What start-up hedge funds need to know about raising capital.
By Devarshi Saksena, Hedge Funds Partner at Simmons & Simmons and Joe Woodbury, Director at IQ-EQ Regulatory Services.
Any prospective hedge fund management business needs to navigate a series of key decision points in order to find the right business structure and product type that will allow it to attract investors and scale its investment strategy.
Making good decisions means you can reach your market quickly and deploy what, at the inception of your business, is likely to be finite working capital efficiently. Conversely, poor decision-making can deplete your working capital and create a product that doesn’t work for your target investors.
In this section, Devarshi discusses some of the most important decisions that you will need to think through in getting from the drawing board to your chosen market.
Regulatory options for U.K. hedge fund managers
The first key decision for any potential U.K.-based start-up hedge fund manager is how to obtain the regulatory permissions that it needs from the FCA in order to manage a hedge fund. Should you apply directly to the FCA for authorization to manage the fund in your own right, or should you instead team up with a regulatory hosting platform provider and use that platform’s licence?
The benefits of direct authorization are that: • The hedge fund manager will be able to manage the relevant product in its own right – using its own authorized entity and employing its own brand, without any third-party involvement. • The hedge fund manager will also have its own autonomous operational architecture, systems and compliance – providing it with greater autonomy. • Traditionally, having your own FCA-regulated entity has been viewed in the market as a sign of credibility, both amongst investors and service providers.
Main takeaways 1. Managers team up with a platform provider to make use of the regulatory hosting and appointed representative services that they offer. 2. The Cayman Islands remains the jurisdiction of choice for most liquid strategies on the strength of low cost of establishment, high-quality service providers and a favourable tax regime.
Devarshi Saksena, Hedge Funds Partner at Simmons & Simmons
That being said, it is now increasingly common to see managers teaming up with a platform provider to make use of the regulatory hosting and appointed representative services that they offer. This service provides managers with a route to market without the time and expense of a direct authorization (obtaining a licence directly could take in excess of six months, whereas using a platform route takes about two months) and having a reputable platform provider behind the manager in many cases will provide investors with greater confidence in the operational and compliance infrastructure that the manager will be able to utilize. There are also a number of other benefits to using a regulatory hosting platform provider, such as a beneficial regulatory capital position and a reduced recruitment burden that allows new managers to focus on their most significant priority in attracting investors: delivering performance and building a strong track record. This is further discussed below at “Using a Hosting Solution.” The question of direct authorization versus appointed representative does not necessarily need to be a binary one. Often, the best of both worlds for a new manager is to start out with the support of a platform provider and then, a few years down the line having achieved scale in terms of assets under management and operational architecture, to obtain direct authorization. This provides the benefits of quicker time to market and reduced up-front cost while allowing the manager the autonomy of direct authorization once it has established itself in the market.
Fund or managed account
Another key decision for start-up managers to make as they consider how to bring their strategy to market is whether to start out with a commingled fund or to begin with or a bespoke, investor-specific managed account structure.
A managed account will be specific to a single investor, so it does not have the potential for scalability that a fund does. Generally, managed accounts are much more customized than commingled funds and require increased levels of negotiation with the investor. However, provided that negotiation of terms with the investor does not become protracted, a managed account structure has some potential to offer reduced time to market and allows for the creation of strategic relationships with large investors.
The reduced time to market enables managers to commence trading and building a track record for their strategies that down the line they may use as a springboard to launch a fund, particularly if they can persuade the investor in their managed account to come in as an anchor investor to the new fund.
Despite the benefits of managed accounts of speed to market and attracting investors, there are also a number of disadvantages. The investor will often insist on using their chosen trading counterparties and are often in a strong negotiating position for favorable terms to their investment.
A managed account will almost always be limited to one investor, so it is not scalable in the way that a commingled fund would be.
Fund domicile and structure
Once a manager has decided on launching a fund they will then have decisions to make on where to establish it and how to structure it. Traditionally, London-based investment managers running liquid strategies choose a Cayman “master-feeder” structure: Cayman because it offers both a robustly regulated and flexible structure that investors (particularly those in the U.S.) are familiar with; master-feeder because it offers the potential to pool capital from U.S. tax-exempt, U.S. taxable and rest of the world investors in a structure that works for each of those investor communities from a tax standpoint and achieves economies of scale for the investment manager. However, there are a number of other options that hedge fund managers also consider and set up - the most frequent being the Irish Qualifying Investor Alternative Investment Fund (QIAIF) and the Luxembourg Reserved Alternative Investment Fund (RAIF), either because the primary target investors are based in certain EU27 countries (e.g., France, Italy and Spain), where an EU fund can be more easily marketed, or because they benefit from particular tax treaties in relation to specific asset classes (e.g., credit). These structures can also be set up as master-feeders for the reasons mentioned above.
Other factors when determining domicile of a fund include investor perception, tax considerations and the availability of adequate service providers.
Certain investors will be put off by offshore structures; however, Cayman remains the jurisdiction of choice for most liquid strategies on the strength of low cost of establishment, high-quality service providers and a favorable tax regime.
Joe Woodbury, Director at IQ-EQ Regulatory Services
Using a hosting solution
Given the cost and compliance obligations of running your own hedge fund, as mentioned, it can be easier and more cost effective for first-time managers to launch their fund via a regulatory hosting solution. Portfolio managers and traders can operate under a principal firm’s licence as an “appointed representative” (AR) and have that firm provide the regulatory and AIFMD infrastructure and compliance framework enabling them to launch and run their fund. This outsourcing process allows managers to launch a fund in as little as four to six weeks, as opposed to six to 12 months for direct FCA authorization, giving new ventures time to focus on generating alpha and raising capital.
How does it work?
Your firm will be able to conduct regulated activities by operating as an AR under the principal firm’s licence. The principal firm will also have the appropriate permission to be the Alternative Investment Fund Manager (AIFM) of your fund and will be responsible for the portfolio and risk management activities associated with AIFMD. By operating as an AR you will be able to market and distribute a fund under your name and branding, with the principal firm being responsible for signing off and approving any financial promotion material that you may produce, with appropriate risk warnings and disclaimers.
Key considerations and benefits:
Drawbacks
Plug and play
Setting up a hedge fund by traditional methods can be time consuming, complex and costly. That’s why IQ-EQ developed the Discovery Platform – a robust and efficient investor platform that can launch your fund in three to five weeks. Designed to deliver the demands of our most dynamic clients and managing every aspect of procedure and strategy through IQ-EQ’s global network of
specialists, the Discovery Platform gives clients immediate access to a dedicated sub-fund structure.
FCA authorization, ongoing compliance post-authorization
Once your firm has successfully grown assets and achieved scale, your principal firm will be able to assist you through the direct FCA authorization process. The principal firm will understand your firm’s business inherently well through the hosting process and as a result will be best placed to advise on how and when it makes sense for your firm to apply for direct authorization. Once your firm has become fully FCA authorized in its own right, the principal firm can continue to support the client on compliance matters. This is done in a similar way to monitoring under a hosting model, only that that the regulatory risk is now in your firm’s own name.
About the contributors
Devarshi is a hedge funds partner at Simmons & Simmons in London and focuses on structuring alternative investment funds, single investor vehicles and managed accounts, as well as providing continuing advice to asset managers on their investment product ranges.
A significant part of Devarshi’s practice is dedicated to helping start-up European hedge fund managers right from inception across all investment strategy types and hedge fund domiciles and ensuring that they make strategic decisions early on to give them the best prospects of long-term success.
Joe is Director at IQ-EQ, where he is responsible for the launch of asset management businesses and their associated investment funds. He works very closely with prospective launches across hedge, private equity, real estate, venture capital and corporate finance and covers a diverse range of entrepreneurs looking to establish their businesses under the FCA regulatory environment.
