How to Start Your Own Hedge Fund

|
 |  Includes: DIA, QQQ, SPY
by: Joe Ponzio

What does it take to start a hedge fund? The scary truth is that virtually anyone can start a hedge fund; and, it can be fairly inexpensive and easy to do. Why is this so scary? Among other reasons, hedge funds can attract investors while providing very little information; so, investors may not be able to make well-informed decisions. Then, hedge funds don't need to provide regular (or audited) information on an ongoing basis. If your manager is a crackpot and you have to stay invested for the remainder of the year (or quarter or whatever), you could wind up with very severe losses.

(Prospective investors should choose very carefully.)

Of course...that won't stop me from telling you how to set up a hedge fund. After all, I get a kick out of divulging Wall Street's billion dollar secrets for free.

The Hedge Fund Entity

Hedge Funds are typically structured as:

  • a limited (or limited liability) partnership, or
  • a limited liability company, or
  • a trust.

What structure you choose depends entirely on what you want and the laws in the state in which you are forming. (Non-U.S. readers should explore the entities in their home countries as well.)

For the remainder of this article, I'll be referring to the most common hedge fund structure — the Limited Partnership, or LP.

To set up a limited partnership is fairly easy and inexpensive. In Illinois, you answer six questions on a fill-in-the-blank form, get a cashier's check for $150, and send it to the secretary of state. How tough are the questions? If you can come up with a name and write your address, you are in business.

Running Total: $150.00

Getting the Tax Id Number

You'll need to get a tax id [FEIN] number from the IRS. Simple enough — go to the IRS website and get it online in a matter of minutes. It's fast, easy, and free.

Running Total: Still $150.00

Becoming an Investment Advisor

If you will have 15 or more investors in your hedge fund, you'll need to register as an investment advisor with the SEC. (Note: That doesn't mean you'll have to register the hedge fund. We'll get to that in a bit.) If you'll have less than 15 investors, you may still have to register in one or more states. (See Rule 203(b)(3)-2 of the Investment Advisers Act of 1940.) I'd play it safe and register with the SEC. It's not scary — they're actually there to help you so long as you are not defrauding investors.

To become an investment adviser, you'll need to sit for a regulatory exam — the Series 65. The Series 65 is a 3-hour, 140 question exam, of which 130 count towards your final score. It's not the hardest exam in the world (part of the "scary" conversation above); but, you'll need to score a 68.5% or better to pass.

The Series 65 doesn't teach you a darn thing about investing. Instead, it's a "minimum competency" exam designed to test your ethics and understanding of basic securities laws and practices. A study guide and a few hours of quiet reading can make you a pro.

Scheduling Your Exam

Your state will generally "sponsor" you to take the exam (as opposed to the Series 7, which requires a firm's sponsorship); so, you fill out Form U-10, sign over a check for $120, and schedule your exam.

Once you've successfully completed the exam, you are now licensed (though not yet registered) as an investment adviser.

Running Total: $270.00

The "Registered Investment Advisor" vs. "Investment Advisor Representative"

At this point, you have a decision to make — Do you run your partnership/advisory business as a sole proprietor (eg., Joe Ponzio Sole Proprietor) or do you (as is more commonly done) create an investment advisory company to shield yourself from personal liability (eg., Joe Ponzio Funds, Inc.)?

To be safe, you create a corporation (or LLC, whatever) to act as general partner of your LP. (Your investors will be the limited partners). You're cheap; so, you create your Illinois corporation for $175 instead of expediting for $300. Once incorporated, you'll get a FEIN for your company as well.

Thus, you will personally be the Investment Advisor Representative [IAR] of your company, which will act as the Registered Investment Advisor [RIA].

Running Total: $445.00

Registering Your RIA and IAR

You're just about there. First, you have to register your company as the RIA, which you will do through the Investment Adviser Registration Depository [IARD]. The instructions are on the IARD site; so, I'll spare you the details. It's not rocket science; but, it will likely take you a few hours to figure it all out. (When I was starting my firm, I spent the better part of three months figuring all of this out. Then again, I didn't have an article like this one to read!)

As of the time of this writing and through July of 2009, it is free to set up your firm on the IARD system.

Once your firm is set up, you'll need to "register" yourself with your firm by filing a Form U-4. Coming in at 28 pages, it looks like a beast. (You can also file it electronically.) So long as you don't have a lot of disclosures (eg., if you're not a criminal), you won't fill in half of them.

Submit your U-4 with a $30 check...

Structure of Hedge Funds and Investment Advisers

Voila! You are now an investment adviser, running an investment advisory firm and a hedge fund.

Total Cost: $475.00

I told you that it was scary easy.

Some Things to Consider

For less than $500, you could technically be in business. You'll need a few things to get started:

For Your Investment Advisory Firm:

  • By-laws
  • Compliance manual
  • Code of Ethics
  • Supervisory Procedures Manual
  • Investment Adviser/Portfolio Management Agreement
  • Everything else to run your business (website, business cards, etc.)

For Your Hedge Fund:

  • A LP agreement
  • Private Placement Memorandum
  • A presentation or brochure about your proposed investment style (needed for capital raising and road shows)
  • A custodian/brokerage account to house the fund's securities

...along with checking accounts, etc.

If you are feeling really cheap, you can find a lot of this stuff online, and then tweak it for your business; or, you can pay a compliance service to provide you with many of these things.

Registering Your Hedge Fund with the SEC

Hedge funds don't technically register with the SEC. Instead, you'll have to register your LP interests offering (corporations have stock; LP's have interests; LLC's have memberships; trusts have units of beneficial interest) with the SEC if you are offering the hedge fund to investors other than friends and family. So...you don't register your fund; you register your offering, usually under Rule 506 of Regulation D of the Securities Act of 1933.

Though there is no fee for registering your offering, you will have to get a CIK number from the SEC and file Form D with the SEC and with each state in which you plan to offer or sell interests.

Obviously...

Having gone through a lot of these steps over the years, it's a lot easier for me to say than for you to do. Though I spent a few months digging around in the dark to get my firm started, I can now say that it is not all that difficult or expensive if I had to start over again.

As you can see that hedge funds are not as mysterious as Wall Street wants you to believe. In the end, a hedge fund is a partnership — not some special entity — that has a general partner (you or your investment firm) and limited partners (your investors).

Then again, don't mistake this article as advice or compliance help. This is a broad overview of how to set up a basic hedge fund. The laws, rules, and regulations can change; so, make sure you are up to speed based on your situation.