Jerry Lees, Chairman of Linear Investments, writes in the latest special report from HFMWeek: How to start a hedge fund in the EU in 2016.
“A PIVOTAL PART OF YOUR SUCCESS WILL BE FINDING IN-HOUSE SEEDER FUND CAPACITY COMBINED WITH A CAP INTRO TEAM SPECIFICALLY FOCUSED ON EMERGING FUNDS AND WORKING ON A RESULTS BASIS”
Surviving Change: Jerry Lees of Linear Investments investigates the ever-shifting hedge fund environment
I don’t think it is any surprise that it has become increasingly difficult to set up a new hedge fund unless it is a spin-off from already established and sizable funds. The sector is suffering from post-2008 fatigue with overall unimpressive results combined with extreme wariness on behalf of investors.
Nevertheless, it is still very possible to set up a new hedge fund in today’s environment and succeed – you just need to be pragmatic and take all the help you can get. DIY is not the answer – you will waste much of your valuable skills on mundane and time-consuming tasks that are better fulfilled by experts who have done it before and can deliver a solution on a plate. As Warren Buffet said, “It’s good to learn from your mistakes. It’s better to learn from other people’s mistakes.”
In researching and planning this article, I looked back to my previous articles on this subject. I searched to see how my advice reflected market conditions at the time and, based on another two years’ experience working with over 150 clients, how that advice might change. Our clients are all in this sector: managed accounts, wealth management, brokers etc. of which 70 are solely hedge funds. A very different market also raises the question of what you should do now versus in the past.
Summarising my conclusions last year, I noted the following:
• It is now significantly harder to attract investors
• Fee expectations across the board are significantly lower
• Regulatory pressures are immense
• Operational costs have escalated
• It is crucial to have an audited track record
Altogether it sounds like a tough call and I have not changed my prognosis. If anything it has become harder to raise capital; fee expectations are being squeezed further and regulatory pressures continue to mount with greater burdens. At the same time operational costs are increasing steeply and the catch-22 requirement for a track record of at least three years’ high yield is a difficult hurdle to meet before serious funds come through the door.
Answers to questions
What is happening, why is it becoming more difficult, and what can be done to differentiate yourself and survive while you build that all important track record?
I quote from the Credit Suisse Mid-Year Investor Sentiment Survey as follows:
“73% of investors surveyed indicated they were likely or very likely to allocate capital to hedge funds in the second half of 2016. However 84% of respondents reported redeeming from hedge funds in the first half of 2016 (over 60% of those who redeemed where driven by specific manager underperformance or strategy drift). Of those who redeemed, 82% expect to recycle capital to other hedge fund managers.”
In other words, an 11% fall in capital allocated to hedge funds in Q1 2016. According to another report, in January 2016 alone net outflows from hedge funds were $21.5 bn, the largest redemption annual start since 2009, followed by overall losses of over $20bn.
We can see why investors are extremely cautious and nervous of non-institutional hedge funds in why there is huge competition for seed capital between emerging hedge fund managers. Raising capital is therefore a huge challenge. In order to succeed your emerging fund needs to focus on track record, marketing strategy and your core value proposition – what differentiates you?
Don’t underestimate track record and outsourcing
As I said earlier track record is critical. You need to be able to start with sufficient friends and family funds to make the track record credible. In order to address the conflicting issues of increased regulatory burden and other consumers of your time, you need to outsource as much as possible in order to retain your focus. With a small team you cannot afford to cover regulatory set-up and reporting, compliance and risk management (risk technology and human resource), IT and operational risk, office and facility set-up, legal and structure, as well as put forward a capital raising team and marketing programme.
By outsourcing many of these processes to a platform solution such as Linear, you can demonstrate all the operational technology and compliance/risk controls necessary to convince investors that your fund is of institutional quality. These compliance, operational and risk controls tell the investors that there is a third party intermediary platform looking after their investment. The platform controls and limits the business risk that often makes institutional investment in an emerging fund impossible. The investor can be certain that the platform will not risk the bulk of its other client and investor relationships because of one small, defaulting fund.
Continued regulatory pressure and increasing operational expenditure creates a need for greater infrastructure, IT systems for proof of best execution, research procurement, middle and back office expenses, and so forth. That makes it essential to be regulated while building a track record. Applying for your own FCA licence will now take you around 18 months, a catastrophic delay if you are waiting to build the crucial track record.
Outsource everything where possible!
Outsource compliance to a simple overhead, become an appointed representative (AR) in a few weeks and establish a regulated record while waiting for the FCA. Outsource office and IT infrastructure to an organisation that is fully compliant with MifidFID II and AIFMD. Outsource trading so that you keep execution costs to a minimum and don’t waste time or spend money on trading costs that come straight out of your bottom line.
Middle and back office, risk systems, operational procedures, detailed analytical tools (analysing performance/Beta/Sharpe etc.), and production of state of the art performance reports can be added to the outsource product. Office space without a long-term commitment, massive personal guarantees and large deposits can be part of the platform. IT should be private cloud based to maximise efficiency and meet regulatory stipulations, run by experts in the field. Managing technology is a profession unto itself, unless you spend most of your free time building servers and managing networks, you will need help managing technology at your new firm. Essentially, Linear Investments’ platform will supply all of these services on a short/medium and long-term basis on a flat fee or a percentage of AuM basis, without taking equity in the venture.
Now to the key topic of raising capital. A pivotal part of your success will be finding in-house seeder fund capacity combined with a cap intro team specifically focused on emerging funds and working on a results basis. They will bring established relationships with multiple investors and an understanding of the investor requirements.
Don’t believe the larger prime brokers if they tell you they will find seed capital, unless you are already at $300m-$500m, they just can’t help you. They cannot justify the resources, they don’t have the contacts, and they won’t spend the time, leaving you with false hope. Don’t underestimate the importance of a good capital intro team. The cost and difficulty of an in-house cap intro makes outsourcing vital.
Brexit, Basel III and prime brokers!
Small funds are struggling even more in gaining access to global PBs. Basel III forces PBs to shore up their balance sheets, accordingly dropping smaller clients who do not justify the balance sheet or are simply not profitable enough. This is where integrating with the boutique prime broker brings the advantage of an aggregated platform serving multiple smaller hedge funds.
Your prime broker provides the fundamental services of custody of assets and access to financing and securities lending. Other services that are central to the offering of a prime broker include executing orders and portfolio reporting. The suite of services to be offered by Linear as a prime broker has generally expanded in recent years beyond the core services others offer.
There are very few offerings as extensive in nature as Linear Investments’ platform – which brings all of these elements together under one roof. The platform is fundamentally the most valuable asset and tool you could adopt to ensure success in establishing or growing your fund. In addition to having a chaperone agreement, enabling US fund raising within US regulations, Linear operates in London and Hamburg and is therefore in a position to obviate the effect of Brexit in terms of European marketing.
To find out more about Linear’s Hedge Fund Platform and how Linear can help you operationally, including: multi-jurisdictional fund setup, prime brokerage, capital introduction, FCA umbrella licencing, outsourced trading, MiFID II compliant infrastructure, and middle & back office support check out the relevant pages and email: firstname.lastname@example.org or call:+44(0)203 603 9809