Starting A Hedge Fund - Prepare To Drown In Expenses
Many years back, I was searching for information on how to set up and run a hedge fund. The question I had was this: Can I start one myself? However, I was sorely lacking in information. In particular, I want to know how much it is going to cost. And it was not an easy task. I managed to gather bits and pieces from the internet and friends in the industry. But like solving a giant puzzle, there are always missing pieces. Pieces that you know you are missing, and pieces that you don’t know you are missing. And costs are definitely one of those.
I guess I could have talked to a fund lawyer specializing in hedge funds. But it was not a firm thought then. I was not some star portfolio manager from Renaissance Technologies or Citadel looking to go start his own fund. Neither am I loaded with cash to seed the fund nor do I have billionaire sponsors lining up to back me. So I don’t want to go to a fund lawyer sounding silly, looking less than half-committed, and end up wasting both sides’ time.
Anyway, to cut the long story short, I did not end up starting a hedge fund. Instead, I joined a start-up hedge fund and got involved in the setting up process. And only then did all the pieces fall into place. Not surprisingly, I have way underestimated what is needed. That was, however, quite a number of years back in 2016, so some of the things I mentioned here may be outdated. For example, the costs have probably gone up by now given how prices of virtually everything have risen. And there may be new regulations that put more costs in front of you. Well, regulations only get more and more onerous and never the other way around. Nevertheless, I believe what I am going to share is probably still useful as a reference.
For those who are contemplating starting and running a hedge fund with the investment management company based in Singapore, there are a few things you might want to know.
Managed Account Or Fund Structure?
We often use the term “hedge funds” loosely. It is just a broad term. And some “hedge funds” actually do not have funds. Instead of pooling all the money they raised into a fund, they managed separately the individual private accounts of their clients. We call these managed accounts. There are advantages to this approach, such as lower costs, since that does away with the need for a separate legal entity. However, this may not always be feasible if the individual accounts are too small to achieve economies of scale or to execute your investment strategies.
I will be focussing on the more typical fund structure approach. There are 2 entities involved. First, you will need to incorporate an Investment Management Company (IMC). This is where the investment team sits. After that, you need to create another legal entity for the Hedge Fund (HF). The HF is just a vehicle that holds the pooled assets of all its investors. And it engages the IMC to manage these assets. It sounds kind of roundabout, but this elaborate arrangement is necessary. It segregates the investors’ assets and isolates them from business risks associated with the IMC.
Expenses On The Investment Management Company (IMC)
1. Incorporating the IMC: $300-$400
The IMC is a private company you can easily incorporate with the Accounting And Corporate Regulatory Authority (ACRA) for a few hundred bucks. You can see the list of applicable fees on ACRA’s website.
2. Registering with the Monetary Authority of Singapore (MAS): $1,000 per year
Before you can conduct money management business, you need approval from the Monetary Authority of Singapore (MAS). For a start, you are likely to register as a fund management company instead of applying for a capital markets license. The requirements are easier to fulfill. That makes the IMC a Registered Fund Management Company (RFMC). Going forward, you just need to comply with the rules and pay an annual admin fee of like $1000. RFMC is subject to slightly less onerous rules and requirements than its licensed counterparts. But it comes with certain restrictions. For instance, the IMC cannot manage more than $250 million. But that is a happy problem to have because you can always apply to upgrade to a Licensed Fund Management Company (LFMC) subject to MAS's approval of course. For details, I suggest you refer to the guidelines on MAS’s website.
3. Maintaining the base capital of $250,000 at all times
As an RFMC, you need to maintain a base capital of $250,000 at all times. This is a mandated buffer set aside to meet financial obligations. A breach is serious, and recalcitrant offenders can have their registration or license revoked. This means internally you have to set a higher threshold, say $350,000, so that you would not inadvertently breach below the regulatory level. While this is not an expense, it is still something you have to prepare and set aside.
4. Getting a physical office: $2,000 per month
You will need office space. And sorry to disappoint you, but your bedroom or study room is not going to make the cut. You can work anywhere you want, but you are required to have a proper physical office. And for compliance reasons, the space has to be segregated and protected from non-authorized personnel. Do also bear in mind that this is a place many prospective clients would like to see. So it should look sufficiently adequate. An easy option is to rent a small room in a serviced office. That takes care of many things e.g. essential facilities, utilities, internet connectivity, etc. Depending on where the office is located, the rental can be vastly different. For office space near the central area for 3-4 people, we can be looking way north of $2000 per month.
5. Getting the manpower you need: $12,000 per month
This is potentially the largest chunk of the company’s expenses unless it is entirely operated by business partners. MAS dictates that you have minimally 2 directors, each having at least 5 years of relevant experience to qualify for an RFMC. And one of them must be a full-time employee resident in Singapore. Technically, you can appoint any employee as director. But in most startups, the Chief Executive Officer (CEO) and Chief Investment Officer (CIO) will be the ones fulfilling this criterion.
Besides your CEO & CIO, ideally, you should also have a corporate secretary, a finance officer, a compliance specialist, an IT support staff, an internal audit person, and someone running the marketing or investor relations. But there is no rule to say you can’t hire someone who is both IT savvy and good at finance, or the CEO/CIO can’t double up as the marketing director. It is fairly common for people in startups to wear multiple hats. Compliance, however, is a full-time dedicated function. And due to conflict of interests, you can’t have the CEO/CIO wearing this hat. You are, however, allowed to outsource this function to an external service provider.
What if you can’t pay? Then the only alternative is to find trusted partners who share the same passion as you. And they must have sufficiently deep pockets to see themselves through the next couple of years. Else this venture is almost guaranteed to fail. It is, however, by no means easy to find that many partners. So let’s just assume you are the CIO, and the CEO/Marketing is your business partner. Both of you hire another 2 people to fill the roles of a finance/IT and compliance officer. It is highly unlikely you will go for senior professionals from large institutions unless you can pay really generously. So let's assume we go for 2 junior hires and budget about $12,000 a month.
6. IMC Audit: $10,000 per year
As a regulated entity, the IMC has to engage an external auditor to perform an annual audit. The IMC is not eligible for audit exemption. The auditor will scrutinize everything from your company's processes to the financial statements. Audit fees can vary significantly between auditors. If you go for the BIG four auditors, then you get the BIGGEST four invoices. What I would suggest is to forget about such branding when you are still trying to make ends meet. You might be able to negotiate with a lower-tier auditor to do the job for under $10,000.
Expenses On The Hedge Fund (HF)
Contrary to what many people may think, the hedge fund actually does not have any direct hires other than a board of directors for oversight. But that does not mean its expenses are low. Because it engages the service of many third-party providers. And these services do not come cheap. Typically, these expenses are deducted from the fund. But when the fund is small, as is usually the case for the less well-known start-ups, there are implications. An annual expense of say $100,000 on a fund with an AUM of $1 million means the first 10% your fund makes goes into paying off these expenses. That is a killing blow to any track record you want to build. And if there are early external investors, it would be unfair for them to bear such a big burden. So in such instances, the IMC typically absorbs all these expenses on behalf of the fund before it grows to a reasonable size.
7. Cayman Islands offshore fund associated and other regulatory fees: $20,000 per year
Let’s say you incorporate an offshore fund in the Cayman Islands – one of the tax havens. There are probably lower-cost options like the British Virgin Islands (BVI), but I am only familiar with the Cayman Islands, so I will go with that. The Cayman Islands is also the choice of domicile for most offshore funds, accounting for more than half of all offshore structures.
There are of course fees you have to pay to maintain a fund in the Cayman Islands. You will need to pay on a yearly basis – a mutual fund registration fee, a Cayman government fee, a Cayman registered office fee, an annual returns filing fee, a CIMA director fee for each director on board the fund, etc. And in 2018, the Cayman Islands Monetary Authority (CIMA) introduce a new rule requiring all regulated funds to appoint an Anti-Money Laundering Compliance Officer (MLRO) and a deputy MLRO. You can outsource this function to the fund administrators. And yes, unfortunately, there is a fee. In the business world, there is no free lunch. Cayman-based financial institutions are also subject to FATCA reporting obligations for tax purposes. It is beyond me to explain. But suffice to know that you will also need to pay to get people to do the reporting for you.
As a ballpark, all this stuff might set you back easily by $20,000 or more per year.
8. Legal Advisory Fees: $25,000 -$50,000 one-time set-up expense
You will need lawyers to draft and file all the legal materials for the HF. The most important document is the private placement memorandum (PPM). This document details everything from the portfolio managers, the investment mandates, strategies, risks, and fund terms to service providers, etc. And you will need 2 groups of lawyers:
A Cayman fund lawyer because your HF is domiciled in the Cayman Islands.
A Singapore fund lawyer because the IMC is incorporated in Singapore.
Needless to say, your costs have only one direction to go – UP. Again, charges can differ significantly. Let’s budget between $25,000 – $50,000. This setup cost can be charged to the fund. And while this is not strictly following the accounting standards, it is common practice for small funds to amortize this setup expense over a maximum of 5 years. This helps to distribute the costs so that early investors are not unduly penalized. This is to be fully disclosed in the PPM and financial statements. Again, startups often absorb these set-up costs.
9. Fund Administration: $3,000 – $4,000 per month
Would you put money in a hedge fund where the PM himself does the calculation and confirms the NAV? I don’t think so. The process is inherently flawed as the PM can manipulate performance data without independent oversight. Not to say that he will, but without proper process, he can.
This is where the fund administrator steps in. They track all the positions and trades of the fund and reconcile them against the broker statements at the end of each month to arrive at the official NAV. This leaves no room for tricks. Besides this, they also process investor subscriptions and redemptions, calculate the fees, send the hedge fund clients a monthly fund statement, perform Anti Money Laundering (AML) checks, and prepare the fund’s annual financial statement for audit purposes, etc.
Fund administration is one of the largest expenses. They charge a monthly fee, usually, a couple of basis points based on the size of your fund subject to a minimum. Again, prices vary according to the complexity of your fund and administrators. But as a rough estimate, put aside $3,000-$4,000 per month for a small fund.
10. Fund Audit: $10,000 – $15,000 per year
Yes, the fund also needs to do an annual external audit. And it can be a tad more expensive than the IMC audit. 2 groups of auditors are involved. A local auditor does all the groundwork, and another auditor registered with CIMA to review and do the final sign-off. Budget $10,000-15,000.
11. Fund Custody Fees: $0
Big banks and prime brokers safe-keep the fund’s assets on their behalf. In return, they charge a custody fee. It is usually a very small percentage of the total assets in their care per month subject to a minimum. But if you are not that brand conscious, you can opt for brokers that do not charge custody fees, or at least not explicitly. These brokers recover the custody costs through the trade commissions earned. So if you trade infrequently, you may incur an inactivity fee on your account. That, however, is insignificant compared to the custody fees you pay the branded guys. In any case, you can forget about opening a prime broker account at bulge bracket investment banks if your fund is anything lesser than $100 million.
Putting The Pieces Together
Now, if we piece everything together, expenses for the first year can be around $300,000 (the actual will be more because what I listed is not exhaustive) and a bit lower thereafter without the initial setup costs. And this still excludes the $250,000 base capital you need to maintain. And as I mentioned earlier, you might have to aim for a higher threshold of $350,000 instead if you don't want MAS to pay you a visit. Of course, if your company is generating a healthy profit since day one, then this might not be that much of a concern. But I doubt it.
Assuming your running expense to be $300,000 per year, to break even on just a management fee of 2%, you require a fund the size of $15 million. Too high? Sorry to disappoint you again, that is an optimistic scenario. With fees trending down generally, you probably would not get a single cent as a start-up charging a 2% management fee. It is highly likely you have to give up more upside and do a 1% or lower. I talked to a fund platform operator briefly once, and he thinks the optimal AUM to start a fund is $70 million.
On a more positive note, the fund can probably stand on its own and absorb the expenses in stride when it is large enough i.e. IMHO when the expenses are less than 0.5% of the fund per year. And I have yet to include the performance fee. But do expect rough patches where you will need the management fee to help you tide through.
Now, what I mentioned is not exhaustive. For example, I have not included expenses on things like web domain, website development, emails, secured cloud servers, backup power supplies, laptops, name cards, design, marketing costs which can be huge, and professional indemnity insurance, etc. This setup also cannot be used to solicit US monies. That will require a master-feeder fund structure comprising a US onshore feeder, a Cayman offshore feeder, and a Cayman Master Fund. 3 sets of financial accounts. More work for auditors. More work for administrators. More complicated tax reporting. And on top of that, you need a US fund lawyer to draft another PPM for the US investors. Basically, expect to pay a lot more. And as I have mentioned, these costs are based on 2016 when I joined the hedge fund. It would surely have gone up by now.
There are other paths one can take though. One way is to start with an incubator fund instead of a full-fledged hedge fund. Another is to look at joining a hedge fund platform who have the expertise and economies of scale to negotiate better deals with the service providers. I did not take those paths so I will not comment much here. In any case, anyone serious about it should do their own homework and consult the relevant professionals.