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Considerations For Start-Up Hedge Fund Managers

Hedge fund managers launching their own money management firm may have an investment strategy that’s uncorrelated to traditional markets, or one that minimises drawdowns, or one that generates true alpha – or all three. That’s not enough. Emerging managers face many decisions in the pre-launch phase from the perspective of running their own business and AlphaWeek’s Greg Winterton spoke to Kevin Cott, Managing Partner at Cott Law Group, to learn more about the operational considerations of launching an investment firm.

GW: Kevin, thanks for taking the time. The first decision for a manager is clearly whether to launch a pooled investment vehicle or whether to go the separately managed account route. What should drive this decision and what are the implications?

KC: Hi, Greg. Yes, that’s definitely the fork in the road moment for an emerging manager. And the answer is that it depends on a combination of factors: the initial investor base, the strategy and the budget.

GW: OK. Start us off with the considerations for the investor type.

KC: In the United States, for managers initially focused on friends and family investors that may not be classified as accredited investors, an SMA platform may be the more practical option – but depending on the registration status of the adviser, it may be prohibited from charging performance fees to non-qualified clients, so there is that to bear in mind. On the other end, if there are institutions involved, they continue to press for separate accounts for transparency and control reasons.

GW: And how about strategy, and budget?

KC: Strategy-wise, if it’s a highly liquid managed futures or equities strategy that can be easily allocated among multiple sub-accounts then the SMA route is pretty straightforward to execute. Generally, the less liquid the strategy, the less an SMA makes sense. On the budget side, launching a fund is more expensive – you have the up-front costs and the ongoing administration and audit costs. There are significant benefits to managing a fund—the ability to scale, loss limitations to investors, performance-based compensation tax benefits to the manager—but these need to be weighed against a realistic assessment of the manager’s budget.

GW: OK. Moving on to business risks – specifically, those which an investor in an emerging manager hedge fund firm is exposed to.

KC: This is definitely an area that I’ve seen grow in importance in due diligence vetting by investors. The two main ones are the ‘hit by a bus’ risk and succession planning. The former highlights the need for key person insurance and key person provisions to protect the investor in case something happens to the principal. What we also recommend is that managers have a written contingency plan appointing a liquidating agent or trustee to provide for the orderly winding down of the fund if something happened that meant the principal of the firm couldn’t carry on.

GW: What about giving equity to an employee? Lots of emerging managers do this to attract talent early on – and reduce the salary component of the talent’s compensation package. Cash flow is all-important in the early days, after all, right?

KC: Yes, but if an emerging manager decides to give away equity in the company, they now need to consider how that member interest is valued if someone leaves - voluntarily or involuntarily. For example, what voting / governance rights do they have? Drafting a multi-member operating agreement that properly addresses these issues can be costly and complex, but if it isn’t done correctly it can lead to a whole host of issues down the road, including litigation. The manager must decide for themselves whether to give away equity but there are risks, and it needs thinking through and analysing thoroughly.

GW: Lastly, Kevin, getting all of their various documents vetted for compliance with marketing rules is an obvious one that all new managers will know. What are the key considerations here?

KC: Well this isn’t just relevant for emerging managers, it’s for everybody, because the SEC recently issued its new Investment Adviser Marketing Rule which merges and modernizes its advertising and solicitation regulation. Some of the changes include creating more flexible, "rules based" standards for marketing, permitting the use of hyperlinked / layered disclosures and excluding certain one-on-one communications tailored to a single investor from the requirements of the rule. It’s really critical to get your documents in order from a compliance perspective – this one is something that most managers are aware of, and good at being pro-active with regards to getting advice from legal counsel on.

Kevin Cott is Managing Partner at Cott Law Group

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