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How To Fund a Hedge Fund

Apr. 08, 2011 1:34 PM ET
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As co-editor of the investment advisory service Taipan Insider, Sara Nunnally brings an exciting approach to the world of international investing. Traveling to such countries as Vietnam, Morocco, Brazil, and Spain, Sara investigates the secret world of emerging markets to turn the focus on investment opportunities and potential profits. Disclaimer: Taipan Publishing Group LLC and Stansberry & Associates Investment Research are separate companies, and entirely distinct. Their only common thread is a shared parent company, Agora Inc. Agora Inc. was named in the suit by the SEC and was exonerated by the court, and thus dropped from the case. Stansberry & Associates was found civilly liable for a matter that dealt with one writer’s report on a company. The action was not a criminal matter. The case is still on appeal, and no final decision has been made.

Yesterday, we received a letter from Smart Investing Daily reader L.D. This question was different from other questions we've fielded so far...

I have been a Professor of Business Law in New Orleans, Louisiana for a number of years and have been fortunate to meet many people here in the business community.

Recently, I was asked by one of my foreign students if I ever considered becoming an intermediary or third party marketer for hedge funds. I understand that these professionals find accredited investors for hedge funds and their compensation is negotiable.

My question for you is: how does one go about finding accredited investors outside of his business, family, and social circle? If you can provide some advice on this, I will pass it on to my class.

I hope to put together a lecture on this for my three business law classes. It sounds like fascinating work to me.

This question took a fair amount of research, and I started at my favorite resource for investment questions, Investopedia.com. I found a couple articles to get me started.

This is by no means an exhaustive research, but it will certainly help point you in the right direction.

First off, I found that accredited investors are also called angel investors. Before the global financial crisis (in 2006), there were about 234,000 active angel investors in the United States, according to the University of New Hampshire's Center for Venture Research.

The Center for Venture Research also found that 728 companies obtained initial investments from venture funds in 2009 -- to the tune of $3.3 billion. But 259,480 angel investors contributed $17.6 billion to 57,225 businesses.

That's a fair amount of money, and as you can see, angel investors are much more likely to lend startup money.

You should also note that the number of angel investors has grown since 2006.

(Investing doesn't have to be complicated. Sign up for Smart Investing Daily and let me and my fellow editor Jared Levy simplify the stock market for you with our easy-to-understand investment articles.)

Angel Investors

So what is an angel investor, and how do you find them?

There are standards. Accredited investors must have a net worth (or joint net worth with their spouse) of $1,000,000, or have income above $200,000 a year ($300,000 jointly).

(Of course, you can widen your sponsor pool by inviting investors of other income levels, but you would have to meet the disclosure requirements of the Securities Act.)

These angel investors form groups all across the country. The Angel Capital Association helps keep track of them, and provide a central forum for investment resources and other member services. Visit the Entrepreneurs page for how this organization can help you, or point you to a local angel investors group that could be more likely to invest with a locally grown business.

Another resource is Hedgefund Conferences (HC).

In real estate the adage is, "Location, location, location." In finding funding, it's, "Network, network, network." Conferences can provide a wealth of new contacts you can tap for sponsors, and better yet, you can learn from some of the best hedge fund managers in the business.

Some new hedge funds have trouble attracting investors, however. There's a dizzying amount of paper work and registration requirements that I won't pretend I have any significant knowledge of... but it's enough to turn some new funds off.

There's an alternative, according to Hannah Terhune from the Capital Management Services Group.

An "Incubator" can be created by breaking down the hedge fund development process into two stages and isolating the first. The first stage sets up the fund and management company entities, as well as pertinent operating agreements and resolutions. This is enough to allow the hedge fund to begin trading, usually with the manager's own funds. By trading under this structure, the manager can develop a track record, which can be marketed legally to potential investors in the offering documents. Then, in the second stage, the PPM [private placement memorandum spelling out subscription and operating agreements] is developed with the performance information included. The Incubator method affords the opportunity for those with a skill for trading (often in their personal accounts) to break down the hedge fund development process into a manageable undertaking.

Once the hedge fund has a history of successfully making money, investors will be a lot more willing to sit down and look at a proposal.

In general, this is how the money flows for a start-up company, and can be applied to hedge fund startups too. From Investopedia.com:

"Alphabet Rounds" are when a company of fund is ready to approach venture capital firms. These guys -- though they've made billions upon billions from taking risks on new companies -- probably won't touch a new company without a significant amount of money already invested from angel investors.

This level is different for every company, but considering that venture capitalist typically plop down several millions of dollars at a time, this can give you an idea of what you should aim for before approaching a venture capital firm.

The Center for Venture Research has a state-by-state listing of venture capital resources for when you're ready for this stage.

Another thing to keep in mind is that funds with under $25 million under management should follow their individual state's requirements for registering the fund. If the fund has more than $30 million, it will need to be registered with the SEC as an investment advisor, according to Terhune.

I hope this article gives you a good place to start your own research, L.D. Best of luck to you, and let us know what you find and how you do!

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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