Launching A Hedge Fund? Call The (Right) Prime Broker

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Written for and originally published by the AIMA Journal (Edition 130)

Most managers taking the leap of faith to launch a new hedge fund don’t think about appointing a prime broker first. Strategy, potential investors, and a compelling pitch probably occupy more of the new or emerging manager’s attention in the decisive early days.

Yet an experienced prime broker can help with a whole raft of services that can make the arduous task of getting a new hedge fund off the ground a tad easier. In fact, the right prime broker may become a long-term partner, on hand for the launch and to help build future growth.

The hedge fund industry is emerging from the COVID pandemic with signs of rude health. In the first quarter of 2022, new capital allocated to hedge funds by institutional investors was reported to be the highest since mid-2015. In the same period, the AIMA Hedge Fund Confidence Index ticked up one point to +17.

Many in the industry say this, along with the challenges and opportunities created by the heightened market volatility brought on by macroeconomic concerns, is likely to fuel a spate of new fund launches. Here are some key decisions the aspiring fund manager needs to make.

STRATEGY AND TARGET INVESTORS



The first is deciding on the strategy and which investors to target. Is the aim to attract renowned allocators or will the fund start small, catering to family and friends? This is a key decision that will determine the structure of the fund and, potentially, where it is domiciled. But whatever the ambition, managers must be aligned with their target investors from the outset.

This requires early discussions on fee structures. Some investors may demand lower fees or other concessions to invest in a start-up hedge fund, relaxing their demands as the fund grows. Eagerness to win an early investment must not lead a new manager to commit to an arrangement that proves to be a bad deal over time.

Many new managers find themselves running a business for the first time. This makes choosing the right COO vital. Not only can the COO handle critical tasks such as due diligence and compliance, an experienced and respected officer can boost the appeal of the fund for potential investors.

PITFALLS


Numerous pitfalls await the new or emerging manager. But help is available from service providers, including prime brokers. Many PBs have been involved in numerous fund launches and are valuable sources of advice, including on how to avoid costly mistakes.

Nonetheless, it is important to choose the PB best suited to the scale and ambition of the emergent fund. The anticipated growth in fund launches has increased competition among prime brokerages, meaning the bulge-bracket titans of the industry are more willing to take on funds with fewer assets under management, say $25 million. However, these large providers may demand a certain level of revenue from their hedge fund clients, who may find themselves dropped if that revenue is not forthcoming.

In reality, many funds have at least two prime brokers – often one large and one mid-sized. It’s commonly accepted that the mid-sized PB are more responsive and have more time to engage with the client, while matching the large firms in asset coverage and capability.

Choosing a prime broker, then, is a critical early decision for the new fund manager. Other appointments include a fund administrator, a law firm and accountants. PBs can usually provide contacts for these and other service-providers.

IN-HOUSE OR OUTSOURCE?


Veterans of multiple fund launches caution CIOs to match spending on these essential services with the overall scope of the fund. These days, a key decision is whether to keep these services in-house or to outsource. Even the COO role can be outsourced.

A major growth area is outsourced trading, which saves funds the cost of infrastructure and in-house traders’ salaries.

With these matters decided, the new manager can concentrate on raising money from investors. A clear strategy is essential, as is a compelling account of why the CIO’s team will be able to implement it. This requires intense research into the potential investor base and the competition. Managers should be prepared to be compared to managers with competing offerings and be ready to articulate why their strategy is different. And better.

Allocators will look at the manager’s investment track record, particularly in running a similar strategy. They will also look at the cohesiveness of the team. Chopping and changing within the senior management is likely to be frowned upon.

Raising capital is hard work, requiring persistence and patience. A potential investor needs to get to know and trust a new manager, who should be prepared for numerous meetings – many of them fruitless. Many new managers make the mistake of underestimating how long the process takes.

But, again, help is available from a prime broker. Capital introduction is a fundamental aspect of the relationship between a PB and a fund. While some PBs might chase money wherever it may be, a responsive high-touch firm will carefully select potential investors appropriate to the size, strategy, and track record of the fund.

RIGHT MONEY AT THE RIGHT TIME



It’s a case of introducing the right money at the right time – and it helps both funds and allocators. The right prime broker also finds time for the small stuff, even down to honing the pitch document and the slide deck.

It may seem premature, but new funds should be thinking how they can build for scale from the start. A lengthening track record running money for family and friends may open the door to investment from, for example, university endowments.

As a fund grows, outsourced services may be taken in-house. Once prohibitive fixed costs can become a worthwhile investment as assets under management increase. In any case, systems and service-providers should be scalable and able to grow with the business.

Prime brokerage is changing and PBs can expect to face questions about their responsiveness and their experience of the hedge fund industry and fund launches.

Of course, a new prime broker can be brought in at any time. But if the manager makes the right choice from the start, they may find they have a partner who will advise and work with them every step of the way from launch to growth.

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