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Why Launching a Hedge Fund Is Harder Than Ever

Although hedge fund launches are expected to soar in 2012, getting one off the ground is much more difficult — and expensive — than ever before thanks to regulatory pressures, savvier investors and the cost of technology.

The pace of hedge fund launches is expected to surge this year in light of the Volcker Rule's ban on proprietary trading at banks. But experts say getting a start-up fund off the ground is harder than ever.

With a regulatory deadline looming in July, investment banks such as Goldman Sachs, Citigroup, Morgan Stanley and JPMorgan have spent the past year cutting down on the practice of trading their own capital, in some cases even spinning off the internal proprietary trading teams into independent firms. Meanwhile, instead of investing in their own hedge funds, some banks have opted for the less risky — and far less profitable — practice of providing start-up capital to nascent hedge fund managers.

But even if a new fund is fortunate enough to score seed capital from a Wall Street superpower like Goldman Sachs, industry sources say investor demands, new technological requirements and the post-2008 investment landscape mean the barriers to success are higher than ever. For starters, new funds are walking into a more challenging operating environment than seven or eight years ago, when having a single prime broker as a counterparty was considered a sound strategy.

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Today, multiple prime brokers are the norm, which in turn puts a start-up hedge fund's IT infrastructure under unprecedented pressure, according to Sameer Shalaby, president of buy-side technology provider Paladyne Systems. "Now you have to have at least two prime brokers out of the gate, and that creates operational headaches," he says, noting that a decade ago, a new hedge fund could launch, set up an account with Goldman Sachs and get a technology platform from them in the process.

"Today, that's gone," Shalaby contends. "You have to have a technology platform that can help aggregate and deal with all the multiprimes. You have to have an ops team. You have to have two counterparties — at least. On top of that, you look at the investor demands — they're more savvy now and they want transparency." An increasing number of investors, for example, are demanding separately managed accounts.

Further compounding matters for new hedge funds are much more stringent compliance requirements than a decade ago. Under the Dodd-Frank Act, firms with at least $150 million in private assets under management will have to periodically file Form PF documents with the Securities and Exchange Commission. The Financial Stability Oversight Council will use those filings to gauge how much risk is flowing throughout the nation's financial system.

"There's so much more that a fund has to do rather than just have a track record," says Tim Calveley, an executive director at Butterfield Fulcrum, an administrator for alternative investment firms. "The industry has really grown and companies like ours have developed products and services to provide hedge funds with a front-, middle- and back-office solution to plug and play and help alleviate a lot of that burden."

Added together, the new requirements on hedge funds make it much more expensive to operate now than before the financial crisis began four years ago. And unlike the pre-2008 world, when a firm could simply cut corners and scrape by, being slipshod today will prevent a hedge fund from raising assets, according to Paladyne's Shalaby. "We get these small funds and they try to cut corners — they can't raise money, and six months later they get tired and they shut down," he says. "Ten years ago there were a lot of those smaller managers that continued, and they did fine. It was not a problem."

Why Banks Seed New Hedge Funds

Despite the myriad challenges that await new hedge funds, managers can take heart, as banks are showing a willingness to provide promising start-ups with money. In the past year, some of Wall Street's biggest banks and private equity firms reportedly have been seeding hedge funds in what industry sources say is a wise investment at a time when returns on many capital investments often are low.

"Given where the yield curve is, it makes sense to put money into hedge funds," explains Nicholas Colas, the chief market strategist at ConvergEx, which provides technology to asset managers. For banks that have a prime brokerage unit, it's a relatively low-risk wager on a manager who could be worth much more down the road, he adds. "If they pick good managers presumably when they give capital to hedge funds, that's the potential to build a several billion-dollar hedge fund client with a relatively modest seed capital amount."

If a fund manager has a definable investment strategy and a solid track record, it makes sense for a bank and its clients to get involved with a fund early, before it becomes too difficult down the line, sources note. "There's limited capacity with most strategies, and so by seeding or investing to capture capacity, it gives you and your clients an opportunity to be with a winner early versus chasing them later for capacity and access," says Ron Suber, the head of prime brokerage at Merlin Securities.

But even with banks willing to provide new hedge funds with funding, experts say, raising early stage capital is as challenging as ever. In order to entice investors, a manager needs to have a track record of solid performance that stretches back at least three years, a strategy that inspires confidence and no more than two consecutive months of drawdown, some suggest.

"Investors used to care far more about the investment results and process, and far less about the business model around it," says Michael Tiedemann, senior managing director at Tiedemann Wealth Management. "Those have converged. ... So what that means is, you have to have better systems and more professionally institutionalized operations, and all of that costs money."

As the Senior Editor of Advanced Trading, Justin Grant plays a key role in steering the magazine's coverage of the latest issues affecting the buy-side trading community. Since joining Advanced Trading in 2010, Grant's news analysis has touched on everything from the latest ... View Full Bio

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