Current Issues in Hedge Fund Start Ups

Over the last six months I have had the opportunity to meet with a number of individuals looking to start up a hedge fund. Whether it is a proprietary trader at a large investment bank or a portfolio manager/trader at an existing hedge fund, the result has been the same. They have not launched or are trading their own money. Why? First, capital raising is extremely difficult. Hedge fund investors, if they are allocating at all, are adding to existing positions in large hedge funds with established track records and institutional grade operations. There is little appetite for taking a flyer on a start-up hedge fund. The typical proprietary trader at a large investment bank has had no exposure to outside investors and thus, has no Rolodex to mine. The portfolio manager/trader may or may not have had exposure to investors while working at the hedge fund they are leaving. Some investors like to bet the jockey. To some extent, they believe that past performance is indicative of future results. For both groups, whether their performance record is portable is a big issue when it comes to marketing the fund.

Secondly, running a hedge fund "business" is vastly different from portfolio management or trading. Investors are looking for hedge funds that they believe will survive and thrive. Start up hedge funds face significant obstacles to execution on the business/operations side. Most start ups lack the money to invest in institutional grade systems and hire the people necessary to monitor the systems put in place. They take for granted the infrastructure they previously operated under while part of a larger organization. To gain the capital needed to launch a hedge fund business, some start-ups are seeking out seed capital but this is viewed as less than ideal given the trade offs in economics.

Third, the regulatory landscape is unsettled and many people believe that waiting until things stabilize will allow for better decision making. Examples here are the Volker proposals on proprietary trading, potential SEC registration rules, change in taxation of carried interest, increase in income/capital gain tax rates and Medicare taxes arising from the health care bill, etc.

Fourth, many of these individuals are on Gardening Leave and prohibited from starting a new venture until the expiration of the non-compete agreement.

Build it and they will come is not a mission statement. The good news is that once the obstacles clear, there will be a significant wave of start up hedge funds. They will need CFOs and COOs and CCOs and IT and back office. While the preference would be to hire experienced personnel to fill these slots, (and money well spent given the economics of greater AUM that experienced hires may have access to or help land) opportunities will arise for first timers to land one of these roles given the pressure on compensation.

-George Roeck