The process of creating a new hedge fund can be very challenging. If a fund is going to be successful, it not only needs to adhere to a significant number of regulations, but it also needs to take into account several different factors.
What is the Process Behind Hedge Funds?
Through the use of investors’ pooled funds and, on occasion, borrowings, hedge funds utilize a variety of investment strategies in the hope of producing an active return, also known as alpha. To accomplish this objective efficiently, seasoned and experienced investors are recruited to serve as managers of hedge funds. These investors will work to increase returns by employing leverage and derivatives.
The practice of ‘hedging,’ in which one takes the opposing position in a related asset to reduce the likelihood of incurring a financial loss, is an essential component of the investment approach employed by hedge funds. Hedge funds’ strategies frequently involve high risk because the funds’ primary objective is to produce high returns for their investors; consequently, hedge funds must minimize risk whenever and wherever it can be done.
Making investments in hedge funds, in contrast to investing in mutual funds, is limited to rich individuals and/or institutions, and those investors are required to maintain their stake for a predetermined period. Hedge funds are essentially investment partnerships that can invest in practically anything, provided that their investors are informed of the strategy before making any investments.
Before the financial crisis of 2008, hedge funds were subject to a lower level of regulation compared to mutual funds. Since then, however, regulators have increased their focus on hedge funds to make their operations more open and accessible. Because of this, they are subject to a great deal of regulation and it is significantly more difficult to launch one in the United Kingdom when compared to other nations.
As a matter of fact, as a result of the complexity, many new businesses seek the expert knowledge of outside businesses to aid with establishing the fund to guarantee that it complies with the laws and regulations that are applicable in their particular jurisdiction.
The Steps Necessary to Launch a Hedge Fund
When starting a hedge fund, the first thing you need to do is familiarize yourself with the guidelines set forth by the local regulator. For instance, in the United Kingdom, this would be the Financial Conduct Authority (FCA), which is the governing body of the country in charge of regulating hedge funds.
In addition, to set up a new hedge fund, managers of existing hedge funds are legally required to obtain approval from the Financial Conduct Authority (FCA) under the terms of the Financial Services and Markets Act of 2000. The acceptance process can take as long as six months, and a new investment may be subject to monitoring for an additional twelve months after it has been established.
When it comes to the process of authorizing a new hedge fund, there are a variety of considerations that are taken into account. However, one of the steps in the process involves the investment manager demonstrating that they possess the monetary capacity as well as the adequate staff, systems, and controls necessary to manage the fund.
Candidates for employment at the hedge fund are required to demonstrate their level of expertise by passing a test that is either wholly or partially based on managerial experience gained in countries other than the UK. New hedge fund creators have to take into consideration a variety of other aspects, including the organizational framework that the fund will function within and the service providers that will be in charge of its management.
Because the regulations will be different depending on the territory and the market, it is essential to seek clarification from the local regulators in every situation.
The proper organizational framework for a hedge fund
The kinds of investors that a hedge fund wants to do business with and the requirements they have for the fund, such as its tax status, voting rights, and capacity to use leverage, are what guide the framework of a hedge fund. Stand-alone funds, master-feeder funds, umbrella funds, and segregated portfolio companies are the three most common types of structures found in the hedge fund industry. Stand-alone funds are the most common type.
A hedge fund will have a stand-alone structure if it intends to operate as one fund in the future, shares of which will be available for purchase by investors. On the opposite side of the spectrum, you have segregated frameworks, which are handled as independent legal entities and in which each shareholder has a completely separate fund account with its liabilities and assets. These structures are considered to be on the more secure end of the spectrum.
The master-feeder structures, also known as umbrella structures, serve as a sort of compromise between the two opposites of the stand-alone structures and the segregated structures. These are utilized in situations in which the prerequisites of each shareholder, such as their tax status or restrictions on leverage, are distinct from one another. For this structure to function, separate feeder accounts must be established. These accounts, which are customized to meet the requirements of each investor, must then be linked to a single master fund. The master fund is responsible for trading on the funds’ behalf.
Taking Charge of a Hedge Fund
Many hedge funds will look to employ the assistance of a management firm; however, a fund can be self-managed, which can result in significant time and cost savings. In this kind of situation, the management team would serve as the appointed officers of the fund. However, it is important to keep in mind that according to UK law, the fund needs to have at least two independent directors who are based outside the country.
Having said that, the Investment Manager Exemption allows an investment manager to have their base of operations in the United Kingdom if they meet certain requirements (IME). For the manager to qualify for the IME, they are required to maintain their independence at all times while supplying investment management services, for which they are entitled to receive compensation. In addition, each transaction would have to be carried out in the typical manner of the company’s operations. It is important to keep in mind that the investment manager can’t have more than a 20% stake in the total assets of the hedge fund.
The founders will need to hire not only an investment manager but also an office manager, an impartial auditor, a custodian and/or primary broker, legal counsel, and a tax consultant in addition to hiring an investment manager. These individuals will be the providers for the fund and will be responsible for controlling and managing the hedge fund.
In conclusion, the process of establishing a new hedge fund can be approached in more than one way. The establishment of a new fund and/or its management of it could be outsourced to a third party if the founders choose to take advantage of that party’s expertise and experience. No matter how one goes about establishing a new fund, one must be familiar with the procedures followed by the regional regulator as well as the relevant laws that pertain to the management of investment vehicles.