By Evan Judd, Independent Director Bell Rock Group
Even in the most challenging and difficult economic environments, the allure of starting a hedge fund is still a powerful draw for many experienced investment professionals. Starting your own firm on your own terms, being your own boss, running things your way, all the while beating the market, creating massive alpha, and garnering enormous performance fees is certainly incentive enough for most. But the days of two guys with a Bloomberg and a dog in a room over the garage have long since passed, remembered fondly by those who survived it, and resentfully (often with tears) by those who didn’t. The challenges now faced by emerging hedge fund managers are enormous, costly, time consuming, and require a broad range of experience and skill sets among the management team in order to navigate them successfully.
Clients, partners, service providers, regulators, and directors are among the many constituencies that must be satisfied in order to be successful. The process can require an enormous amount of time, effort, and a dedicated attention to detail encompassing a broad spectrum of structural, legal, and operational issues, which are, quite frankly, a major pain in the ass to deal with unless one is fully prepared.
Of course, some challenges are bigger and more complicated than others. This article will not pretend to cover them all, but will instead focus on some of the more significant challenges that emerging hedge fund managers routinely face as they seek to build a robust, institutional quality management firm, and eventually differentiate themselves from the crowd.
Identifying Critical Issues and Moving Toward Institutional Quality
Let’s assume for the moment that your assembled group of talented investment professionals has launched your new hedge fund with friends’ and family money. You have a sound, tax efficient offshore structure in place, and have forged relationships with reputable service providers; good legal counsel, independent third party administrator, custodian, prime broker, and auditor. You have appointed a qualified board that includes independent directors. You’re up and running, and now turn your attention to building a successful track record, and growing your business. This is the challenge facing all emerging managers; how to move from the start up phase into the next stage of the growth cycle.
The most obvious challenges facing all managers at this stage are building a successful track record, and raising enough capital to get noticed. A meaningful, marketable track record is one that demonstrates the hedge fund’s skill to perform over several market cycles. The minimum amount of time generally accepted by large institutional investors is 3 years, and somewhat shorter (1-2 years) for a fund-of-funds or family office. The related challenge of raising enough capital to get noticed is another problem altogether. A track record just takes time. Raising capital requires that you get noticed. It is very difficult to pop up on the radar screen of institutional investors with AUM of less than $100 million, or often even larger amounts.
So, what is a hedge fund manager to do? You could build a fully staffed department of sales and marketing professionals, (and there is certainly a time and place for that) but at this point in the firm’s life cycle, longer-term thinking is required. The idea is to focus on investment disciplines and work to demonstrate institutional quality infrastructure and operations. Work toward the goal of developing your business into an institutional quality hedge fund.
But what, exactly, does that mean? What is an ‘institutional quality’ hedge fund?
Put simply, it is a hedge fund that exhibits a mix of well-developed, high quality infrastructure and process characteristics that large institutional investors often require before making an investment allocation. Robust infrastructure provides some assurance that the fund is a sound place to invest their money. Some examples include:
- deep teams and solid, scalable investment management processes
- robust compliance and corporate governance functions
- meticulous and thorough risk management
- a culture which emphasizes transparency
- high quality, reputable service providers
- detailed reporting and responsive client service
Deep Investment Team
The critical element here is to try to minimize key man risk by building a deep, stable management team with a full range of skill sets and investment experience. A deep pool of investment talent has a greater ability to identify and act on investment opportunities within and across various asset classes.
Senior level support staff in positions of risk management, operations, and investor relations are key divisions of labor, and serve to strengthen the investment process and bolster scalability. The idea is to build a strong platform that allows the hedge fund to attract, hire, and retain top investment and supporting talent. This leads to an accumulation of institutional memory that the firm can draw upon in response to changing market conditions and crisis situations.
Supporting business functions with technology investments has never been more important. Technology plays a pivotal role in developing investment processes. However, if history is any guide, many start-up hedge funds will have underestimated the magnitude of what is needed to build a successful technology platform for their investment business. Investment teams often have a Wall Street trading background, an environment where extensive infrastructure resources are already in place and provided by the company. As a consequence, the operational infrastructure of a new hedge fund is often under-resourced in favor of building a robust investment strategy and attempting to raise capital.
Technology today has the benefit of high-speed internet connections, enormous data storage capacity, and processing capabilities that were unknown only a few years ago. Choosing the right technology for your hedge fund, a system that allows you to manage risks associated with all pre- and post-trade actions, and can monitor your risk management, compliance, and investor relations functions, can be a significant competitive advantage. Planning for scalable growth by choosing the right systems technology and software will make your firm more productive and efficient, and plays a vital role in attracting institutional investor interest.
Of course, a discussion of technology raises the question of cybersecurity. The most advanced systems available will be next to useless if they are not secure. Firms must be prepared with policies and procedures to address how to safeguard business critical and client-specific information. Some measures to consider when addressing cybersecurity risk include:
- develop a strategy to prevent, detect and respond to cybersecurity threats, including complex password protections, routine penetration testing to discover and address areas of weakness, and steps to ‘harden’ the system such as limiting access to sensitive information
- conduct a periodic assessment of the location and sensitivity of information, and the vulnerability of systems used for data storage and retrieval
- adopt an incident response plan, and engage in extensive personnel training
- develop, follow, and enforce written insider trading policies and procedures
- encourage a culture of compliance
Culture of Compliance and Transparency
Institutional investors demand a high standard of quality and integrity in a hedge fund manager before making an allocation. The due diligence is very detailed and often time-consuming for the manager. Increasingly, they will scrutinize every aspect of the business to make sure their capital is being preserved and managed to the highest possible standards of compliance, transparency, and operational business practices.
This due diligence focus is easily understandable when considering the high degree of concern with headline risk. The risks of a portfolio blow up, manager malfeasance, and regulatory violations are ones that all investors want to avoid. However, they can be minimized when resources are dedicated to risk management and compliance procedures that provide a solid framework of management checks and balances. Some specific issues to consider include:
- Strict adherence to fiduciary duties
- Good faith, loyalty, confidentiality, prudence, and disclosure requirements
- No front-running or trading trade against clients
- A strong culture of compliance through independent risk monitoring with a clear separation of investment and risk management responsibilities. Develop, implement, and enforce procedures for compliance oversight;
- through information flow of trade actions and portfolio positions.
- to resolve disputes between portfolio managers and compliance officers.
- Regular, detailed reporting with full transparency
- Always be mindful that the capital belongs to the investor. They want to know how it is being invested. Granular reporting with full, position level transparency and portfolio analytics are elements that will be viewed favorably.
Long Term Focus
Building an investment business into a truly world class institutional quality hedge fund is a very challenging phase of the growth cycle. It takes a well articulated vision and clarity of purpose to make it happen, but with talent and resources dedicated to implementing long-term infrastructure solutions, it is an achievable goal that will make a hedge fund an attractive destination for institutional investor capital.
Qualified independent directors are a key component of a robust corporate governance framework that contributes to a high level of institutional quality. Fund directors with superior expertise in risk management, compliance, legal and regulatory developments, operations, and tax issues, greatly enhance a fund offering and its marketability. A truly independent set of eyes and ears offers the investor enormous peace of mind, and is a critical component of the necessary checks and balances required for implementation of best practice corporate governance.
Bell Rock Group is well positioned to assist hedge fund sponsors in addressing all of their independent director needs. With increased regulatory and compliance requirements, it is of paramount importance that each fund fulfills all Cayman regulatory requirements. Corporate governance supported by Bell Rock independent directors provides a range of oversight such as the provision of a dedicated compliance officer to each entity if required, provision of a Money Laundering Reporting Officer (MLRO) and for FATCA, the provision of a Cayman point of contact and FATCA Responsible Officer.
Bell Rock is a leading provider of highly skilled and professional independent directors who have over 60 collective years of industry experience in investment management, law, risk management and banking, with extensive experience living and working in Asian markets ranging from Japan to Hong Kong, Singapore, and India. We are experienced in the regulatory, legal and operational requirements in Cayman and other jurisdictions. Each Bell Rock professional acts on a limited number of boards to ensure that adequate time is available to deal with any and all matters that arise. Our professionals meet the criteria for regulated funds and provide a level of comfort to investors that true and independent oversight of fund activities is in place.
Bell Rock is a truly independent firm. We are not affiliated with any services provider, investment manager or law firm. Our professionals do not invest in any of the funds we act on and we maintain a conflict free approach to our services.
Bell Rock is regulated by the Cayman Islands Monetary Authority (CIMA) under the Companies Management Law (2003) and is audited by a CIMA approved audit firm.