How hedge fund start-ups can build a more efficient, streamlined operation.
By Mush Ali, Founder, One Ten Associates.
In this report, a hedge fund industry expert explores best practices for assembling the right people, processes, and technology to succeed in the first year of operation and beyond.
Main takeaways:
1. The most important part of any business is its people. Make sure you assemble a core team that has a balance of investment, operational, and marketing expertise. 2. The majority of year-one costs should involve funding a combination of salaries, outsourced partners and technology.
Launching a hedge fund requires a tremendous commitment from the core team in terms of time, capital, and patience. Many start-ups are exceptionally skilled at investment strategy, but relatively few have built a business from the ground up.
The most important part of any business is the people. The core management team needs a balance of investment, operational, and marketing expertise; the majority of year-one costs should involve funding a combination of salaries and outsourced partners. For example, a standard equity long/short fund, which is not very operationally intensive, typically incurs start-up costs of approximately $1 million or £1 million in the first year.
According to Mush Ali, founder of One Ten Associates, a fund management recruitment firm that specializes in strategic non-investment hires for the hedge fund industry, this cost reflects the essential people businesses need to compete effectively.
“Most hedge funds have their front office team in mind,” he said. “When we help them find the right COO, that salary ranges from $150k to $200k. The CFO will need one junior support staff, assuming the strategy is straightforward. For more complex strategies, you may need a technical accountant or more non-investment support to help with valuation. After that, many successful businesses also hire a marketing specialist.”
Even if the principals forgo payment in year one, which is common, investment analyst, operational, and support staff salaries represent the bulk of the budget. From here, the list goes on to include the basics: legal, regulatory and compliance costs for management company setup, office space, insurance, payroll and benefits, accounting, and tax, as well as branding and travel costs for marketing.
Even the initial marketing presentation needs to go through a legal and compliance review. It requires the minimum disclaimers and guidelines on marketing requirements by investor type to avoid violating private placement rules in the relevant jurisdictions.
Businesses operating in the UK are regulated from day one, which is another monthly cost and required level of business formality that must exist before any revenue is generated.
In addition, very little revenue is likely to be generated during the first year. This is because of the time that elapses from the moment the core team decides to start a business until the first dollar enters the fund. Start-ups should expect this period to last between six and 12 months. It often doesn’t matter if a portfolio manager is very well known. Institutional investors have extremely meticulous processes, and competition is intense.
Specifically, there is a cadence of events that is difficult to compress. Even if the analyst is convinced of the fund’s approach, they need to:
Varying levels of due diligence and background checks are then undertaken, which can take longer than expected if the business is not prepared for this or hasn’t set up the business and fund in a way that the investor deems acceptable.
Once all teams have given their approval, the investor has to generate the capital to invest. Investors aren’t typically sitting on cash, so the timing must align. To be sure, timelines are longer than they were five or 10 years ago.
Assembling the core team
None of these timelines can begin, however, until the core management team comes together. While the roles will vary from business to business and strategy to strategy, Ali emphasizes that a great deal depends on how much the COO chooses to outsource.
“The current trend is outsourcing as much as possible, more than in previous years,” he said. “The team can be quite simple in these cases. It’s the investment team, the COO and their support person, a marketing expert, and occasionally an office manager. The technology outsourcing providers are more reliable, and they hire talent who understand the hedge fund space very well. Investors have no issue with it.”
One key point to remember is that the core management team’s skills should complement one another. In other words, a portfolio manager who knows the investor landscape very well may benefit more from hiring an operationally focused COO, while a PM who has never pitched to investors may be better served hiring a COO with a business development background. If each person in the core team has the same skills and knowledge areas, it can raise the risk of infighting as they try to justify their own positions.
One of the risks start-ups may not account for is that of losing a member of the core management team within the first year. Often, the hedge fund is the first business any partner has started. There is no existing framework to fit into, which makes it difficult to anticipate how each partner will react to the situation. Sometimes, businesses simply hire the wrong people and disagreements arise. Other times, partners realize they are not cut out for the uncertainty that all start-ups must endure.
“According to Ali, hiring the right COO can be a make or break decision. The skills needed by your COO will evolve as the business evolves. At the beginning your COO will need to be very good at reviewing documentation as there will be endless agreements and documents that need to be reviewed. Alongside that, they will need to have a strong network to ensure the right suppliers are selected to be able to ensure the right operational decisions are made to support investment strategy. The decisions made at the start can be very different in 12 to 18 months time - that is the case for all aspects of a start-up and a seasoned COO will know how to navigate the different phases of the evolution of the fund, which ultimately will save you money!”
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Building out essential technology
While all of these decisions are being made, businesses must also think about technology. Like the core team, infrastructure depends on strategy.
More complex credit and systematic funds, for example, may cost closer to $2 million to start due to the level of technology integration, salary demands for the skill sets involved, and the manual processes necessitated by OTC trading.
Systems:
Systems are the biggest decision, one that the CIO and COO should make together. Building out complete systems in-house allows for a full-shadow NAV, but this may be unrealistic for businesses with tighter budgets. Outsourcing middle and back office operations and related technology to a third-party provider, typically the fund administrator or a market specialist, has become a more common solution.
Outsourcing:
But, in fact, it is rare to fully outsource front office solutions. Usually, businesses seek to purchase solutions that combine order management and portfolio management with connectivity for electronic execution.
“Much of this is driven by the experience of the team,” Ali said. “The more experience they have, the more likely it is they know what technology they need. Quant and CTA futures strategies are more technologically intense, for example, and so the investment team naturally will be more technically minded.”
Ali also explains that there is usually a constant debate about how much technology the business
should outsource. On one hand, there is a desire to maintain control by keeping systems in-house. On the other hand, there is a need to not overspend or take on too large of an IT management burden.
Compliance is a great example. If you don’t know compliance, you are less able to assess whether your service provider is providing high-quality assistance.”
In general, the first two years are spent building an efficient, if imperfect, operation. At that point, when revenues are coming in, businesses can step back, reassess and fine-tune. Furthermore, they will be in a better position to determine if more activities should be outsourced to the fund administrator, or if the business should add more systems to automate and handle higher trading volumes.
Most important of all, businesses can ask themselves: if we were building this from scratch, would we make the same decisions?
About the contributor
Mush Ali founded One Ten Associates in 2011. Since 2004, Ali has focused on recruiting across the hedge fund space and has had great success identifying CFO/COO profiles for hedge funds in London as well as supporting his clients with non-investment hiring across operations, compliance, and sales/marketing/IR.
