Convince Your Family To Invest In Hedge Funds

Hedge funds are a risky investment option, and government restrictions and high buy-ins make them inaccessible to most. However, for those who are interested, there are ways to get your family to invest in a hedge fund.

First, it's important to note that only institutional investors, like pension funds, or accredited investors can invest in hedge funds. Accredited investors are those with a net worth of at least $1 million or an annual income of over $200,000 ($300,000 if married). If your family members meet these criteria, you can consider pitching them a hedge fund investment opportunity.

To start, you'll need to define your investment strategy and ensure it's replicable, scalable, and not dependent on specific economic conditions or government policies. Common hedge fund strategies include long/short equity positions, merger arbitrage, investing in distressed companies, and quantitative approaches.

Once you have a clear strategy, you'll need to assemble a competent team of service providers, including a lawyer, auditor, and administrator. You'll also need to register with the Securities and Exchange Commission (SEC) and state regulatory bodies, as well as pass the Series 65 exam to become an investment advisor.

With your team and legal requirements in place, you can begin marketing your hedge fund to potential investors, including your family members. Be sure to comply with all laws and regulations during this process. Provide your prospective investors with your audited track record, explain your strategy, and ask for their investment.

Keep in mind that starting a hedge fund is a challenging and costly endeavour, and there are many regulatory and legal hurdles to navigate. It's essential to do your due diligence and consult with experts and professionals before proceeding.

Raising capital

You may find the following sources good for initial investment capital:

• Endowments or foundations
• Friends and family

To attract more sophisticated investors, you'll need to convince them with a track record of repeated success, a clear and understandable investment strategy, and a highly skilled and experienced team.

A common strategy is to hire a professional marketing team to sell your fund to outside investors. They will craft the right narrative, explain the investment process, and highlight the fund's successes.

Hedge fund managers are prevented by regulations from publicly advertising a specific fund. However, they can set up informational websites that explain their investment strategies and experience, and they can offer specific trading ideas on these websites.

Hedge funds are often marketed by the fund manager, who networks with friends and business acquaintances, or through third-party placement agents. The agents are intermediaries for pension fund managers and other professional and institutional investors.

Another strategy is to offer seed investment arrangements to initial investors. In exchange for a substantial investment in the fund, the investor receives a discount on fund management fees or partial ownership interest in the fund. These initial investors often do their own networking to solicit other investors.

Hedge fund managers generally produce brief marketing materials, known as a "pitch book" or "tear sheet", to give to prospective investors. This covers the basic information on the fund's strategy and manager, and its terms for investing.

Setting up the paperwork and legal structure

Choose a Business Structure

Hedge funds typically operate as either a limited partnership (LP) or a limited liability company (LLC). The LP structure is the most common, with the investment advisor or adviser acting as the primary partner and a group of investors as the secondary partner. Alternatively, a general investment manager can choose any business structure that suits their needs. It is important to consult with the secretary of state in the state where you plan to incorporate your fund to understand the specific requirements and options available.

Register with the State

Once you have determined the appropriate business structure, choose a name for your fund and begin the legal paperwork process. You will also need to apply for a Federal Employer Identification Number (FEIN) from the Internal Revenue Service (IRS). This can be done online through the IRS website or by completing Form SS-4.

Draft Corporate Bylaws

The level of documentation and regulatory compliance will depend on the hedge fund's investment strategy. At a minimum, the corporate bylaws should include a mission statement, a compliance manual, a code of ethical conduct, a supervisory procedures manual, and an advisor portfolio management agreement. It is essential to consult with legal professionals experienced in the investment management industry to ensure all documentation is accurate and compliant.

Register as an Investment Adviser

To establish a legal partnership, the fund must register as an investment adviser with the Investment Adviser Registration Depository (IARD). This process can be completed online for free. By registering, the fund acknowledges its fiduciary duty to provide investment advice that is in the best interests of its clients.

Register Fund Representatives

If the hedge fund will have representatives providing investment advice, they must register as investment advisers with the U.S. Securities and Exchange Commission (SEC). This typically involves taking the Financial Industry Regulatory Authority (FINRA) Series 65 regulatory exam, which tests knowledge of securities laws, ethics, and practices. Passing this exam results in a license to operate as an investment adviser in the relevant state.

Register the Hedge Fund Offering

The hedge fund must also register the offering of the limited partnership with the SEC by completing Form D in each state where the fund will be offered. This registration includes disclosing key partners, large investors, and the fund's primary investment strategy and approach.

Comply with Consumer Protection Provisions

Hedge fund managers are subject to registration and reporting requirements under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. If the manager has less than $25 million in assets under management (AUM), they are not eligible for SEC registration and must follow the laws of their home state for registration and licensing.

In summary, establishing the legal and paperwork structure for a hedge fund is a complex and regulated process. It is essential to consult with legal professionals and comply with all relevant state and federal requirements to ensure the fund operates within the boundaries of the law.

Hiring a team

Even with external service providers, you won't be able to do everything yourself. Label this step "3", but you'll have to build your team from the start because you'll get questions about it in your pitches. And you don't even stand a chance of starting a fund unless you have an existing team that has worked together for years.

First, note that $100 million in assets under management (AUM) is barely enough to support a "team". You might earn $1.0–$1.5 million in management fees from that, and infrastructure, overhead, and compliance expenses will eat up a good portion of those fees. You might have a few investment professionals at that level, a few support staff, and many outsourced service providers.

Once you move closer to $1 billion in AUM, you might hire several more investment professionals, a few more support staff, and even more outsourced services. Quant funds have more IT needs and tend to have bigger teams, but many value-oriented funds start with just the founder, one person on the investing side, and someone else in support.

If you only have the funds to hire one person, make it someone on the administrative/operational/marketing side. That may sound crazy, but you will spend an unbelievable amount of time on non-investment-related tasks, such as talking to lawyers and accountants, reviewing legal documents, and answering questions from potential investors. Without someone else to handle these tasks, you might spend 50% or more of your time on them, which limits your ability to create and implement investment strategies.

But let's say that you have grown your AUM, and now you can afford to hire more full-timers and interns. You might be tempted to ask candidates to complete case studies, stock pitches, or other modelling/technical tests… But at a startup hedge fund, that's the wrong approach. Yes, investment staff need to understand all of that, but the most important quality is that they must be willing to get any task done no matter how random or ridiculous it is.

Having a degree from Harvard or Oxford or 3 years of experience at Goldman Sachs are extremely poor indicators of this quality—in fact, they're often negative indicators! Your best bet is to tap your network and reach out to coworkers from previous jobs, and if you need to go beyond that, start asking those coworkers for referrals.

As your fund grows beyond the "startup" phase, the hiring process will become more traditional, with decisions based more heavily on discussions of investment ideas. As your AUM grows, your headcount won't necessarily grow linearly with it, especially if you're running a quant fund; there are multibillion-dollar funds with only a few investment staff. Your headcount is more likely to scale up linearly if you're running a value-oriented fund that requires more people for research and due diligence.

As you grow, the non-investment headcount might increase more rapidly because your compliance and reporting requirements will increase—but you won't necessarily need to come up with more investment ideas. Many large hedge funds have a 1:1 ratio of investment personnel to non-investment personnel, and sometimes it's closer to 1:2.

Marketing the fund

• Build a strong network: Hedge fund managers often rely on their network of friends, family, and business acquaintances to find potential investors. It is important to have a network of high-net-worth individuals who recognise your expertise in investment management.
• Comply with regulations: When marketing your fund, ensure that you comply with all applicable laws and regulations. Consult with a legal professional to understand the specific requirements in your jurisdiction.
• Demonstrate a strong track record: Prospective investors will want to see a proven track record of successful investments. Have your investment strategy and track record audited to add credibility to your pitch.
• Craft a compelling narrative: Work with a professional marketing team to craft a compelling narrative around your fund. Explain your investment process, highlight your successes, and provide clear and concise marketing materials (such as a "pitch book" or "tear sheet") that outline your fund's strategy, terms, and manager information.
• Utilise informational websites: While hedge fund managers are restricted from publicly advertising specific funds, they can create informational websites that explain their investment strategies and experience. These websites can also be used to offer specific trading ideas and attract a wider audience.
• Leverage third-party placement agents: Hedge fund managers often work with third-party placement agents, who act as intermediaries and help connect them with professional and institutional investors, such as pension fund managers.
• Offer seed investment arrangements: Consider offering initial investors discounted fund management fees or partial ownership interest in exchange for a substantial investment in the fund. These investors can then become brand ambassadors and help solicit additional investors.

Pitching to investors

The Pitchbook

A hedge fund pitchbook is a marketing tool used by funds, money managers, wealth managers, and commodity trading advisors (CTAs). It highlights the unique value of their investment program to prospective clients and investors. It provides an overview and analysis of a program's strategy and performance and offers insight into the expertise of the strategy's principals.

A pitchbook is a key tool to raise assets under management (AUM). It should be designed to tell your fund's story and highlight its strategy's differentiation. It should also be concise, providing just enough information to entice investors to engage in deeper conversations around the fund offering.

The Pitch

When pitching to investors, it is important to be personable. Institutional investors often place as much weight on your character as they do on your strategies and returns.

Your pitch should be specific, repeatable, and understandable. It should not be overly dependent on specific economic conditions, government policies, or a key individual. Institutional investors prefer strategies they understand 100% rather than potentially higher-return but complex and unclear strategies.

Your pitch should also include stories about mistakes and what you learned from them. No investor is perfect, and investors will appreciate your honesty and willingness to learn from your failures.

The Investors

When raising capital, it is important to target the right types of investors. For example, pitching to a large institutional investor will be a slower and more bureaucratic process than pitching to a small family office.

Large institutional investors will likely require an introduction via other fund managers, trustees, or your prime brokerage provider. They will also conduct an informal background check to assess your reputation in the community.

Small family offices and high-net-worth (HNW) individuals will be faster to make a decision but will require more meetings to reach a critical mass of capital.

Endowments and pension funds are extremely conservative and usually avoid brand-new funds unless they already know the manager(s).

Due Diligence

Before committing, investors will want to thoroughly evaluate your fund. They will look at the quality of your service providers, such as lawyers, auditors, administrators, marketers, and compliance officers, to judge your fund.

Investors will also want to see a solid track record. They will be more likely to invest if you can demonstrate repeated success with your initial funding, a clear and understandable investment strategy, and a highly skilled and experienced team.

The Ask

When pitching to family and friends, it is important to remember that they may not have the same level of investment knowledge as institutional investors. Provide them with educational materials and explain the risks and potential rewards of investing in your hedge fund.

Be transparent about the fees and minimum investment requirements. Family and friends may be more flexible with their investment terms, but it is important to set clear expectations from the beginning.

Finally, be prepared to answer questions and address any concerns they may have. Building trust and confidence is crucial when pitching to family and friends.

Frequently asked questions