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JANUARY 2008 • emii.com

The New RealityStart-up managers need to temper capital raising and growth expectations amid a glut of funds.

Choose Your Weapons WiselyThe first and most important choice for a start-up fund is selecting the right investment strategy.

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The Hedge Fund Start-Up Survival Guide

JANUARY 2008 THE HEDGE FUND START-UP SURVIVAL GUIDE 3

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6 Choose Your Weapons WiselyBy Andrew BloomenthalThe first and most important choice a start-up man-ager needs to make is selecting the right investmentstrategy, but that choice is anything but simple.

12 The New RealityBy Eric RosenbaumWith the market clogged by nearly 10,000 hedgefunds, start-up managers must accept a new realityabout capital raising and marketing, one that requiresthem to better understand the true prospects forgrowing assets in the first few years of operation.

18 The Potential of Emerging Economies By Gregory MorrisWith more investors looking abroad for better returnsand the Israeli market receiving an upgrade in its riskassessment, one local investment house sees anopportunity to attract foreign investors.

20 Think Like An OwnerBy Eric RosenbaumDespite a host of complex legal and regulatory issuesto deal with, lawyers say the most critical issue forfirst-time managers is often more basic: the change ofmindset from an employee of a corporation to a busi-ness owner.

24 Competent Service Providers Are the Key to CredibilityBy Andrew BloomenthalWhen it comes to technology and operations, nascentmanagers can quickly gain respect by outsourcing toqualified providers.

The New Reality

Table of Contents

12

18The Potential of

EmergingEconomies


4 THE HEDGE FUND START-UP SURVIVAL GUIDE JANUARY 2008

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Editor’s NoteWelcome to the Hedge Fund Start-Up Survival Guide, an indis-pensable manual to everything first-time managers need to knowabout creating, growing and managing a successful hedge fundin today’s market.

The Start-Up Survival Guide is chockfull of insight and advice fromthroughout the hedge fund universe, beginning with the first thingevery manager needs to consider when they are starting a new fund:strategy. A plethora of investment choices, as well as a number ofavailable hybrid models, have made the task daunting, but our guidesimplifies the process with a breakdown of the strategies and somepractical advice from industry experts (see story, page 6).

Next, the Start-Up Survival Guideaddresses the second most importantconsideration: capital. Not only does theguide provide advice on how to make afund attractive to capital providers, it alsoexplains how to continue attracting moneypost-launch through a focused marketingstrategy (see story, page 12). Beyond that,the guide also includes articles on legaland regulatory requirements and techno-logical and operational considerations, giv-ing managers a complete compliment ofadvice on the issues most relevant to their success.

The Hedge Fund Start-Up Survival Guide is the latest in a series ofspecial supplements produced by Institutional Investor News exclu-sively for our newsletter subscribers. It is part of our commitment tobringing our readers the freshest news and in-depth analysis onimportant sectors and timely topics within the financial markets.

All the best in 2008,

Erik KolbEditor of Business PublishingInstitutional Investor News


The New RealityStart-up managers need to temper capital raising and growth expectations amid a glut of funds.

Choose Your Weapons WiselyThe first and most important choice for a start-up fund is selecting the right investment strategy.

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WHEN FINANCIAL SCHOLARAlfred Winslow Jones first con-ceived the idea for hedge funds backin 1940, his philosophy wasstraightforward: create an invest-

ment vehicle that combined leveraging capabilities with thepower to sell stocks short, thereby allowing investors to thrive inany market condition. Winslow reasoned that such a paradigmwould attract top-tier management talent, who would flourishbased on the strength of their stock-picking prowess regardless ofmarket direction.

Almost 70 years and 7,000 hedge funds later, Winslow would besurprised at the breadth of the industry resulting from his ideas.But he might be equally surprised at just how specialized andexpansive modern hedge fund investment strategies have become.In fact, less than 20% of the funds in existence employ the classiclong/short approach. Instead, many choose from a bevy of alter-native categories and subcategories. And with nearly every knowninvestment approach folded into the universe of hedge fundmethodologies, start-up managers face overwhelming choiceswhen creating their models.

According to Brian Snider, senior vice president of New York-based hedge fund consultancy Hennessee Group, it’s not an easydecision to make. “The most appropriate thing for a start-upmanager to do is to determine his strengths, then tailor the fund’sinvestment strategy around them,” he said.

Snider discourages managers from modeling their funds based onthemes of the moment or simply because they are popular withinvestors. “That’s bad practice,” he added. “Investment decisionsshould be made based on the skill of the manager and the quali-ty of the organization.”

Increased Choices, Increased ComplexityAn expanded strategy spectrum can complicate the playing field

for unseasoned players, who may fail to anticipate that mostinvestment strategies with high performance potential will invari-ably experience periods of drought at one time or another. This isparticularly true for strategies targeting more cyclical sectors.

Take credit-oriented strategies, for example. Though most thriveamid an abundance of cheap debt, the lack of defaulted corporatedebt opportunities in today’s market would make such a strategydicey at best, particularly for managers who don’t adequatelyhedge their positions.

“You can make the case that if you maintain a relatively well-hedged portfolio with low correlations to the equity markets, youshould be okay,” said Snider. “But if you’re a long-only value man-ager, there’s going to be times when your strategy falls out offavor. It’s inevitable.”

When San Diego-based Context Capital Management was gear-ing up to launch a global distressed debt hedge fund in November2007, it brought on board veteran distressed debt manager JackHersch to run it. With about $30 million currently under man-agement, the Context Python Master Fund invests in some 35companies experiencing some degree of legal, financial or opera-tional difficulties. Hersch longs the names that have meaningfulrecovery potential while shorting those deemed beyond repair.

On the operational side, Hersch studies a company’s history, com-petitors and structural mechanics. He examines the location of acompany’s plants, and he profiles its customer base to betterunderstand consumer trends. When a company faces litigation,Hersch often attends court proceedings in an effort to understandthe nuances of a case. Once he achieves clarity on these issues, hecompares a company’s current trading levels with what he projectsthey’ll be once the problems are resolved, then longs or shorts thename accordingly.

With more than 20 years of experience investing both proprietarycapital and other people’s money in distressed opportunities,Hersch is confident in his ability to accurately gauge a company’s

Choose YourWeapons WiselySelecting the right investment strategy is the first and most important choicestart-up managers need to makeBy Andrew Bloomenthal



potential for resurrection. “It’s a triage process,” he noted. “Weanalyze troubled companies to determine what’s causing theirbreakdowns. Everything has a resolution, but there may not beenough value after employing the solutions to make the actionworth it, in which case we short the name or avoid it altogether.”

Though Context Python has no geographical bias, Hersch steersclear of investing in bankruptcies in Asia, claiming he’s less com-fortable operating there than he is in dealing in WesternEuropean and North and South American countries. “I’m notconvinced that if I show up in certain Asian countries with a lienand try to collect collateral, they won’t put me in a tiger cage untilI change my mind,” he joked.

Combining DisciplinesNot content to stick with a single investment theme, some man-agers rely on a multi-strategy approach to running their funds.

In managing his firm’s flagship fund -Full Value Partners - Steve Samuels, gen-eral partner at Bulldog Investors,employs a pastiche of strategies for the$185 million portfolio. This includesinvestments in REITs and other realestate interests, distressed debt and,interestingly, a 20% allocation to specialpurpose acquisition corporations(SPACs), which are shell companieswith no operations that go public withthe intention of using the proceeds toacquire or merge with other companies.

Though Samuels was dubious of SPACswhen they were first brought to hisattention, upon further inspection, hefound their profit potential to be com-mensurate or higher than many other

investment offerings on a risk-adjusted basis. “I primarily likethe fact that the SPAC promoter - who raises the money -must find a vehicle, make a deal and bring it to shareholderswithin a timeframe of something like 18 months to two years,”said Samuels. “If they don’t find anything by then, the moneyis returned to shareholders. Until that happens, the moneygoes into a trust that can’t be pierced. Worst case scenario: theycan’t find a deal and we get our money back, plus what thetrust earns in interest. But since the promoters are so incen-tivized to find something viable, something good invariablycome out of it.”

Full Value Partners likewise invests widely in closed-end mutu-al funds, which attracts Samuels on the basis that they trade onexchanges and often at significant discounts to their net assetvalues. And all of that is easily measurable. “You and I couldargue all day whether Citigroup is a sound investment idea,”said Samuels. “But if a closed-end fund is trading at $8 and it’sworth $10, that’s a discount of 20%. It’s irrefutable.”

Targeting Other Funds In talking about hedge fund investment strategies, funds of fundsmust inevitably be part of the discussion, given that that theirnumbers dominate the industry. With nearly 3,500 presently inoperation, funds of funds represent nearly half of all hedge fundsin existence. And although their fundamental concept is straight-forward, narrowing down the universe of sub-managers to investin is anything but.

Brian Chung, senior portfolio manager at the Stamford,Connecticut-based SSARIS Multi-Manager Absolute ReturnFund, doesn’t rely on track record in choosing managers.Contrarily, he characterizes his approach as highly opportunistic,pouncing on trends and themes.

After the fund’s investment committee metlast year, Chung decided to adopt a moreneutral stance on the U.S. equity markets,which ultimately resulted in their shift awayfrom long-biased managers and a shifttowards managers who could go net short ifthe right situations emerged.

“We take a top-down approach and add tothat by meeting with the best minds inmoney management,” Chung explained.“This generates good ideas we wouldn’t havethought of ourselves. In 2006, for example,one fund manager showed us that the sub-prime mortgage market was fraught withstructural inefficiencies, prompting us to takea neutral - even slightly negative - stance onthe U.S. housing markets. This investmentphilosophy made sense to us.”

“The mostappropriatething for a start-up manager to do is to determine hisstrengths, then tailor thefund’s invest-ment strategyaround them.” — Brian Snider

From Left to Right: Jack Hersch, managing partner of Context Python

Master Fund, and Steve Samuels, general partner at Bulldog Investors



The Diversification RuleIn order to maximize diversification, an academic principal dic-tates that funds of funds should strive to invest in 20 underlyingmanagers. Brad Balter, whose $150 million fund of funds - BCMDiscovery Fund - houses about 18 underlying managers, agreeswith this philosophy.

“Anything beyond 20 dilutes performance,” said Balter. “Ifyou’re carrying 70 managers, where each one represents 1% to2% of your portfolio, even a manager who’s up 10% for theyear will give you only a couple of basis points. That doesnothing for you.”

Balter furthermore believes that keeping the numbers low letsfund of funds managers better focus on the underlying managers’day-to-day operations, making it easier to detect inefficienciesand potential blowups. “I’d rather allocate my time to doing myhomework, so I don’t permanently impair capital,” Balter noted.

But in this age of increased specialization, Chung believes it isnecessary to breach the 20 manager rule and employ some 45funds in his fund. “Within convertible arbitrage, for example,there are at least three sub-strategies: traditional arbitrage, volatilearbitrage and credit-related arbitrage. You need all three to be rep-resented,” he explained.

Emerging Managers: Leading the PackEven in a realm where low correlation is the driving force, a hier-archy exists among the performance of different hedge fundinvestment strategies. According to statistics from BarclayHedge,emerging markets managers dominate the space, averagingreturns of 18.6% through September of last year (see chart, page10). Equity long-only managers fared second best, bringing in anaverage return of 14% for the same time period. Rounding outthe top three were merger arbitrage players, who collectively aver-aged 12.9%. Meanwhile, fixed income arbitrage players fared the

worst, averaging just 0.65%, while equity market neutral fundsdid slightly better, bringing in 3.1%.

Sol Waksman, president of BarclayHedge, offered some perspec-tive. “Given that the stock markets of emerging market compa-nies had an excellent year, it’s not surprising that emerging mar-ket managers have done well as a result,” he said. “Just look at thefour biggest emerging market countries: Brazil, Russia, India andChina. They’re off the charts.”

Maintaining ManeuverabilityIn November 2004, Toronto-based hedge fund operator SelectiveAsset Management had three distinct funds: a long-biased fund, ashort-biased fund and a fund of funds, which essentially combinedthe first two offerings into a single investment for those investorsseeking simplicity and ease of operations. But without a great deal ofassets under his belt, firm president Robert McWhirter grew frus-trated that he was spending so much on accounting and other oper-ational fees to maintain the three offerings.

So, after receiving approval from investors, McWhirter made thedecision to roll all of the investments into the long-biased fund,which is called the Selective Assets Long Biased Equity Hedge Fund.“We’re happy with our decision and with the way it’s going,” he saidof the $8 million fund, which takes a quantitative approach.

Meanwhile, McWhirter still maintains the legal structures of thetwo other funds, given that he already spent the money and ener-gy to facilitate their paperwork. “Besides, if a $50 million investorshows up and wants a short-only portfolio, we can just re-openthe short-bias fund and away we go,” he said.

Furthermore, McWhirter advocates building as much flexibilityinto offering memorandums as possible to prepare for any contin-gency. “In our long-bias fund, we can still legally do hedging,” hesaid. “There are expectations from our investors that we won’t,but it’s within our parameters to do so. Also, right now we investin North American stocks. But if we wanted to shift focus to thirdworld countries, we’d put it to an investor vote and make it hap-pen. Or else we’d start up a new fund so we could allow customersto keep their original investment, plus give them something new.”

Controlling Risk In the theoretical realm, shorting positions provide enoughintrinsic risk control in the hedge fund space. But in practice, thismay not be enough. Therefore it behooves managers to rely onother risk control measures as well.

For starters, taking care to educate investors on the differencesbetween risk and volatility is crucial. That may be easier said thandone, given that this distinction often confounds the fund man-agers themselves, according to Snider. But failure to grasp this canbe hazardous to a fund—especially if skittish investors hastily

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From Left to Right: Brian Chung, senior vice president at SSARIS Advisors,and Robert McWhirter, president of Selective Asset Management


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10 THE HEDGE FUND START-UP SURVIVAL GUIDE JANUARY 200810 THE HEDGE FUND START-UP SURVIVAL GUIDE JANUARY 2008

Assets in Dec 06 # of Funds Assets in Sept 07 # of Funds Average ReturnsStrategy (in Millions) in Dec 06 (in Millions) in Sept 07 for 07 (through Sept)

Convertible Arbitrage $34,710 164 $35,820 175 3.97%

Distressed Securities $95,250 178 $138,780 210 3.72%

Emerging Markets $261,420 786 $330,300 973 18.60%

Equity Long Bias $186,780 846 $215,520 1030 10.41%

Equity Long/Short $250,020 1102 $273,360 1268 7.42%

Equity Long-Only $63,270 198 $76,230 210 14.04%

Equity Market Neutral $58,560 226 $62,220 225 3.08%

Event Driven $115,230 268 $163,770 315 8.50%

Fixed Income Arbitrage $158,790 636 $161,700 708 0.65%

Macro $77,820 280 $82,230 328 7.79%

Merger Arbitrage $22,440 66 $39,840 83 12.91%

Multi-Strategy $210,990 286 $228,930 320 8.17%

Other $34,290 312 $38,520 368 4.81%

Sector Specific $95,250 612 $118,290 738 10.94%

Fund of Funds $971,700 2913 $1,211,100 3460 7.11%

Total Industry $1,660,500 5978 $1,974,900 7000 8.88%

Hedge Fund Assets and Performance by Strategy

Source: BarclayHedge

withdraw their investments following a downturn in performance,when in actuality it may be the best time to add to their investments.

“If a manager is fully invested at $100 million and a sudden peri-od of poor performance causes $30 million in redemptions, thismanager is now a forced seller of those positions,” Sniderexplained. “That is the last thing he wants to be when there areample opportunities to exploit.”

The key to making certain investors understand the differencebetween risk and volatility is explaining to them that a high standarddeviation doesn’t necessarily imply high risk. Conversely, low standarddeviation doesn’t automatically signify low risk.

“Look at the implosion of the mortgage-backed market, where tripleB-rated securities showed no volatility up until this year,” Snider noted.“Then this year happens and it becomes clear that there’s tons of riskinherent in these securities. The low volatility these securities experi-enced in years past was not reflective of their true risk, and investor fail-ure to understand this can be highly detrimental to a fund.”

There are other risk control mechanisms. In the Context PythonMaster Fund, Hersch refuses to initiate a position larger than 5% ofthe overall fund and will rebalance the fund should an existing posi-tion swell beyond 8%. “The two worst trades you can make are to belong and wrong and to not to be long enough,” Hersch said. “A 5%position is big enough that it moves the needle if we’re right, and if

we’re wrong we’re comfortable enough with the downside that wewon’t be badly hurt.”

ConclusionWhen all is said and done, what’s the best way for a start-up managerto determine his or her strategy? Simply stated, it is by staying withinthe realm of the discipline he or she knows best and by resisting thetemptation to model the fund based on current trends. “You may ini-tially be able to bring in assets by exploiting fad strategies,” Snider said.“But if your organization doesn’t have the ability or experience to gen-erate decent returns over the long haul, the fund will be short lived.”

Another lesson to heed: keep the language of the strategy simple andeasy to understand. “When choosing managers to invest in, we avoidquantitative strategies and technical trend strategies,” Balter said of hisfund of funds product. “If their approach can’t be described in a sin-gle sentence, that’s a huge red flag. Computer codes don’t mean athing when things go awry."

Naturally, most quant managers feel more confident in their tech-nique, especially those that augment computer-selected names withtheir own due diligence efforts. “It’s not just about hitting a comput-er key and stopping there,” said one such quant manager. “We takethe names provided, overlay them with questions about liquidity anddetermine their ability to be shorted, if necessary. It’s all about apply-ing filters to names and heightening our focus on those companies.Any manager worth his salt will do this.”i



Convertible Arbitrage - This strategy entails procuring long-only posi-tions in convertible bonds or warrants and the subsequent shorting ofthe corresponding stock. The bond and warrant pricing is based onseveral criteria, including price of the underlying stock, and the expect-ed future volatility of returns. Such pricing is often inaccurate due toilliquidity in the convertible debt and warrant markets, giving rise to sig-nificant profit opportunities as positions are acquired in anticipation ofthe market price eventually reflecting true value.

Distressed Securities - This strategy looks to public companies or acountry’s central bank for securities that are either in default, in dis-tress, under bankruptcy protection or are likely to soon descend intosuch unfavorable status.For fixed income instruments, which comprisethe lion’s share of the overall asset class, distressed securities typical-ly are classified as being below investment grade, have a yield inexcess of 1000 basis points over the risk-free rate of return on U.S.Treasuries and may include corporate credit as well as issuance byemerging market governments.

Emerging Markets - This strategy focuses on traditional fixed incomeand equity markets outside the United States and Western Europe,including those in Asia, Latin America, Eastern Europe and Africa.Considered highly volatile, with less reliable and less standardizedinformation available about their securities, these markets tend toexhibit inefficiencies resourceful managers can exploit.

Equity Long Bias - Simply stated, this strategy takes predominantly longpositions that are minimally hedged, thereby making it more vulnera-ble to market declines. Most funds typically have a long bias because,over the long term, stock markets tend to rise along with general eco-nomic growth.

Equity Long/Short - Managers of this strategy typically buy stocks theyperceive to be undervalued while shorting those they perceive to beovervalued. They routinely target competing companies within thesame industry sector for opposing positions, which theoretically pro-vides downside risk protection in any market climate. While the longside generally outweighs the short side in most directional equityfunds, a small group of funds exhibit short sides that exceed the longsides - sometimes by significant margins.

Equity Long-Only - Containing absolutely no short positions whatsoev-er, this strategy appeals to managers who believe there are limits tothe number of compelling short ideas and that the recent flood ofmoney into hedge fund investments has hampered their ability toexploit those rare short ideas that do arise. Though some argue thatlong-only funds betray the definition of hedge funds by failing to exploittheir ability to generate returns independent of the underlying assetsthey invest in, others maintain that long-only funds still fit the definition,given that they may employ leveraging techniques and that theyimpose the traditional 2% management/20% incentive fee structure.

Equity Market Neutral - This strategy aims to capitalize on invest-ment opportunities unique to some specific group of stocks whilemaintaining a neutral exposure to a broader group of namesdefined by sector, industry, market capitalization or geographicalregion. Such a strategy is a favorite among managers with apropensity for ferreting out solid stock picks, particularly those whocan identify a virtually equal number of names to both long andshort within a larger group. Overall sector performance is largely

immaterial because, no matter what happens, the gains and loss-es of the selected stocks will offset one another.

Event Driven - This strategy involves investments - both long andshort - in the securities of corporations experiencing significantevents of note, such as mergers, acquisitions, liquidations, bank-ruptcies or reorganizations. Such tangible events can catalyzechanges in the expected value of the underlying security.Significant profits may be enjoyed by savvy managers who cancorrectly interpret what the projected corporate event will meanfor a company’s bottom line and take positions accordingly.Anticipating timelines for the effect of such events to take placecan be hard to predict, making the event-driven game one of themore speculative strategies.

Fixed Income Arbitrage – This strategy aims to exploit the price dif-ferences between related short-term bonds from either public orprivate issuers. These mispricings, which may be exploited on aleveraged basis, yield a contractually fixed stream of income, let-ting arbitrageurs adhere to their mandate of achieving steadyreturns with a low degree of volatility. Most managers who employthis strategy trade on a global basis and tend to focus on interestrate swaps, U.S. Treasury securities and yield curve and creditspread trading, as well as volatility arbitrage.

Macro – Managers of this strategy invest in a bevy of differentinvestments - including long and short positions in various equity,fixed income, currency and futures markets - basing their decisionson the present economic and political climate that a particularregion is experiencing. For example, if a manager believes the U.S.is headed into recession, he might elect to sell short U.S. stocks orfutures contracts on certain U.S. indices.

Merger Arbitrage - This strategy involves a transaction-specificevent, in which the stocks of two merging companies are simulta-neously bought and sold to create a riskless profit. Specifically, themanager examines the risk of the merger deal failing to close ontime—an uncertainty that typically causes the target company’sstock to sell at a discount to the price that the combined companywill fetch when the merger is closed. Where a regular managerfocuses on the profitability of the merged entity, a merger arbi-trageur cares about the probability of the deal’s approval and thelikely timetable for the deal to transpire.

Multi-Strategy – Managers of this strategy employ several hedg-ing techniques within the same pool of assets, with the objectiveof delivering consistently positive returns regardless of the direc-tional movement in equity, interest rate or currency markets. Analternative to funds of funds, the multi-strategy paradigm targetsa wide scope of asset classes, including long/short equities, realestate investments, event-driven strategies and convertible bondarbitrage, and relies on diversification to reduce volatility anddecrease single-strategy risk. Only funds with significant capitalon their balance sheets have the resources needed to effective-ly employ this strategy.

Fund of Funds - A portfolio of underlying managers, this strategy isalso known as multi-manager investing. The advantage of such avehicle is its built-in diversity, but the higher fees associated withthis product have made some investors leery.

Glossary of Strategies


The NewRealityA glut of funds forces start-up managers to be more sober about capital raising, growth prospects By Eric Rosenbaum



S TART-UP HEDGE FUND managersmust take a slew of considerations intoaccount before going ahead with alaunch, many of which have nothing todo with investment performance. Capital

and the ability to attract assets are paramount to a nascentfund’s ability to survive. Indeed, it’s the fund’s lifeblood. Butwith the market clogged by nearly 10,000 hedge funds,start-up managers must accept a new reality about capitalraising and marketing, one that requires them to betterunderstand the true prospects for growing assets in the firstfew years of operation.

Among the critical factors distinct from the ability to gener-ate returns, the manager’s specific investment style must beanalyzed relative to the already glutted market. It is safe tosay that the days when yet another long/short U.S. equityhedge fund could gather assets in a hurry are long gone, andmanagers should analyze how their choice of strategy fits intothe overall market. Start-up funds also need to put togethera business plan that includes access to a network of familyand friends, high-net-worth investors and small institutionswithin their geographic footprint, as big institutions for themost part will be disinclined to invest with the fund duringearly marketing efforts. In addition, first-time managersmust consider their pedigree and how it will help or hinderthose marketing efforts.

Furthermore, personal capital to back the new venture is anessential consideration. A manager’s personal investment inthe fund from day one is critical, but even more important issufficient funds in the bank to keep the fund afloat in theearly days, before any profits roll in. In today’s market, theperiod during which even a strong performing fund may gowithout significant assets, and therefore profits, can be meas-ured in years, not months. And this reserve of capital is amake or break issue for most new funds. For more complicat-ed strategies, the start-up also must expect higher tradingcosts as part of the initial operating expenses, often duringthis period of time before profits are generated.

It is only after all of these initial considerations have beenaccounted for, that start-up hedge funds can begin in earnestto consider how to gain specific marketing traction. Mostoften, this analysis takes the form of enlisting the support ofthird-party marketing organizations, seed capital firms andmulti-strategy hedge fund shops that can help push a manag-er over the threshold of success. However, today’s reality isthat these partners may not even look at a fund with less thantwo or three years of experience under its belt, because thirdparties can’t effectively market a start-up fund in today’s glut-ted market. Therefore, a business plan that accepts a reality

in which the fund may be on its own for up to three yearswill place first-time managers on the side of caution, goodjudgment and proper business risk management. And whenthe time does come for the start-up fund to enlist the supportof third-party relationships, the manager must place empha-sis on not giving up so much control in the rush to raiseassets that the entrepreneurial spirit behind his or her entryinto the hedge fund game is diminished.

Myth UnderstandingsIt has been typical in hedge fund circles to maintain a belief in themantra: ‘If you build it, they will come.’ Today, however, the firstorder of business for new hedge funds must be the casting off ofthis myth and an acceptance that today’s market presents morechallenges and obstacles than easy money. The pervasive mystiqueabout hedge funds - that outsized returns generated by a talentedindividual are a sure-fire path to success - is no longer a viablebusiness plan. In fact, that type of thinking is evidence of a lackof a business plan, according to hedge fund executives.“Production of good performance does not beget assets,” saidPatrick Keane, managing director of third-party marketerLiability Solutions. “Even if you put up 30-40% returns, it doesnot mean assets will come.”

Ultimately, the most important analysis for today’s start-upfund is the exact nature of its goals. Hedge fund managersmust ask themselves what, in their minds, would equate withsuccess. For those whose goal is growing from $10 million inassets to a billion dollar-plus fund on the radar of majorinstitutional investors within two years’ time, the reality oftoday’s market makes that scenario the extreme exception tothe rule. For those whose goal may be growing to $50-100million in their first two years—itself not an easy task—thegoal may be harder to achieve, but it is still available to thosefunds that develop a smart business plan. “People are eternal-ly optimistic,” Keane said. “Someone who is absolutely com-mitted to opening a hedge fund is convinced that, as long

From Left to Right: Adi Raviv, head of the alternative investments groupat Northeast Securities, and Patrick Keane, managing director of third-party marketer Liability Solutions



they put up the numbers, assets will flow to them, but it isjust not that simple. There are lots of funds out there withgreat numbers sitting at $20 million in assets.”

Star PowerOne hedge fund asset-gathering dynamic that has notchanged in today’s market is that a first-time manager whocan leverage experience at a well-known hedge fund brand orinvestment bank trading desk is more likely to raise assetsand gain the attention of institutions in a shorter period oftime. Even here, though, there have been chinks in thearmor, as recent launches that could leverage brands such asGoldman Sachs and the Carlyle Group encountered obstaclesto asset growth. While that doesn’t change the basic equation- the better the pedigree, the better the chance that pedigreewill be a determining factor - it does highlight the difficul-ties for even the best-positioned new funds.

“Even with a significant pedigree, it is a difficult world, andthere have been significant new launches that recently cameup woefully short of intended targets,” said Scott Prince ofseed capital firm Skybridge Capital. “More and more of theinstitutional capital coming into the business is flowing tothe experienced managers - particularly those already up andrunning for a long time - with huge institutional-like infra-structures.” While he stressed that it is still viable to start ahedge fund with any amount of capital, that manager has tobe extremely patient about prospects for asset growth.

Pedigree, however, is a tricky word. In today’s market, it iswrong to assume that an academic pedigree is going to go along way. Experience at a well-known hedge fund tradingdesk or investment bank is much more important when start-ing a new fund than an academic pedigree, the likes of whichonce made funds like Long Term Capital Management theinvestment world’s darling. “Unless you have a legendaryreputation behind you - say you were the right hand personfor a multi-billion dollar hedge fund manager - it is prettyhard,” said Howard Altman, co-managing principal atRothstein Kass. “And it will take a lot of time, particularly togain the attention of institutions.”

Only Fools Rush InThe patience that Skybridge’s Prince alludes to comes fromthe fact that few start-up funds can leverage a marquee hedgefund. Many without this ability to ‘self-credentialize’ mayhave the investment talent, uniqueness of strategy and smartbusiness plan that will allow asset growth, just over a longerperiod of time. “One of the first things I ask start-up fundsis, assuming you raise no money for the next two years, howlong can you do this? How much have you put aside to paypeople and keep the fund afloat?” said Chip Perkins, princi-pal of third-party marketing firm Perkins Fund Marketing.“If they say less than two years, it probably won’t work for

them. People that don’t understand that start swinging hard-er at the ball out of panic and miss it.”

The challenge of raising assets in the first few years of oper-ation makes it that much more critical for start-up funds toprepare a business plan that initially includes an informalnetwork of family and friends, their own personal investmentin the fund and, possibly, small institutional investors intheir geographic footprint, such as family offices and high-net-worth individuals. To that point, Rothstein Kass recent-ly completed a survey that indicated family offices could beone of the largest potential markets for new hedge funds,although Altman believes that, for start-up funds, thisopportunity will still be difficult to exploit.

The bottom line formula for survival in the first few years isrelatively simple: temper your expectations about assetgrowth and, as a result, make sure to have enough operatingfunds on hand to keep the fund afloat even if profits are non-existent. While market experts shy away from placing anexact number on how much a start-up fund needs to survive,they indicate that having operating funds on hand for at least18 months of operation is essential for any new business.

Start-up funds have to understand that it is going to be atleast a two-year process to gain the traction that will allowthem to approach the investors that are large enough to takethem to the next level, said Adi Raviv, head of the alternativeinvestments group at Northeast Securities. An optimistic tar-get for new funds is to gather between $50 million and $100million in assets in the first two to three years of operation.The $100 million mark, in particular, is considered by manyhedge fund experts to be point at which a fund has the crit-ical mass to begin a true institutional marketing effort.

“If your goal is to be a $25 million fund for friends and fam-ily and you aren’t paying Manhattan or Greenwich rents, youcan make a living,” Perkins said. “There are plenty of excep-

Howard Altman, co-managing principal at Rothstein Kass


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16 THE HEDGE FUND START-UP SURVIVAL GUIDE JANUARY 200816 THE HEDGE FUND START-UP SURVIVAL GUIDE JANUARY 2008

tional managers who are at $25-50 million today. However,if you want institutional money, you have to get north of$100 million.”

According to Daniel Dorenbush, managing director andglobal head of hedge fund services at RBC Capital Markets,a common mistake made by new funds is to spend lavishlyon appearances, as opposed to focusing on the critical costs.He noted that he has seen as many managers become success-ful starting with a bare bones mentality as those who spendheavily in the early days. “I’ve seen guys start with nothingand guys start with the gold package and both have been suc-cessful,” he said, “but only when they focus on a target mar-ket and on building the appropriate institutional infrastruc-ture for the long term. You don’t need to start day one withan office on Fifth Avenue.”

Frank Duffy, head of business development at hedge fundservice provider Price Meadows, added that start-up fundsshould be very cost-conscious in the early days and thatbuilding an institutional-quality business does not necessari-ly mean a fund has to pay for the most expensive real estate,legal firm, accountant and auditor. The reputation of theservice provider is more important in building institutionalinfrastructure than merely choosing a brand name vendor atthe highest price.

Helping HandsFor most start-up funds without a marquee pedigree, theroad to gathering assets among institutions will require theassistance of third-party marketing firms and seed capitalfirms. However, with the glut in the marketplace today andinstitutions’ preference for more estab-lished funds, it is unlikely that thesefirms will be of much help to a start-upfund in its first few years of operation.Today’s reality is that most start-up fundsshould expect to be on their own for twoto three years. If they can reach the $50-100 million threshold in that period oftime, then it makes sense to start lookingat third-party marketers. As it is, howev-er, the environment no longer exists inwhich a third-party marketing organiza-tion can go out and raise institutionalassets for a fund with $25 million or lessin assets and a limited track record.

“If you don’t have the contacts and theresume to find at least the first $25 mil-lion in assets on your own, you shouldn’teven start a fund,” Duffy said. “Placinghuge confidence in a third-party mar-keter as a savior for your fund is a big

mistake,” he added, noting that it also would be a huge wasteof money.

Third-party marketers can work with a fund at any level, but thesmaller the fund, the greater the challenge. For example, LiabilitySolutions only works with a brand new fund when the fund hasa particular pedigree and unique investment niche that wouldallow it to generate interest among institutions. However, that isthe exception to the rule. “The buy side is overrun with funds try-ing to raise money, and the selection criteria will continue to getmore and more difficult,” Keane said. Todd Goldman, principalin Rothstein Kass’ Bay Area office, concurred, adding that “thebest marketers in the world can’t take a fund from $5 million to$50 million.”

The two other main options for start-upmanagers are traditional seed capital organi-zations and multi-strategy hedge fund shopsthat are looking to take stakes in new funds.While these relationships can be essential forstart-up funds, it is critical to structure thedeal in a way that does not force a first-timemanager to forsake the entrepreneurial spir-it that brought him or her to the hedge fundbusiness in the first place. “Plenty of seedgroups will give money to a $10 million guyif he is willing to give up a huge percentageof the business,” Perkins said. “Unless youhave $100 million, these seeders have youover a barrel.”

Nonetheless, because third-party mar-keters are not a realistic option for thefirst two to three years of operation andbecause a start-up fund most likely can’treach the $100 million threshold on its own,seeding arrangements are critical. “If you

“If you don’thave the con-tacts and theresume to findat least thefirst $25 millionin assets onyour own, youshouldn’t evenstart a fund.” — Frank Duffy

From Left to Right: Frank Duffy, head of business development at hedgefund service provider Price Meadows, and Daniel Dorenbush, managingdirector and global head of hedge fund services at RBC Capital Markets



don’t have a legendary background or come into the gameextremely well connected with investors at a large institution, it isreally hard to be successful without the help of a seeding firmtoday,” Altman said.

While many start-up funds worry about giving up the keys tothe house when signing seed agreements, Altman emphasizedthat a seed organization should not just be viewed as a wal-let. The best seeders are strategic partners that are positionedto help a start-up manager build a viable, long-term businesswith an institutional-quality infrastructure and not just pro-vide some upfront cash, he explained. Furthermore, goodseed organizations know it is not in their best interest to killthe entrepreneurial spirit of nascent hedge fund managers, sothis hesitation should not be difficult to overcome througharms-length negotiations.

As the market becomes more saturated and third-party mar-keters find it more difficult to take brand new funds to insti-tutions, seed organizations are evolving to meet the needs ofstart-up funds. One example of a seed organization that isbridging the traditional seed model with a private equityfund approach is Skybridge Capital. Skybridge will placebetween $25 million to $50 million of its capital in a groupof eight to 10 funds in exchange for a percentage of the man-agement and incentive fees during a three-year lockup.However, Skybridge provides more than just the initial capi-tal push. It performs full-time marketing on behalf of itsfund of funds, as well as operational support. For many start-up funds that do not have the time or expertise in marketing,this model can be very beneficial.

“The smaller you are in terms of fund assets, the longer thetime frame in which to grow your business,” Prince said. “Wecan help by creating institutional legitimization for start-upfunds and accelerating the fundraising effort,” he added, not-ing that most first-time managers do not have the expertise,time and resources to go on road shows targeting the high-net-worth and family office markets.

In its first fund of funds, Skybridge raised four times theamount of money it provided in seed capital from outsideinvestors. For example, a manager that Skybridge fundedwith $50 million at the beginning of 2007 had raised a totalof $250 million by year-end. For its purposes, the pedigree ofthe individual can be among the most important factors,which is why Skybridge focuses on talent that is coming outof an investment bank or larger hedge fund. It also will helpmanagers who have not yet left the bank or hedge fund forwhich they currently work to start up their funds.

Many big multi-strategy funds that already see large assetflows and have full-fledged marketing arms are now serving asimilar role for start-up funds: bringing them under their

umbrella and leveraging their existing institutional market-ing infrastructure. However, hedge fund executives cautionfirst-time managers about actually becoming part of a multi-strategy fund shop. “It is best for a start-up fund to attemptto attract an allocation from a multi-strategy fund ratherthan actually join the shop,” said Raviv. “It is difficult if youare actually within the multi-strategy hedge fund to reconcileits needs with your desire to run your own fund and buildyour own brand and track record.”

For their part, third-party marketers don’t have an invest-ment in the underlying fund, according to Prince.Furthermore, the cost of hiring a seasoned full-time marketerwould be prohibitive, as well as the fact that there is a scarci-ty of that talent available to start-up funds. Therefore,Skybridge believes its model combining the seed capital withmarketing creates greater institutional legitimacy. “Capitalalone has become somewhat commoditized,” he added.

Stable Start-upsWhether a start-up fund decides to go it alone or work witha seed capital firm, a third-party marketer or a multi-strate-gy hedge fund manager, the final lesson for new managers isthat marketing is an ongoing process. According to hedgefund executives, one of the classic mistakes made by newfunds is to believe that their initial investors will be perma-nent investors. As in any asset gathering business, it is the‘stickiness’ of assets that allows a viable long-term businessmodel to be built. In the hedge fund context, this means thatstart-up managers must constantly be in the mindset ofreplenishing assets.

Initial investors may have needs that change over time andinvestment boards may reshape investment policy, leading toredemptions. Furthermore, if funds are not careful in therush to raise assets, they may attract too much capital from‘fast money.’ For example, many hedge fund marketersbelieve that funds of funds move in and out of single strate-gy funds rapidly, either due to the tactical nature of theirinvestment allocation or the pursuit of the style du jour. Astart-up manager that is too reliant on funds of funds as aninvestor base - or any one client type, for that matter - mayplace itself at a high risk of mass redemptions. It is importantfor new funds, and any partner organizations, to develop adiverse investor composition so that assets remain stable.

“I don’t necessarily believe that funds of funds are fastermoney than other investor types, but you do need to have agood balance between investor types and remember that mar-keting is a 24/7 job,” Keane said. An investor base willchange over time, and those changes will not necessarily be arelated to a fund’s investment performance, but rather to thecomplex nature of today’s investor base. “No investor is for-ever,” he added. i



L ATE LAST YEAR, the FTSE Groupsaid it would promote Israel from‘emerging’ to ‘developed’ status as ofJune. No other index manager has fol-lowed suit yet, but the shift by such a

major institution gives investors in Israel some unusual lever-age. Investors from outside the country can still expect emerg-ing market returns while reasonably expecting safety moreakin to that of a developed market. At the same time,investors and asset managers in Israel can point to the catego-ry shift as evidence of soundness for the overall economywhile still attracting the kind of venture capital that seekshigher returns.

Over the past few years, the expansion of Israel’s economy hasbeen mirrored in the rapid growth of its capital markets. Themajor indices of the Tel Aviv Stock Exchange (TASE) haveconsistently risen over the past three years, with the BlueChip TASE 25 index rising 140% in dollar terms during thatperiod. That, in turn, has led to growing foreign investment

in the Israeli market and the rise of exchange-tradedfunds (ETFs) as the preferred tool to access it.

One of the companies at the epicenter of thismarket in transition is KSM, based in the businesscenter of Tel Aviv. The firm is the largest marketmaker for index-linked certificates (ILCs) in Israeland manages more than 80 ILCs tracking diversecommodities, currencies and leading share indicesin Israel and globally. ILCs are similar to ETFs,except ILCs are fully obligated to the index pricerather than to its underlying asset value.

Co-founder and chairman of KSM, Roy Regev,said the company’s ILCs - and especially its hedg-ing tools - offer a “sophisticated yet simple” gate-way to emerging markets. He noted that the tran-sitional nature of the Israeli economy, as well asthose of larger advanced emerging markets like

China and India, make both straight index vehicles and shortsmore useful and important.

“Emerging markets have been popular in recent years asinvestors in developed countries are seeking outlets beyondtheir own economies,” said Regev. “The Israeli GDP hasgrown about 5% over the past few years. That is not as greatas China’s 10%, but it is considerably higher than the 2% wehave seen in the developed economies. Of course, risk isexpected to be greater in emerging markets, but with the sub-prime problems in the U.S. affecting Europe there also is riskwithin developed markets.”

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As a result,three trends arec o n v e r g i n g .First, there isthe natural flowof investmentsto emergingeconomies dueto the accept-ance of higher

risk for higher return, Regev said. That is now being joined by analmost ironic flight to quality from the troubles in the developedeconomies to the soundest of the emerging markets, heexplained. The new impetus, plus the long history of expansionin emerging markets, increases the urgency that hedging strate-gies are in place. Few expect a serious problem to develop inChina, India, Israel or other advanced emerging markets, but thesize of the foreign exposures in those economies make hedgingthe prudent move, he said.

Part of the Excellence Nessuah group, one of the largest invest-ment houses in Israel, KSM accounts for more than half of thetotal market in ILCs and covered warrants on the TASE. The cer-tificates have been traded since 2003 and have increased the dailyvolume in market indices. KSM has developed more than 80products, including 25 custom made for the Israeli market, anddaily trading in the firm’s ILCs is substantial, representing 20%of daily trading volumes on the TASE.

A good deal of that success can be ascribed to Regev’s expertise.He grew up in Israeli investment circles,earning an MSc in finance from Tel AvivUniversity. Prior to co-founding KSM,Regev was a partner in a strategic con-sulting firm and worked with leadingtechnology companies in the Israeli mar-ket. Today, in addition to running KSM,Regev is a member of the TASE market-ing committee.

“In 2003, we decided to combine ourexpertise in index trading with ourentrepreneurial spirit to establish KSMwithin the structure of ExcellenceNessuah,” Regev said. “We were notthe first with an ETF in Israel, but wewere the first to show the market whatthe ETF could do.”

KSM’s main expertise for non-Israeliinvestors is its wide range of local reversestrategies. “We currently have more than10 different reverse trackers to hedge

almost every angle of the Israeli market,” Regev said. “To have thoseavailable is very unusual for an emerging market of our size. Wehave the TASE 25, TASE 100 and even a small-cap hedge, which isthe only reverse tracker on any small-cap index outside the U.S.Beyond Israel, we have a unique reverse tracker on the CNX Niftyindex, which is based on the National Stock Exchange of India, andshortly we will have a reverse tracker on the Chinese market.”

One of the most unique features of the Israeli market is its Sundaytrading, and KSM offers its international clients an opportunity totrade most of the world’s leading indices on a Sunday. “To date, ourmain customers have been hedge funds that invest in Israel, but wehope to expand to a larger pool of investors in 2008,” Regev said.

Regev believes the wider use and utility of reverse trackers hasallowed some investors to reduce their use of derivatives for hedg-ing. “This has occurred for three reasons,” he said. “First, you don’tneed to roll a reverse strategy as you do with derivatives. Not onlyis the roll a complication, it exposes you to interest rate and divi-dend risks. Second, the liquidity within the reverse trackers is fargreater than other hedging tools in the market. And third, ourreverse trackers cover every angle of the Israeli market.”

Regev noted that the low correlation of emerging markets todeveloped markets does not mean zero correlation. “Due to thesubprime problems and the slowing of the worldwide economy,we will see some effects too,” he said. “GDP growth in Israel willgo from 4.5% to about 3.8%, but not much lower. China willcontinue to grow, at least through the Olympic Games this sum-mer. However, volatility everywhere will be much higher, and we

will see some hard corrections in 2008. As aresult, the use of hedge solutions will grow.”

In reclassifying Israel, FTSE noted that thecountry’s economy “meets all quality of marketscriteria for a developed market and has done sosince being included on the watch list in 2006.A new FTSE Index for developed markets inEurope, the Middle East and Africa will beintroduced for those investors wishing to inte-grate Israel within their existing DevelopedEurope portfolios.”

The promotion of Israel from emerging todeveloped market does have some conse-quences, but the outlook is broadly positive.“In terms of the economy, it is great to havean objective firm say that the economy is get-ting better,” Regev said. “That is good fordirect investment.”

For more information on KSM, visit their websiteat www.ksmci.com.

“To date, ourmain customershave beenhedge fundsthat invest inIsrael, but wehope to expandto a larger poolof investors in2008.”

— Roy Regev

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in m

illio

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Foreign Direct Investment in Israel

2005 2006 *2007

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4,792

14,301

8,902



T HE BEST PART OF creating a newhedge fund may be the entrepreneurialspirit of the endeavor, yet that verymindset can result in a host of legalheadaches for funds not careful from

the outset. While there are a plethora of legal complexitiesrelated to the tax implications of the fund structure and advi-sor incorporation that fill legal tomes longer than any hedgefund manager could ever want to understand on their own,lawyers say the most critical issue for first-time managers isoften more basic: the change of mindset from an employee ofa corporation to a business owner.

Prior to starting up their new hedge funds, most managerswere traders at an investment bank or junior managers andanalysts at an established hedge fund. Therefore, lawyersstress that, while these managers may be investment geniusesand whizzes with complex derivatives, their biggest legalissue is transitioning into the mindset of running a businesson their own.

“Most new managers are largely clueless when it comes toregulatory issues and structuring concerns,” said GeorgeMazin, partner in charge of the hedge fund practice atDechert. “They know how to put in buy and sell orders, buteverything else has been done for them.”

Case in point, many traders come out of a bank or largerhedge fund where they were part of a team, and they startadvertising the performance of that team as if it was theirown, placing it up on web sites or in marketing materials.This is the type of basic mistake that is obvious to lawyersand seems as if it should be obvious to hedge fund managers,but often it is not because they have never had to concernthemselves with running their own business. The good newsfrom the standpoint of hedge fund lawyers is that legal and

regulatory risk are two risks that funds can actually have con-trol over and can do a lot to minimize. In other words, whileminimizing these risks will never make a fund a lot of money,it may very well save the fund a lot of money when consid-ered from a more nuanced, long-term perspective.

David Nissenbaum, a partner at Schulte Roth & Zabel, saidthe number one issue for new hedge funds is to make surethey understand what it means to operate as a fiduciary. Bylaw, this means they have to act in the best interest ofinvestors, and that is very different from the environmentmost new managers come from, working for an investmentbank or hedge fund shop that has been the fiduciary assum-ing all of the risk related to managing clients’ assets. Thefiduciary responsibilities under investment law are uniqueand distinct from the environment in which these tradershave come up. “When you are the fiduciary yourself, yourthinking has to be permeated by much more careful analysis,whether it is related to making a trade, hiring a serviceprovider or managing pools of money on behalf of multipleclients,” Nissenbaum said.

Furthermore, when a trader, analyst or junior manager isworking for a larger institution, all of the reputation risk alsois at the level of the corporation. Proper understanding ofreputation risk and client trust is a critical mindset shift fornew funds. All of the decisions made by hedge fund man-agers - from their approach to client disclosures to due dili-gence on investments and service providers - circle back tothe heart of the risks of starting up your own investmentbusiness. “Many new managers don’t fully realize that even ifthey are doing the same type of trading they were doing atanother fund or investment bank, it is completely differentin the context of their own shop,” Nissenbaum said.

The fiduciary equation also means preparing yourself forinvestor challenges unrelated to actual fraud. Ron Geffner, apartner with Sadis & Goldberg, explained that one of the key

Think Like An OwnerHaving a start-up mindset can place first-time managers in a legal minefieldBy Eric Rosenbaum



initial components of shifting the mindset of start-up fundmanagers is getting them to understand that legal challengesare likely when investors lose money. This is not limited tocases in which the manager has committed securities fraud,but also cases in which a manager may have a bad stretch ofperformance or made overly aggressive bets. Traders do notcome out of a background where they have had to assumethis risk themselves and, as a result, it is critical to preparethe hedge fund for times when investors may try to legallyattack it in response to poor performance.

Pre-Nups for Start-upsBeyond the shift of the legal and reputational burden awayfrom a large corporation to the start-upfund, another critical aspect of forminga hedge fund business is settling on anappropriate operating structure for keypersonnel and an appropriate structurefor relationships with third-party mar-keting firms and seed capital providers.Lawyers stress that these are decisionsthat many first-time managers will notbe at all familiar with, but if they arenot dealt with in a proactive way, theycan come back to haunt the fund witha vengeance.

Structuring the hedge fund in the con-text of long-term business planningprobably has changed the most in recentyears. Before the last decade, hedgefunds were most often synonymous withthe individual managers, and thereforethere was no real exit strategy put inplace from a legal perspective. Over thepast few years, as large institutions have

gobbled up hedge fund shops—most notably the watersheddeal by JPMorgan for Highbridge Capital Management—theissue of exit strategies has become a critical part of the legalframework for new funds, and not an issue that can be easi-ly tackled retroactively. As institutions remain as hungry asever for alternative investment acquisitions, deciding on anownership structure that is prepared for the long-term futureof key personnel is increasingly important. Furthermore, ascompetition for hedge fund talent is intense, deciding on anexit strategy for key personnel at the firm, as well as the firmas a whole, also is an important issue on the legal checklistfrom day one.

“The most prevalent issue for start-up funds launched bymore than one individual is that they fail to execute a wellthought out agreement among principals and, in the event ofa divorce, don’t know how to extricate themselves,” Geffnersaid. “There is a misconception out there that these legaldocuments are boilerplate. They are not, and you can’t goback and easily modify them either.”

Not long ago, it was just the year-to-year income of keypersonnel that hedge funds had to be concerned with, butnow they are following the path of the brokerage industrytwo generations ago, with various legal approaches to part-nerships, participation in firm equity and the need to pre-pare for the exit of senior managers, as well as the potentialsale or merger of the firm. Lawyers stressed that not proac-tively dealing with these issues at the time of structuringthe business often means having to buy out officials, and

that is never profitable. “No one wantsto be part of these back-end divorces,and it can be nasty from the perspectiveof your investors as well,” said JamieNash, an associate with Kleinberg,Kaplan, Wolff & Cohen.

Seeds of Discontent?In today’s saturated hedge fund market,start-up funds also are more and moredependent on the support of third-partymarketers and various types of seed capi-tal organizations in order to grow assets.The days of the proverbial garage-runhedge fund growing to billions of dollarson the strength of investment perform-ance alone are a distant memory. From alegal perspective, this means that start-upfunds have to spend a good deal of timesettling on the legal nature of their rela-tionships with third-parties, in particular,with seed capital organizations. And ifnot dealt with proactively, this is another

From Left to Right: George Mazin, partner in charge of the hedge fund practice at Dechert, and David Nissenbaum, a partner at Schulte Roth & Zabel

“There is a mis-conception outthere that theselegal docu-ments are boil-erplate. Theyare not, andyou can’t goback and easilymodify themeither.” — Ron Geffner


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structural issue for the firm that can be exceedingly difficult,if not downright impossible, to fix retroactively.

“Working with a seeder is an extremely serious decision to makebecause it is extremely hard to renegotiate,” Nissenbaum said.Seed capital organizations typically have the strongest type ofminority owner protections. If not executed properly, a start-upfund can end up in a situation where the entrepreneurial spirit, inwhich it entered the hedge fund arena to foster, can be complete-ly overwhelmed by the ceding of too much control, and profits,to the seed firm.

Also, as competition for up-and-coming hedge funds inten-sifies among seed capital firms, the traditional seeding modelis facing new competition. Start-up funds need to be exposedto all of the rapidly multiplying seed models, and legal firmsthat are structuring dozens of these deals each year are oftenin the best position to provide counsel.

Another critical component of the legal language of funds -also related to the race to gather assets in a saturated market- is the balance between liquidity and creating a stable cashflow for portfolio management. In some cases, a tradingstrategy may be so liquid in its underlying securities that thehedge fund has much greater flexibility in offering frequentredemptions to institutional investors without hamstringingits portfolio management. However, for many strategies thatdeal in illiquid markets, the marketing impetus to offerinvestors attractive liquidity terms can be at odds with whatis best for the fund’s cash flow, and ultimately for both thefund and its investors in terms of performance. “I’ve seencases where hedge funds set lock-up terms with too muchflexibility because they thought they would not be able toeffectively market the fund otherwise, but it ended up dis-rupting the management of the fund,” Nash said.

Mazin noted that this issue can take managers in the oppo-site direction as well. Some managers are so paranoid abouta run on their fund and their business disappearing overnightthat they impose long lock-up periods. “This is one of mostdifficult issues they wrestle with, trying to create permanencefor their fund but actually making that a more difficult taskdue to these fears,” he added.

Three QuestionsUltimately, for all the complexities of setting up an invest-ment fund and incorporating a business, the most importantconversation with a new hedge fund can be boiled down tothree questions: What type of strategy are you going to run?Where are you going to have offices? And who are you goingto target as your clients? These questions are extremelyimportant because of the lack of specialized knowledgeamong so many start-up funds coming out of a trading back-

ground. “Lots of managers mistakenly assume that one sizefits all, so they look at peer structures and think that willwork fine for them. There is often not a perfect answer, butthere is this simple set of questions to get the conversationstarted,” Mazin said.

Lawyers say it is extremely important to have a detailed con-versation about the nature of a fund’s trading strategy andwhere the fund is to be domiciled because the tax implica-tions will vary widely based on the fund’s approach and loca-tion. It is very possible that selecting the wrong legal struc-ture for a particular fund strategy could leave a manager withan annual tax bill that eats up even sizable investmentreturns. “Large investment management companies don’t leta business start until the tax people have vetted it, but start-up funds don’t have tax departments,” Mazin said.

What’s more, because hedge funds are involved in so manycomplex security types and can incorporate in both domes-tic and offshore markets, the tax ramifications haveincreased. Lawyers described clients who began their careerin Hong Kong and now also have offices in London, NewYork and India.

There is no easy answer as hedge fund shops expand aroundthe globe and trade in more complex securities. With the setof issues related to the shift in mindset from employee tobusiness owner, the analysis is easier to outline for a generalaudience. However, hedge fund lawyers say that, when itgets down to the layer of specific tax treatment for varioussecurity types and various onshore and offshore markets, thesituation can only be evaluated properly on a case-by-casebasis. Nonetheless, it is safe to assume that Mazin’s set ofquestions will at least lead funds in the right direction andhelp them to steer clear of the red-flagged areas from a taxor legal perspective. i

From Left to Right: Jamie Nash, an associate with Kleinberg, Kaplan,Wolff & Cohen, and Ron Geffner, a partner with Sadis & Goldberg



I N THE REAL ESTATE world, an old clichédictates that the preeminent success factor islocation. In the realm of technology and oper-ations for start-up hedge fund managers, theissue of chief importance is credibility. And in

the minds of prospective investors, nothing injects credibili-ty like the comfort of knowing a manager has aligned with ateam of competent third-party service providers. Without aqualified attorney, auditor, fund administrator and primebroker squarely in place, a manager’s ability to raise capitaland achieve smooth execution is severely impaired.

“These services require outsourcing for one main reason:there are more institutional investors interested in hedgefunds than ever before,” said Colin Bugler, managing direc-tor and head of global prime brokerage at RBC CapitalMarkets. “From an operational perspective, the minimumstandards institutional investors will accept are vastly higherthan what high-net-worth individuals and private clientsdemand. So if a manager wants allocation from a pensionfund or other institutional player, they better raise the barand become more institutional in nature themselves.”

Long Arm of the LawWhile each of the aforementioned third-party disciplines areunequivocally vital to the start-up process, procedurallyspeaking, the journey begins by procuring legal expertise.After all, document creation must precede all else. Or as oneindustry expert succinctly put it, “You’re nothing without anoffering memorandum.”

Manoj Nadkarni, a hedge fund manager with theWashington-based ChipInvestor Group, relies on outsidecouncil to articulate strategy and manage investor expecta-tions in his offering documents, especially given that his sec-tor-specific fund strays significantly from the typical

long/short model. “With regards to risk, the dynamics of sec-tor funds are different,” Nadkarni said. “The more explicitlyyou explain this from the onset, the better off you are withregard to retaining investors in the future, particularly ifthere are draw-down periods.”

Michael Tannenbaum, founding partner at the law firm ofTannenbaum Helpern Syracuse & Hirschtritt, concurredthat clarity with disclosure documents is critical. But hisexperience tells him that the lion’s share of the trouble moststart-up managers encounter has more to with daily infra-structural difficulties than anything else.

“The operational risk associated with building infrastruc-ture goes beyond the ability to trade properly and assessthe markets,” Tannenbaum said. “It has to do with theday-to-day business operations: paying rent, paying thelighting bill, making sure the technology is up to scratch.These are the below-the-investment-line issues that makeor break a manager.”

Competent Service ProvidersAre the Key to CredibilityWhen it comes to technology and operations, nascent managers can quickly gain respect by outsourcing to qualified providersBy Andrew Bloomenthal

From Left to Right: Michael Tannenbaum, founding partner atTannenbaum Helpern Syracuse & Hirschtritt, and Manoj Nadkarni,fund manager at ChipInvestor Group



Tannenbaum’s best legal advice for start-ups: execute a one- totwo-month dry run before rolling out the fund. Althoughdoing so may delay a manager’s planned launch date, it’s bet-ter to avoid humiliation by identifying and rectifying issues inprivate, rather than doing so under the watchful eyes ofprospective investors.

It’s Primetime!Beyond legal services, there are no hard and fast rules dictat-ing the order for acquiring the remaining service providers.Typically, however, securing the prime broker is the nextmove, if only because such entities often have relationshipswith fund administrators and auditors and can easily facilitatethose introductions.

In scope, the traditional prime brokerage role is vast. In addi-tion to providing custody services like securities clearing,prime brokers facilitate capital introduction by pairing man-agers with investment clients, offer technology support byhandling execution and reporting and provide financing toleverage client assets. Some prime brokers also lease officespace to hedge fund managers, providing them with a suite ofon-site services.

“The parameters of what we do are becoming broader andbroader as prime brokers try to differentiate themselves in abid to capture greater market share,” said Bugler, who sharesTannenbaum’s observation that emerging managers’ mostcommon misstep is failure to effectively run the business.This, he reasoned, is largely because many start-up managersare stepping out on their own for the first time after stintsas proprietary traders for investment banks, where their for-mer employers previously handled allthe logistics.

“If a hedge fund has problems in thefirst few years of life, it’s not because offailed investment decisions. It’sbecause they don’t properly manage thebusiness side of their fund,” saidBugler. He advises managers and primebrokers to establish clean lines of com-munication in order to function withoptimum operational efficiency.

“Investors are willing to listen to amanager explain away poor perform-ance due to poor market conditions orbad timing, but they’re not so patientwith operational errors,” addedBugler. “If you have to explainaccounting adjustments, correctmark-to-market figures or re-state

your net asset value because of poor communication with theprime broker, that doesn’t give investors a sense that you’re incontrol of your business.”

A Perceived Conflict of Interest?Some managers are dubious of prime brokers, many of whomearn large chunks of their profits from fee-based commissionsand through spreads on clients’ long and short positions. Forsome investors, this paradigm fosters an atmosphere offavoritism, where prime brokers pay more attention to theirhighly levered clients, leaving their long-only clients hangingin the wind.

“Many times, what a prime broker is looking for differs fromwhat a fund manager is looking for,” Nadkarni said. “For me,the important thing is what’s good for the fund and what’sgood for our limited partners. Prime brokers are mostly con-cerned with landing that ideal candidate: one who’s leveragedin the neighborhood of 150%, does a lot of shorting andmakes them a ton of money through margin trading. Primebrokers are aggressive, and we changed ours when we realizedthey were not acting in our best interest. I’m pleased withthat decision.”

For his part, Bugler conceded that prime brokers have indeed his-torically made their bread and butter through providing securitieslending coverage to clients. But he noted that a large contingentof brokers is evolving in an effort to become more accommodat-ing to a wider spectrum of clients.

“As hedge funds have evolved, prime brokerages have aug-mented their offerings in response,” Bugler said. “Initially,

they started off by introducing capital intro-duction programs. This was followed byenhanced technology offerings, risk plat-forms, risk engines and performance analy-sis. We recognize these things as needs in themarket, especially for small managers withsmall wallets.”

Administering the FundFor single manager funds, hedge fundadministration involves the dual tasks ofmonthly accounting, including the calcula-tion of performance fees, and investorrecordkeeping, which entails monitoring theproportion of the fund that each limitedpartner owns. It also entails collateral man-agement and cash processing. While admin-istrators perform the same functions forfunds of funds, they also act as custodians ofthe investments, carrying out all the transac-tion processing on those positions.

“If a hedge fund

has problems in

the first few years

of life, it’s not

because of failed

investment deci-

sions. It’s because

they don’t proper-

ly manage the

business side of

their fund.”

— Colin Bugler



“Investors, particularly institutionalinvestors, gain a great deal of comfortfrom having both an independentadministrator and, on the fund of fundside, a custodian holding all of theinvestment assets,” said Elliott Brown,global product manager at JPMorganHedge Fund Services, which servicesmore the 240 funds with approximately$85 billion in combined assets undermanagement.

“I’d say the biggest advantage to out-sourcing is that it allows managers tofocus on their skill set, which is manag-ing money, while the administrator staysup to date with new technology and sys-tems upgrades,” Brown added. “There’sa huge cost for hedge funds to keep theirsystems up to date, and by outsourcingthere’s a certain economy of scale.”According to Brown, two-thirds ofJPMorgan’s clients are single managerfunds and one-third are funds of funds,with new business evenly split betweenthe two.

As Sure As DeathWith about 250 hedge fund clients,Denver-based Spicer Jeffries providesmanagers with audit and tax services,including year-end financial statements, and K-1 prepara-tions, which report capital gains, interest income and expens-es the fund’s partners incur.

Spicer Jeffries manager Sean Tafaro’s best advice for hedgefund managers is not unlike that dispensed by other serviceproviders: maintain constant communication with the audi-tors, especially with respect to new product offerings andnew trading strategies.

“It’s important for the auditor to know about these changesbecause different financial products are taxed differently, andit’s crucial to have an understanding of this before you get toyear end,” Tafaro said. “Things can be done before year end to smoothout the tax process. Plus, for marketing and SEC purposes, investorsfeel more comfortable when this is prepared by professionals.”

Victor Chiang, chief operating officer of Boston-based BCMDiscovery Fund, said he explicitly monitors potential under-lying managers to make sure they are aligned with reputablethird-party providers all around. If they’re not, he’ll elimi-nate them from contention. Chiang’s chief worry is that care-

lessness and human error will cause mis-takes, especially when people incorrectlybelieve they have more cash on handthan they actually do.

“It happens more than it should. Peoplemake trading errors because they don’thave an accurate picture of their portfo-lio and position sizes. Trade reconcilia-tion is everything,” said Chiang. “Forthe most part, if you’re using one of themajor prime brokers, all of them willoffer you good technology, but technolo-gy is only as good as the person who’susing it. Are they checking the tradeblotter? Are they checking the dailyP&L? It’s important for fund managersto know with certainty that they are.”

Moving Operations In-HouseOnce a fund takes root and substantiallygrows in assets, some may wonderwhether it is sound practice to then hirein-house talent to handle technology andoperations. “The answer is ‘yes’ and‘no,’” declared one industry expert. “Asfunds grow in assets, head count increas-es with the addition of full-time employ-ees, just as it happens with any company.But they’ll never take the place of thethird-party providers.”

The expert conceded, however, that in-house legal, account-ing and administrative staff may function well as liaisons tothe third-party providers. An in-house chief counsel, forexample, would interact with the outside law firm, just as achief operating officer would communicate with the third-party administrator. “If you’re an investor you want non-biased checks and balances in place,” the expert said. “Thatnever changes.”

However, some believe that certain situations are indeed con-ducive to in-house operators taking lead roles. “There’s noquestion that, when the assets under management rise, youcan get by with in-house staff in certain situations,” said oneproponent of such action. “The fund can hire in-house coun-sel, even in-house computer programmers. The more moneyyou have, the easier it is to do it. But not all managers wouldbenefit. A manager who publicly trades securities that areeasily valued would have fewer problems with reporting thana manager on the other end of the spectrum, who trades ininvestments with little liquidity or distressed instrumentswhere clear valuation issues are more complex.”i

The BreakdownWhat are the specific functions of the fourmain service providers? The Hedge FundStart-Up Survival Guide breaks it down:

Attorney• Fund structure• Legal documents• Regulatory requirements• Registration

Prime Broker• Clearance, settlement and custody• Reporting• Financing• Capital introduction• Technology

Accountant• Annual audit• Tax returns• Schedule K-1• Tax issues• Compensation structures

Administrator• Investor communications• Marketing subscriptions/redemptions• Books and records (onshore/offshore)• Partner capital accounting• Valuation• Performance calculation• Management fees


©2007 The Bear Stearns Companies Inc. All rights reserved. Bear Stearns ® and A Great Deal Depends on Working With The Right People ® are registered trademarks of The Bear Stearns Companies Inc. (BSCI). A culture of service.A tradition of strength.SM is a service mark of The Bear Stearns Companies Inc. Prime Brokerage Services is a business unit of the Global Equities division of Bear, Stearns & Co. Inc. (BS & Co.). Prime brokerage services are offered inthe United States by BS&Co. and outside of the United States by Bear, Stearns International Limited (BSIL). Clearing and custody services are provided by Bear, Stearns Securities Corp. (BSSC). BS&Co., a direct subsidiary of BSCI,is a United States registered broker-dealer and a member of the NYSE, NASD and SIPC. BSSC, a guaranteed subsidiary of BS&Co., is a United States registered broker-dealer and a member of the NYSE, NASD and SIPC. BSIL, anindirect subsidiary of BSCI, is authorized and regulated by the United Kingdom Financial Services Authority. Sources: (1) and (2) Lipper HedgeWorldService Provider Directory & Guide, 2006/2007 edition. Results are from a survey of1700 Institutional investors and based on three primary factors, scores, respondent comments and number of responses. Respondents were asked to rate participants in the following areas, Client Service, Securities Lending, Financing,Reporting, Technology, Operations and Capital introduction. (3) Global League Table 2007, Global Custodian Prime Brokerage Survey

It takes both to be a leader in Prime Brokerage.

#1Prime Broker by Assets

of US Funds1

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A culture of service.A tradition of strength.SM

2007 GLOBAL CUSTODIAN PRIME BROKERAGE SURVEY 3

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