to compliance, and in many cases are under fire from investors due to poor results. Is it any wonder that an average of 500 to 700 U.S. funds close each year? While fees used to be ample, these have been eroding for a number of years, particularly as performance has faltered. The traditional two and twenty fee structure — management fees at 2% of AUM and performance fees at 20% of investment returns — is becoming less common as investors increasingly push back. Moreover, smaller firms are getting heated competition from big funds and are trimming fees to compete.

The use of hurdle rates (i.e., benchmark levels of return that a fund must clear before performance fees kick in) has also become more frequent. Moreover, investors willing to lock up their money for several years, make a big investment or put money in a new fund can get even better deals on already reduced fee schedules.

Yossi Jayinski, Grant Thornton Audit Services partner, says: “When investors believe performance has been poor, it’s not surprising that they scrutinize fees. We’re seeing fees continue to come down in response to investor pushback. Management fees are now between 1% and 2%, and for a small fund trying to attract new clients it might be even less than that.” New hedge funds are charging average performance fees of 14.7%, a sharp drop on the 17.1% typically charged in 2014.

At the same time, an onslaught of new regulations — SEC registration for advisers stemming from Dodd- Frank, the Foreign Account Tax Compliance Act (FATCA), anti-money laundering (AML) requirements and other regulatory regimes — are raising compliance costs sharply. SEC registration also comes with significant new disclosures.

In general, the SEC is focusing more closely on disclosures, and on identifying and monitoring risks of registered investment companies and registered investment advisers, in light of the growth of new and more complex investment products and strategies, like those of hedge funds. Compliance and expertise of in-house or outsourced compliance arrangements are a growing area of scrutiny from the SEC, with proposed changes to the Form ADV requiring hedge funds to disclose details of their outsourcing arrangements for compliance.

“Hedge funds need to give serious thought to their compliance function and how it meets the needs of their business,” cautions Patanella. “The fastest way to repel capital is to have an SEC investigation finding or fine.”

For related content, see SEC Seeks to Modernize Investment Reporting and Disclosures, originally published by Grant Thornton on July 20, 2015.

The Dodd-Frank Act
Adviser registration
The Investment Advisers Act of 1940 included an exemption from registration for an investment adviser including those to hedge funds — with fewer than 15 clients within the preceding 12 months, and which did not hold itself out to the public as such. Under Dodd-Frank, that sweeping exclusion has been eliminated. Hedge funds with more than $150 million in regulatory assets under management (RAUM) in the United States now have to register. (Note that there are additional requirements if you’re a venture capital fund or a foreign private adviser.)

Among the requirements of a registered investment adviser (RIA) filing with the SEC are:

  • Filing disclosures on Form ADV
  • Designating an individual as chief compliance officer
  • Maintaining financial books and records to facilitate SEC examinations
  • Keeping client assets with a qualified custodian

Form PF Form PF is a joint initiative of the SEC and the Commodity Futures Trading Commission (CFTC). Its purpose is to allow the Financial Stability Oversight Council to monitor risks to the U.S. financial system. Private fund advisers have to file an annual Form PF if they advise private funds with more than $150 million in RAUM.

A hedge fund is defined for purposes of Form PF to be generally “any private fund that has the ability to pay a performance fee to its adviser, borrow in excess of a certain amount, or sell assets short.” Large hedge fund advisers above the $1.5 billion RAUM threshold have additional reporting obligations, including quarterly filings for some data.

Hedge funds are now required to provide information on Form PF as follows:

  • Gross and net assets of each private fund
  • The aggregate notional value of the fund’s derivative positions
  • Performance
  • Counterparty credit risk exposure
  • Trading practices
  • Percentages of fund ownership
  • Financing (including secured and unsecured positions)
  • Valuation and methodology
  • Liquidity of holdings
  • Portfolios of insiders

Such an abbreviated listing understates the complexity of Form PF, which requires extensive data identification, collection, verification and aggregation. Much of the information has never been required on any form, and simply locating and gathering the data has been a major challenge for some funds.

AML The Securities Industry and Financial Markets Association (SIFMA), an association of several hundred securities firms, banks and asset managers, has released a suggested AML due diligence practices guide for hedge funds. The SIFMA document prescribes two regimes, simplified and increased, of procedures, based on the level of risk, adherence to an equivalent AML regime and other factors.

Blue sky laws Hedge funds also have to make blue sky filings in each state where they have investors. Blue sky laws are state regulations designed to protect investors against fraudulent sales practices by requiring sellers of new issues to register their offerings. These generally run no more than a few hundred dollars, but in the case of New York, where a filing is required before the initial investment, the cost is over $1,000.

Additional regulations
Other regulatory regimes that affect hedge funds include:

  • The Financial Crimes Enforcement Network’s (FinCEN’s) proposed AML rule applicable to SEC RIAs remains on track to be finalized in 2016. This proposed rule would extend the Bank Secrecy Act, AML and suspicious activity reporting (SAR) regime to investment advisers. FinCEN proposed the rules in part to address its concern that individuals would use advisers to launder illicit proceeds and terrorist funds. Hedge funds will be required, like banks, brokerages and mutual funds already are, to file SARs with FinCEN.
  • The CFTC issued new rules that went into effect in 2012, requiring hedge funds or hedge fund advisers who previously were exempt from the CFTC’s registration requirements to register as a commodity pool operator (CPO) or a commodity trading adviser (CTA). Even those who are exempt need to file an annual notice that they continue to qualify for the exemption. The CFTC is, in part, aligned with the SEC. For example, CFTC registration requirements may require funds to complete Form CPO-PQR, which is the counterpart of the SEC’s Form PF. Hedge funds would also be subject to rules in markets regulated by the CFTC, such as swap transactions.
  • FATCA requires all non-U.S. hedge funds to report information on their non- U.S.-based clients.
  • The Alternative Investment Fund Managers Directive (AIFMD) has rules that apply to any fund, no matter where it’s based, if it takes any money from an EU-based investor. These rules went into effect for AIFMs on July 21, 2014. Most UK- and Europe-based hedge fund managers are now AIFMD-compliant.
  • When the SEC lifted the ban on hedge fund advertising, it also issued regulations that disqualify felons and other so-called bad actors from participating in hedge fund offerings. Bad actors are primarily officers, 20% beneficial owners and fund managers who engage in disqualifying events, including criminal convictions, court orders, final orders and other orders in connection with violations of securities laws.

With expenses rising and fees dropping, hedge funds have their work cut out to maintain profitability. Jayinski says: “The current cost structure of the industry is tough on smaller funds. Firms need to grow, whether organically, raising new funds or through consolidation, so that they generate sufficient income to remain profitable. But cost-cutting has to be done with a scalpel, not a saw: Choosing bargain-basement services and staff may initially help the bottom line, but in the long run it can hurt the firm’s reputation and back-office operations.”

Organizing the fund for tax efficiency
When setting up a hedge fund, there are many factors to consider from organizational, regulatory and tax standpoints. Organizing a hedge fund for maximum efficiency is a task of considerable, sometimes enormous complexity.

Grant Thornton Tax Services Partner Brian S. Moore says: “While never the most important part of launching a new venture, managers need to pay particular attention to the tax structure of new funds. It can impact the ability to attract and retain certain classes of investors. Most sophisticated investors are acutely aware of the tax implications of certain structures, and want to ensure that they are receiving income from funds in the most tax-efficient manner possible, as it will impact their overall rate of return on the investment.”

The following is a brief overview of tax structure considerations:

Tax status of investors A key factor in organizing and structuring a hedge fund is the tax status of the investor the fund seeks to attract.

  • Individuals and for-profit institutions based in the U.S.: They pay U.S. taxes based on their worldwide income.
  • Tax-exempt U.S. investors, including pension plans and charitable entities: They do not pay U.S. income taxes. Importantly, a U.S.-based nonprofit cannot invest in an onshore hedge fund without addressing the unrelated business taxable income.
  • Nontaxable offshore investors (i.e., individuals and institutions not based in the United States): They do not pay U.S. income taxes.

Common hedge fund structures
Master-feeder funds
Master-feeder is the structure most often used by hedge funds. Investors put their money in feeder funds, which in turn supply it to a master fund. All the investing and trading is done by the master fund, which is typically an offshore corporation taxed as a partnership — a flow-through entity — for U.S. tax purposes.

Usually, the master fund receives capital from:

  • A U.S. domestic feeder (typically a partnership called the onshore), with funds from U.S. taxable investors
  • An offshore feeder (usually a corporation), with funds from U.S. tax-exempt and nontaxable offshore investors

The master fund is often incorporated in places friendly to alternative investment entities, especially the Cayman Islands, Bermuda and the British Virgin Islands, although there are numerous locations outside the Western Hemisphere. These jurisdictions, where offshore funds represent a significant part of the local economy, offer well-established investment laws, a strong infrastructure of service providers, and no- or low-tax favorable tax treatments — investors are taxed where they live. Regulatory bodies, such as the Cayman Islands Monetary Authority and the Bermuda Monetary Authority, maintain strong policies and guidelines. Investors see these regimes as underpinning risk management, and managers accordingly select these jurisdictions.

The master-feeder fund structure (and mini-master fund structure) Master-feeder funds consolidate trading activities into a single portfolio, while allowing managers to accumulate funds from U.S. taxable, U.S. tax-exempt and foreign investors. This commonly used structure creates a critical mass of tradable assets, improves the economies of scale and helps reduce costs. This structure features:

  • Management fee
  • Onshore feeder
  • U.S. investors
  • Investment manager
  • Master fund
  • Performance fee
  • General partner (GP)
  • Offshore feeder
  • Foreign or U.S. tax-exempt investors

Single domestic hedge funds Most U.S. startups begin with investors solely from the U.S., so the hedge fund may be structured as a U.S.-based limited partnership (LP) or limited liability corporation (LLC). Generally, each fund will have its own management company and GP; the manager establishes an LLC to serve as the fund’s GP. Onshore funds are usually domiciled in Delaware, because of the state’s long tradition of well-developed and generally business-friendly corporate laws.

Single foreign hedge funds An offshore hedge fund, such as a foreign corporation that trades securities for its own account, is not considered to be engaged in a trade or business in the U.S. Thus its investors are exempt from U.S. taxes. For a few selected funds in their initial stages, this may provide a less costly solution than the more complex master-feeder and side-by-side structures.

Incubator hedge funds As the name implies, an incubator fund provides a controlled environment for investment managers to test out strategies and show what they can do before hiring an administrator and launching the actual fund. The incubator fund has a simple organization structure, usually comprising: (1) an LP or LLC for the fund, and (2) an LLC as the investment manager/GP of the fund (or managing member if the fund is an LLC). An incubator doesn’t provide all the offering documents of a traditional hedge fund, and it is usually only open to the actual managers of the fund.

The manager invests for six to 12 months, sufficient time to create a performance history and to cultivate investors. If there’s sufficient interest, the fund can take the next steps to establish itself as a full-fledged fund.

Side-by-side structures In a side-by-side structure, a single management company manages an LP, organized in the U.S. for U.S. investors, and an offshore corporation, organized overseas for non-U.S. investors. Both funds typically have the same trading strategies, and trade tickets are allocated to each entity. But because the onshore and offshore funds are two separate entities operating independently, the fund manager can better accomplish tax efficiencies for U.S. investors while seeking the best returns for investors not subject to U.S. taxation. The negatives are increased administrative costs as well as decreased leveraging power because assets are in two pools.

Conclusion The hedge fund industry is in the midst of significant change. Regulations are driving up costs. Traditional fee arrangements are being renegotiated. Competition for capital is fierce. Many funds — particularly those just starting out — are more than willing to cut fees to attract money. Investors across the board are much more skittish about safeguarding their money, giving rise to a due diligence process that is increasingly quantitative and complex.

Fund performance is under increasing pressure, and the investor base is shifting. Institutional investors, especially pension funds, are becoming the primary investors in lieu of high net worth individuals. These types of investors tend to prefer well-established funds with a long history of high returns over newcomers lacking committed capital. Consolidation among funds is taking place at a fast pace, especially among smaller funds that are aligning with one another to expand their AUM and, thereby, are better positioned to attract institutional investors. Hedge funds that plan to be successful in this marketplace will need a creative sales and marketing strategy in order to raise assets, a robust compliance program that goes far beyond dotting i’s and crossing t’s, strong relationships with their service provider partners, and a well-planned tax strategy that maximizes efficiency and minimizes risk.

How Grant Thornton can help If you are considering starting a fund, Grant Thornton can help give your firm the critical edge. Our firm can advise on fund formation and structuring, and assist throughout the initial fund launch.

Our specialists have real-world industry knowledge, and as your fund grows from a startup with less than $150 million in AUM to an SEC-registered business, we can address the day-to-day business situations you may encounter. We can provide assistance with matters such as audit, tax and regulatory compliance; investment adviser registration readiness; internal control and risk management reviews; operational and performance evaluations; IT strategy and effectiveness analysis; and litigation support services.

As hedge fund industry thought leaders, we regularly publish white papers, articles and other communications designed to keep emerging managers abreast of industry issues. In addition, we collaborate with various trade organizations and key influencers to host a variety of educational events for our clients, including industry hot topics symposiums, roundtables, webcasts and networking events. Visit for more information about our asset management practice.

Michael C. Patanella
Audit Services Partner
U.S. Asset Management Sector Leader
T +1 212 624 5258

Yossi Jayinski
Audit Services Partner, Asset Management
T +1 212 624 5548

Joseph Magri
Audit Services Senior Manager, Asset Management
T +1 212 624 5380

Sean Matthews
Audit Services Senior Manager, Asset Management
T +1 212 624 5278

Kunjan Mehta
Audit Services Partner, Asset Management
T +1 212 624 5259

Brian S. Moore
Tax Services Practice Leader, Asset Management
T +1 212 624 5547

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