This article marks the final posting in our Establishing and Launching a Hedge Fund series that has spanned the past few months. This week I would like to focus on an area of key importance to both emerging and many established managers alike: raising capital. We speak with anywhere from 2 to 5 fund managers a day and all are pretty deep in the process of raising capital whether it’s their first, second, or third fund…as an echo to this, many of you have identified this as the your biggest concern in starting up a hedge fund on our Quoin Partners reader poll…needless to say raising capital is a huge interest/concern for everyone involved in this space. For the sake of my existing and potential clients, I wish I could provide an easy answer or an introduction to a willing capital source, but I cannot. The fact remains, that while the current environment seems to be thawing, the going remains tough for firms just looking to start out. Gone are the days when startups were launching with hundreds of millions, or billions of dollars in AUM. I recently read that many of the most pedigreed managers are now launching with a mere fraction of this…Does the mean that the prospects for a startup fund in 2009 is hopelessly bleak? I wouldn’t say that, but I would say that the landscape has shifted dramatically and that anyone looking to launch a program in this environment must realistically align his/her goals and become extremely well educated about the key considerations involved in raising their first fund. In this week’s blog I would like to discuss the near universal requirements now being levied on upstart managers by potential investors and provide a quick overview of potential sources of capital (both traditional and non-traditional).

Key Investor Considerations

The credit crisis and the Bernie Madoff scandal (and the many like him) have forever changed the criteria from which potential investors evaluate emerging managers. Firms who are able to rise to the challenge and tangibly demonstrate that they can meet these requirements are generally successful in raising capital, while those who choose to cut corners ultimately will not. Admittedly, this list is not exhaustive, but I have tried to capture some of the key considerations startups should focus on as they embark on raising assets.

• Prepare for long due diligence periods
• Increased transparency and governance requirements
  • Policies and procedures
  • Segregation of duties
  • Front-to-Back Office cohesion
  • Compensation
• Quality and legitimacy of service providers
  • Audit
  • Legal
  • Fund Administration
  • Prime Broker
• Systematic investment processes and strategic discipline
• Risk Management Framework
  • Operational risk – people, process, systems, regulatory, legal, strategic
  • Counterparty risk – credit risk and client ability to pay
  • Market risk – position limits and marking of illiquid instruments
  • Liquidity risk – collateral management and cash requirements
  • Business Continuity/Disaster Recovery – redundant systems, offsite backup, etc.
• Fee structure

Again, each investor will have their specific set of criteria from which they will evaluate your fund but the above list should provide a good general foundation off of which you can build your marketing efforts. A great source of information to supplement your understanding of the above criteria is the April 2008 Report of the Asset Managers Committee to the President’s Working Group on Financial Markets entitled “Best Practices for the Hedge Fund Industry (http://www.ustreas.gov/press/releases/reports/amcreportapril152008.pdf). I have to admit, after all we have been through since April 2008 it is interesting going back and reading this…great source of information though and I certainly recommend having a read.

Potential Sources of Capital

There are a variety of different sources of capital available to an emerging fund manager, each with their own parameters and appetite for investing in startups. Often the investors that one would target in raising your first fund are markedly different than if you were raising follow on rounds. The first step is to determine what type of investor to approach and then to tailor your marketing strategy to best appeal to their specific criteria and attract their interest accordingly. As a quick aside, Quoin Partners does not offer access to seed capital, cap intro, or marketing services to our hedge fund clients. Rather, we typically engage with startup funds in two distinct phases: 1) Phase One (Pre-Capital Raise) – service provider selection/setup, website/logo design, investor presentation design; 2) Phase Two (Post-Capital Raise) – IT/Telco infrastructure, operational setup, recruiting, office space, etc. While we may touch on various marketing strategies in our following blog posts, my purpose this week is to objectively educate our readers on the types of investors who focus on startup hedge funds as opposed to provide any type of advice. While by no means exhaustive, the list below provides a good general overview of potential capital sources and their basic requirements.

• “Friends and Family” Investors
  • Typically first source of seed capital which allows track record generation (6-12 months)
  • While smaller, rounds are completed fairly quickly but fund managers must insure proper documentation and making the right representations prior to taking any investment
• High Net Worth (HNW) Individuals
  • Qualified investors who typically invest in hedge funds individually, as a part of a broader structure, or as part of a family office.
  • Require more due diligence prior to making investment (especially if the investor is a family office)
  • HNW individuals usually accessible via personal networks, conferences, marketing databases, private banks, and so on.
• Institutional Investors
  • Pensions, foundations, endowments, funds-of-funds, consultants, investment firms, asset managers, and banks.
  • Usually require track records of longer than a year
  • Investment process is far more conservative and lengthier which is a result of heightened due diligence scrutiny and risk management criteria
  • Institutions have potential to invest larger sums of money
• Seed Funds (“Seeders”) and Incubators
  • Investors can either be classified as HNW or institutions and usually invest during very early stages of a fund (typically from startup to first round) as a key source of launch capital
  • Deal structures vary from equity ownership, pro-rata profit & loss share, partnership rights, or reduced fees
  • There are seeders that may also provide “assets under management” acceleration to juice track record and therefore increased appeal to potential limited partners for a share of the payout

I will refer to the aforementioned list of investor types as “pure” sources of capital, meaning that they can actually write you a check…however; there are a number of individuals and firms out there who offer access to capital (e.g. cap intro, third party marketers, conferences, and investor databases). I’ll be completely honest, there is a lot of “smoke and mirrors” when it comes to those who claim to offer access to capital and the landscape of players certainly varies from the completely legitimate to the downright shady. However, if you have been pitched on some of these services and feel 100% confident that the claims are in fact true…more power to you. Just make sure to ask some basic questions (e.g. what types of investors do you have access to? What is your confidence scale that you can raise me assets? How much do you know about firms who employ a similar strategy to mine?) and do your due diligence before wasting your time. I wish I could say raising capital was easy, but the reality is that in this environment, investors are reticent to open their wallets with the same amount of cash as the ‘go-go’ days of yore. In other words, the process is going to take time…likely far longer than you originally expected…but if you are confidently armed with a completely transparent governance structure, pristine service providers, world class team, and risk intelligent strategy…you will be successful in raising assets. If you are in the process of raising assets or are just starting down this exciting path and need assistance in legal setup, service provider selection/setup, website and logo design, or investor materials preparation, please feel free to contact me directly at spencer.knibbe@quoinpartners.com This e-mail address is being protected from spambots. You need JavaScript enabled to view it or 203.244.1122.

Final Word

Starting a business is a tremendously exciting experience…not just for the exhilaration of potential upside of being the next new thing, but also for the emotional roller coaster that each new initiative entails. Let’s face it, the best part of business and life is not the ultimate destination but the path that you took to get there. It is the path that defines you, that makes you who you are and intricately weaves itself throughout the fabric of your new business and its culture. We sincerely hope that our Establishing and Launching a Hedge Fund series has proven to be a valuable resource that at the very least gave you some substance as you navigate your respective paths. Whether or not you ultimately become a client, partner, or employee of ours we wish you success in your endeavors…please feel free to drop us a line or give us a call to share your experience as we are more than happy to be a resource for you and vice versa.