Regulations are taking over the world of investment banking and restricting various trading strategies. In response, an increasing number of traders – many with strong track records – are starting up their own hedge funds as an exit route. They believe that there is a market out there for them, but these aspiring fund managers will realise that they face multiple challenges beyond making money. These include dealing with fund raising, IT, marketing, human resources and navigating the increasingly complex regulatory environment on their own.
Challenge One: Raising Funds
The key challenge is the difficulty of raising money for smaller funds. In the US, the top 500 hedge funds control more than 90 per cent of the industry’s assets, according to alternative investing research firm Prequin. In sharp contrast, smaller funds are often individuals who come up with a sum of family money (typically 5 to 10 million USD) and have an unrealistic expectation of the opportunities available.
Contrary to the common belief that getting venture capitalists (VCs) on board is the first step, they quickly realise that VCs often hold back startup funding to entrepreneurial ventures. Instead, they are only keen to get involved once the fund has kicked off and established itself. This leaves only “angel investors” (affluent individuals providing direct capital) who would consider new startup, but this group of individuals remain extremely selective. To attract investment the sales pitch and the timing of entry into the selected market need to be extremely convincing, with investors needing to trust both the prospect and their ability to survive the challenging market conditions.
Challenge Two: Marketing
Marketing of the fund is key to its success, with location, contacts and relevance in the target country essential – Europe and Japan are especially tough markets to enter. There will be many challenges for an emerging manager in those regions and this person will have to get out there to do the marketing and raise awareness of the fund. They will need a track record that is convincing, as well as a compelling story to get the fund off the ground. Track record is a concept of proven performance evidenced with back testing and simulation. A track record will be heavily scrutinised and four-to-five years of audited records are no longer sufficient. The manager will need a one-page track record backed by a brokerage company as well as tax records. Many venture capitalists will only consider a fund structure backed by a third party, and audited by the Big Four. In addition, triangulating references are also often required. Lawyers, brokers, and headhunters all make good referees. Those running the startup will need networks like these if they are to secure backing.
Challenge Three: Regulations
Tightening regulations pose a challenge for any start-up, making the process costlier, harder and slower. The key is to either get a regulatory expert on board or to engage a service provider/consultant to manage the regulatory requirements. Spending time sifting through regulatory complexity rather than being out marketing the fund is a challenge the manager must address. It may be tempting to suggest starting up in places with reduced regulation like The Cayman Islands or Luxembourg. But this may not suit investors, be expensive to set up once legal fees are taken into consideration and limit trading options once up and running.