What are the break-down costs of starting a hedge fund?

Hedge funds have a reputation as an extravagant wealth creator for the managers of the fund. The managers generally receive a management fee as well as a carried interest on fund profits. If the fund is heavily capitalized and makes sound investments, this business entity can certainly generate generous returns for the managers. If this is the case, however, why do more people not start hedge funds. The first answer is that is requires the ability to convince individuals, businesses, endowments, trusts, or money funds to invest money in your hedge fund. This can be difficult if you do not have a track record demonstrating success in the field. The second reason is because there are significant costs in initiating or starting up the funds. In this article we discuss the various costs.

Legal Costs - Setup and Compliance

You will generally need the services of a business or transactional lawyer to help you in setting up the structure of the funds. The structure of the funds can be quite complicated. The most common structure is known as a master-feeder, fund structure. Investors place their money into limited partnerships. The investors are the limited partners, and the individual or business raising the fund is the general partner. The general partner contracts with a management company that manages the investments. There are normally two feeder funds. One is used for US investors, and the second is used for Non-US investors. There may be two separate management companies serving each feeder fund. The feeder funds then invests money into a single master fund. The master fund, which may be organized as a Limited Partners, which another General Partner and contracted management company. The master fund actually makes investments into the investment vehicles, alternative assets, and portfolio companies. The funds are generally organized in Delaware or in an offshore location, such as the Cayman Islands of British Virgin Islands. Forming entities offshore dramatically increases the cost above forming a simply US-based hedge fund. The purpose of this is to establish a foreign tax base. There are numerous transactional fees that will also apply. Your attorney will draft the governance documents (operating agreements or partnership agreements), disclosure documents for investors (private placement memoranda), and investment agreements (subscription agreements). The costs of setting up this structure may vary between $10K - 100K, depending upon the number and complexity of entities.

Hedge funds are heavily regulated by the Securities Exchange Commission and state securities regulators. There are numerous requirements for registration and disclosure to the regulator bodies and investors. You will need to hire a legal firm that has expertise in the compliance requirements. These costs can range from $10K -50k per year.

Fund Administrator Costs

The primary role of the general partner is to raise funds and identify investment opportunities. You will need to hire a fund administrator to handle the accounting and reporting requirements for the various entities. The fund administrator will generally be a company that specializes in this role. The company will also provide extensive advice and guidance on running fund operations. The administrator has trained staff members and software packages to carry out this process. All of these functions are known as “back-office work”. This work becomes more demanding as the hedge fund acquires more assets under management (AUM) and investments. The average costs for a year could range from $5k - $150k depending upon the size and amount of assets under management.

Audit and Tax Costs

Regulatory requirements often require hedge funds to undergo private audit. The results of audit are disclosed during investor solicitations and, in some cases, to regulatory bodies. You will need to work with an auditor (CPA firm) who is separate from your operational accountant and who is familiar with hedge fund operations. The cost of audit will depend upon the amount and number of investments held, the number of entities in the fund, and the number of partners. The price also goes up if the accounting records are not thorough and easy to manage. Also, you will need to work with yet another CPA firm to handle tax reporting and compliance. The annual cost for audit and tax compliance can be between $5 -20K.

Equipment and Technology Costs

The fund will need to invest in computers, office equipment, and software programs. The cost of office furniture, copy machines, etc., will vary depending upon the office setup. Computers adequate to handle sophisticated calculations will be between $1000-2000 each. The various technology or software services can be quite costly. Research databases, such as the Bloomberg terminal, can costs several thousand dollars per month. The heavy costs, however, depends upon the investment analysis documents purchased for specific trades. The fund must be able to professionally host all communications and trading services. There must be adequate encryption and backups. There must also be compliance measures for security purposes. This is particularly true if the company employs software to undertake automated trading. The costs could range from $5k - 250k per year.

Marketing Costs

Remember, one of the most difficult aspects of raising a hedge fund is attracting investors. This requires top-of-mind awareness within the industry. This requires a significant investment in marketing. There are all sorts of marketing, but the broad categories are direct and indirect. Direct marketing targets identified potential investors or groups of investors. Indirect marketing focus on creating general brand awareness among the public. The costs associated with marketing will depend upon the type of marketing employed. It could include printed materials, website and online presence, television and radio commercials, and print. The budge could vary between $1k - 100k (or more).