How to Create a Hedge Fund

Want to Build an Investment Fund?

Recently, an increasing number of readers have asked us to help them to understand Investment Funds, such as a hedge fund, an offshore fund, or a private equity fund.

They are not only financial institutions intending to build an investment company. Many of them are individuals and small businesses. In this article, we make a brief picture of how to build an investment fund so that people intending to create a fund may focus fundamental matters at the very first stage.

First of all, we must start with very basic ideas. There are various types of investment funds, such as

(1) hedge funds,

(2) mutual funds or

(3) exchange-traded funds (ETFs).


The main categories of investment products in USA are:

Stock
Bonds
Mutual Funds and ETFs
Insurance Products such as Variable Annuities


If you are interested in making an investment fund, you are expected to know the difference among them. Then, can you tell which of the three is the easiest to create? Which one is the most difficult to launch?

Hedge Fund: the easiest

Among theses three types, obviously the mutual funds are most familiar. Compared with them, “hedge funds” may sound like the other side of the world. You cannot buy hedge funds from banks, securities firms or stock exchanges. Hedge funds sounds very private and closed, and may be difficult to approach.

However, if you are a fund manager and want to launch your own investment fund, “hedge fund” is the easiest to create. Hedge funds or any other types of private equity funds are so designed that their business can be operated under the least government regulations. On the other hand, investment funds available to the public (such as mutual funds or ETFs) are strictly regulated and must require very difficult and complicated formalities.


Hedge Funds

Hedge funds(only for Accredited investors) pool money from investors and invest in securities or other types of investments with the goal of getting positive returns. Hedge funds are not regulated♦ as heavily as mutual funds and generally have more leeway than mutual funds to pursue investments and strategies that may increase the risk of investment losses. Hedge funds are limited to wealthier investors who can afford the higher fees and risks of hedge fund investing, and institutional investors, including pension funds. [U.S. Securities and Exchange Commission]

A popular notion:-Hedge fund investments generally perform differently, involve higher fees and less liquidity, and may carry greater investment and fraud risk than the mutual funds that investors are accustomed to.

Minimum Corpus In India: 20 Crores

Minimum individual Investment in India: 1 Crore

In general, the hedge funds, usually offered privately, require a large amount of investment from a small number of investors (such as 49 persons or less). For this reason, the hedge funds are not subject to the regulations governing the mutual funds, investment trusts, unit trusts or any other publicly offered investment funds. This means the hedge funds can make profits through derivatives, leverage, arbitrage or any other techniques that the publicly offered investment funds are prohibited from utilizing. Such techniques make the hedge funds risky, to be sure, but at the same time enable them to have a chance to make high returns even when the whole market is weak.


What are private equity funds?

When you invest in a private equity fund, you are investing in a fund managed by a private equity firm—the adviser. Similar to a mutual fund or hedge fund, a private equity fund is a pooled investment vehicle where the adviser pools together the money invested in the fund by all the investors and uses that money to make investments on behalf of the fund. Unlike mutual funds or hedge funds, however, private equity firms often focus on long-term investment opportunities in assets that take time to sell with an investment time horizon typically of 10 or more years.

A private equity fund is typically open only to accredited investors and qualified clients. Accredited investors and qualified clients include institutional investors, such as insurance companies, university endowments and pension funds, and high income and net worth individuals. The initial investment amount for a private equity investment is often very high.


Clarify your prospected customers

Now you know hedge funds are the easiest to create. Hedge funds are a type of private equity firm and the procedures for forming a hedge fund is basically the same as those for other types of private equity funds. So, the procedures described in this article should be useful for those who are considering of creation of other private equity investment funds than hedge funds.

If you intend to create and launch an investment fund, it is needless to say that you are starting a new business. Then, you must start with clarification of your image of prospected customers who may invest in your fund.

One of the most important factors is the number of the customers. In case of private equity funds, the number of the investors must be small enough for avoiding undesirable financial regulations of the government (such as Investment Company Act of 1940 of the U.S.A.). To get enough volume of investments from limited customers, you may need to approach corporate or institutional investors.


Investment Company Act of 1940

This Act regulates the organization of companies, including mutual funds, that engage primarily in investing, reinvesting, and trading in securities, and whose own securities are offered to the investing public. The regulation is designed to minimize conflicts of interest that arise in these complex operations. The Act requires these companies to disclose their financial condition and investment policies to investors when stock is initially sold and, subsequently, on a regular basis. 


Money for Making a Fund

Then, you must think how much money you need for creating a fund. In the United States, for example, it is said you need approximately 50,000 to 100,000 dollars to launch a hedge fund. This may sound small, to be sure, but it is not for investing. It is just a cost for creation and launch. For investing, you need millions of dollars to be managed, but it does not necessarily have to be your money.

In most cases, however, you are not lucky enough to find sufficient amount of investments before launching your fund. Then, you must invest your own money in your fund to show prospective investors how nice it is to invest in your fund. Your prospective investors may usually decide to invest after seeing the actual performance of your fund.

In general, fund managers of hedge funds, buyout funds or other private equity funds invest a considerable amount of money at their own risks. In most cases, they started the business by investing their own money. In other words, they cannot get started until they invest their own.

First Step: Contacting a Financial Institution

To get started, when you have clarified your target customers and have enough capital to launch your fund, you must contact service providers, such as

(1) Law firms,

(2) Financial institutions,

(3) Accountants,

(4) Administrators.

Among such service providers, you should probably contact with a financial institution first. If you need to borrow stocks or a loan for leverage, you must contact with such institutions as a bank offering prime brokerage services. However, very few banks or institutions take such a risk as offering such services for newborn funds. You should rather find a small bank, which offers basic services for fund mangers such as opening a custody account in the location where your fund is to be registered, rather than seeking for possible prime brokers. You need at least two separate bank accounts. One is for investments. The other is for operating costs for your fund. Those two accounts must be separated in a strict manner.

Such banks may provide you with information of local law firms, accountants and administrators suitable for newborn funds. Then, the next service provider you should contact is a law firm. If you are in New York, there are lots of law firms specializing in the hedge fund business, but it should be easier if the bank of your fund introduces you to the local firms. For example, in the Cayman Islands, a lot of lawyers have expertise in hedge fund or other private equity fund business and their fees may be cheaper than those of the lawyers in big cities. Law firms will help you to elaborate the legal structure of your fund and prepare an offering memorandum or prospectus for it. The fees for lawyers must be a major part of the initial cost of your business, but such legal documents will protect you from lawsuits.

Formation of Companies, Trusts and/or Partnerships

Based on the fund structure, the law firm will also take care of formation of companies, trusts and/or limited partnerships that constitute a legal entity of your fund. In many cases, hedge funds or other private equity funds need a number of such entities for managing, operation, advisory or selling in different jurisdictions to constitute the entire scheme.


‘Company’’ means a corporation, a partnership, an association, a joint-stock company, a trust, a fund, or any orga­ nized group of persons whether incorporated or not; or any receiver, trustee in a case under title 11 of the United States Code or similar official or any liquidating agent for any of the foregoing, in his capacity as such. 


In most cases, the main body of the fund, whether it is a corporation or a limited partnership, should be established and registered in an offshore financial center such as the Cayman Islands, the British Virgin Islands or Guernsey. Especially if you are targeting at nonprofit organizations of the United States, such as foundations or the university investment funds, they will require that your fund should be an offshore corporation. Even if your prospected customers (investors) have no such requirements, still offshore financial centers must be the best jurisdiction for registration of your fund. Such jurisdictions were competing with one another in making better legal systems and business environments for investment funds and fund managers.

Among all of them, however, the Cayman Islands is said to be the best jurisdiction in general. In addition to its advanced legislation such as mutual funds law, limited partnerships law and companies law, the time zone of the Cayman Islands makes it possible for the fund managers to do their business in the same time zone as the New York Stock Exchange. For such reasons, the Cayman Islands has become an international standard as a jurisdiction for the business of hedge funds and other private equity funds.

When you have (1) transferred your money to an account with a bank providing services for fund managers, and (2) established legal entities in accordance with the legal structure, all you have to do for launching your funds is to choose an accountant and an administrator. Probably your Cayman bank has information of good local accountants and administrators.

Easy to Create and Launch

As you can see above, it is not difficult to make and launch a hedge fund, if you can manage to cover the initial cost. Today, it is said that there are tens of thousands of hedge funds or other private equity funds in the world. It is partly because it is easy to build and launch. However, the question is: how can you continue the business successfully? Most of the hedge funds are only a small business. Only a few of them can grow big. Probably, the biggest issue is not to grow your investments in the fluctuating financial market, but to get customers, especially institutional customers (investors), such as foundations, university funds or pension funds. Such institutional investors, rather than wealthy individuals, will lead your funds to success.

Last Mantram: Hedge funds are for Sophisticated Persons♦ only


Notes

In addition to the federal securities laws, every state has its own set of securities laws—commonly referred to as “Blue Sky Laws”—that are designed to protect investors.

Under the federal securities laws, only persons who are accredited investors may participate in certain securities offerings. One reason these offerings are limited to accredited investors is to ensure that all participating investors are financially sophisticated and able to fend for themselves or sustain the risk of loss, thus rendering unnecessary the protections that come from a registered offering. Unlike offerings registered with the SEC in which certain information is required to be disclosed, companies and private funds, such as a hedge fund or venture capital fund, engaging in these exempt offerings do not have to make prescribed disclosures to accredited investors. These offerings involve unique risks and you should be aware that you could lose your entire investment.

 A sophisticated person means the person must have, or the company or private fund offering the securities reasonably believes that this person has, sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of the prospective investment.