Drowning in Expenses : Hedge Fund Start Ups

Many years back, I was searching for information on how to set up and run a hedge fund. Can I start one myself? That was my thought then. However, I was sorely lacking in information. In particular, I want to know how much it is going to cost. It was not an easy task. I managed to gather bits and pieces from the internet and friends in the industry. But like solving a giant puzzle, there are always missing pieces. Pieces which you know you are missing, and pieces which you don’t know you are missing. And costs are one of those.

I guess I could have talked to a fund lawyer. But it was not a firm thought then. I was not some pedigreed portfolio manager looking to go start his own fund. Neither am I rich to begin with, nor do I have wealthy sponsors lining to back me up. I don’t want to go to a fund lawyer sounding stupid, looking less than half-committed, and end up wasting both side’s time. Anyway, to cut the long story short, I did not end up starting a hedge fund. Instead, I joined a start-up hedge fund several years later. Only then did all the pieces fall into place. Not surprisingly, I have way underestimated what is needed.

For those who are contemplating starting and running one with the investment management company based in Singapore, there are a few things you might want know.

Managed Account Or Fund Structure?

We often use the term “hedge funds” loosely. It is just a broad term. And some “hedge funds” actually do not have funds. Instead of pooling all the money they raised into a fund, they managed separately the individual private accounts of their clients. We call these managed accounts. There are advantages to this approach, such as lower costs, since that does away with the need for a separate legal entity. However, this may not always be feasible if the individual accounts are too small to achieve economies of scale or to execute your investment strategies.

In this post, I will focus on the more typical fund structure approach. There are 2 entities involved. First, you need to incorporate an Investment Management Company (IMC). After that, you need to create a Hedge Fund (HF). The HF holds the pooled assets of all its investors and engages the IMC to manage these assets. It sounds kind of roundabout, but this elaborate arrangement is necessary. It segregates the investors’ assets and isolate them from business risks associated with the IMC. For more generic information about hedge funds, you can read up an earlier article I wrote 16 Questions To Test What You Know About Hedge Funds.

Investment Management Company (IMC)

Incorporating the IMC: $300-$400

The IMC is a private company you can easily incorporate with the Accounting And Corporate Regulatory Authority (ACRA) for a few hundred bucks. You can see the list of applicable fees on ACRA’s website.

Registering with Monetary Authority of Singapore (MAS): $1,000 per year

Before you can conduct money management business, you need approval from the Monetary Authority of Singapore (MAS). For a start, you are likely to do just a basic registration instead of applying for a capital markets license. That makes the IMC a Registered Fund Management Company (RMFC). Going forward, you just need to comply with the rules and pay an annual admin fee of like $1000. RFMC are subject to slightly less onerous rules and requirements than its licensed counterparts. But it comes with certain restrictions, e.g. the IMC cannot manage more than $250 million. The good news is you can upgrade to a Licensed Fund Management Company (LFMC) anytime subject to approval of course. For details, I suggest you you refer to the guidelines on MAS’s website.

Maintaining the base capital: $250,000 at all times

As a RFMC, you have to comply with a host of rules. One of the rules require the IMC to maintain a base capital of $250,000 at all times. This is a mandated buffer set aside to meet financial obligations. A breach is serious, and recalcitrant offenders can have their registration or license revoked. This means internally you have to set a higher threshold, say $350,000, so that you would not inadvertently breach below the regulatory level. While this is not an expense, it is still something you have to prepare and set aside.

Getting a physical office: $2,000 per month

You will need an office space. And sorry to disappoint you, your bedroom or study room is not going to make the cut. You can work anywhere you want, but you are required to have a proper physical office. And for compliance reasons, the space has to be segregated and protected from non-authorized personnel. Do also bear in mind that this is a place many prospective clients would like to see. So it should look sufficiently adequate. An easy option is to rent a small room in a serviced office. That takes care of many things e.g. essential facilities, utilities, internet connectivity etc. Depending on where the office is located, the rental can be vastly different. For office space near central area for 3–4 people, we can be looking north of $2000 per month.

Getting the manpower you need: $12,000 per month

This is potentially the largest chunk of the company’s expenses unless it is entirely operated by business partners. MAS dictates that you have minimally 2 directors, each having at least 5 years of relevant experience. And one of them must be a full-time employee resident in Singapore. Technically, you can appoint any employee directors. But in most IMCs, the Chief Executive Officer (CEO) and Chief Investment Officer (CIO) are the ones fulfilling this criteria.

Besides your CEO & CIO, ideally, you should also have a corporate secretary, finance officer, a compliance officer, an IT personnel, and a marketing person. But there is no rule to say you can’t hire someone who is both IT savvy and good at finance, or the CEO/CIO can’t double up as the marketing director. It is fairly common for people in startups to wear many hats. Compliance, however, is a full time dedicated function. And due to conflict of interests, you can’t have the CEO/CIO wearing this hat. You are, however, allowed to outsource this function to an external service provider.

What if you can’t pay? Then the only alternative is to find trusted partners who share the same passion with you. And they must have sufficiently deep pockets to see themselves through the next couple of years. Else this venture is almost guaranteed to fail. It is, however, by no means easy to find that many partners. So let’s just assume you are the CIO, and the CEO/Marketing is your business partner. Both of you hire another 2 people to fill the roles of a finance/IT and compliance officer. It is highly unlikely you want to hire senior professionals from large institutions unless you can pay really generously. Let’s go for 2 junior hires and budget about $12000 a month.

IMC Audit: $10,000 per year

As a regulated entity, the IMC have to engage an external auditor to perform an annual audit. The IMC is not eligible for audit exemption even if the annual revenue is below $5 million. The auditor will scrutinize everything from your company processes to the financial statements. Audit fees can vary significantly between auditors. You go for the BIG four auditors, then you get BIGGEST four invoices. Forget about such branding when you are still trying to make ends meet. You might be able to negotiate with a lower tier auditor to do the job for under $10,000.

Hedge Fund (HF)

Contrary to what many people may think, the hedge fund actually does not have any direct hires other than a board of directors for oversight. But that does not mean its expenses are low. Because it engages the service of many third party providers. And these services do not come cheap. Typically, these expenses are deducted from the fund. But when the fund is small, as is usually the case for unknown start ups, there are implications. An annual expense of say $100,000 on a fund with an AUM of $1 million means you got to make 10% first before your fund will show any profit. That is a killing blow to any track record you want to build. It is also unfair for early investors to bear such a big burden. In such instances, it makes more sense for the IMC to bear these expenses on behalf of the fund before it grows to a reasonable size.

Cayman islands offshore fund associated and other regulatory fees: $20,000 per year

Let’s say you incorporate an offshore fund in Cayman Islands — one of the tax havens. There are probably lower cost options like British Virgin Islands (BVI), but I am only familiar with Cayman Islands, so I will go with that. Cayman Islands is also the choice of domicile for most offshore funds, accounting for more than half of all offshore structures.

There are of course fees to pay to set up and maintain a fund in Cayman Islands. Very briefly, you will need to pay on a yearly basis — mutual fund registration fee, Cayman government fee, Cayman registered office fee, annual returns filing fee, CIMA director fee for each director on board the fund etc. And just last year in 2018, the Cayman Islands Monetary Authority (CIMA) introduce a new rule requiring all regulated funds to appoint an Anti-Money Laundering Compliance Officer (MLRO) and a deputy MLRO. If you do not have suitable candidates, you can outsource this function to the fund administrators for a fee. Cayman-based financial institution are also to subject to FATCA reporting obligations for tax purposes. It is beyond me to explain. But suffice to know you need to pay to get others to do the reporting for you.

As a ballpark figure, all these stuffs might set you back easily by $20,000 or more per year.

Legal Advisory Fees: $25,000 -$50,000 one time set up expense

You will need lawyers to draft and file all the legal materials for the HF. The most important document is the private placement memorandum (PPM). This document details everything from the portfolio managers, the investment mandates, strategies, risks, fund terms to service providers etc. And you will need 2 groups of lawyers:

1. A Cayman fund lawyer as the lead lawyer because your HF is domiciled in Cayman Islands.
2. A Singapore fund lawyer to review, edit and add to the document because the IMC is incorporated in Singapore.

Needless to say, your costs has only one direction to go — UP. Again, charges can differ significantly. Let’s budget between $25,000 — $50,000. This setup cost can be charged to the fund. And while not in line with accounting standards, it is common practice for small funds to amortize it over a maximum of 5 years. This helps to distribute the costs so that early investors are not unduly penalized. This is to be fully disclosed in the PPM and financial statements. Alternatively, the IMC can absorb this set up costs.

Fund Administration: $3,000 — $4,000 per month

Would you put money in a hedge fund where the PM himself does the calculation and confirms the NAV? I don’t think so. The process is inherently flawed as the PM can manipulate performance data without independent oversight. Not to say that he will, but without proper process, he can.

This is where the fund administrator steps in. They track all the positions and trades of the fund and reconcile them against the broker statements at the end of each month to arrive at the official NAV. This leaves no room for tricks. Besides this, they also process investor subscriptions and redemptions, perform Anti Money Laundering (AML) checks, and prepare the fund’s annual financial statement for audit purposes etc.

Fund administration is one of the largest expense. They charge a monthly fee, usually a couple of basis points based on the size of your fund subject to a minimum. Again, prices vary according to the complexity of your fund and administrators. But as a rough estimate, put aside $3,000-$4,000 per month.

Fund Audit: $10,000 — $15,000 per year

Yes, the fund also needs to do its own annual external audit. And it can be a tad more expensive than the IMC audit. 2 groups of auditors are involved. A local auditor that does all the groundwork, and another auditor registered with CIMA to review and do the final sign off. Budget $10,000–15,000.

Fund Custody Fees: $0

Big banks and prime brokers safekeep the fund’s assets on their behalf. In return, they charge a custody fee. It is usually a very small percentage of the total assets in their care per month subject to a minimum. But if you are not that brand conscious, you can opt for brokers that do not charge custody fees, or at least not explicitly. These brokers recover the custody costs through the trade commissions earned. So if you trade infrequently, you may incur an inactivity fee on your account. That, however, is insignificant compared to the custody fees you pay the branded guys. In any case, you can forget about opening a prime broker account at bulge bracket investment banks if your fund do not have like a $100 million.

Putting The Pieces Together

Now, if we piece everything together, expense for the first year can be close to $300,000 and a bit lower thereafter without the initial set up costs. And this still excludes the $250,000 base capital you need to maintain. And as I mentioned earlier, you might have to aim for a higher threshold of $350,000 instead so you don’t keep pissing MAS off. Of course, if your company is generating a healthy profit since day one, then this might not be that much of a concern. But I doubt.

Assuming your running expense to be $300,000 per year, to break-even on just a management fee of 2%, you require a fund the size of $15 million. Too high? Sorry to disappoint you again, that is an optimistic scenario. With fees trending down generally, you probably would not get a single cent as a start up charging 2% management fee. It is highly likely you have to give up more upside and do a 1% or lower. On a more positive note, the fund can probably stand on its own and absorb the expenses in stride when it is large enough i.e. IMHO deduct less than 0.5% from the fund. And I have yet to include performance fee. But do expect rough patches where you will need the management fee to help you tide through.

Concluding Remarks

Note what I mentioned is not exhaustive. For example, I have not included expenses on things like web domain, website development, emails, secured cloud servers, backup power supplies, laptops, name cards, design and printing of marketing materials, professional indemnity insurance etc. The set up also cannot be used to solicit US monies. That will require a master feeder fund structure comprising a US onshore feeder, a Cayman offshore feeder and a Cayman Master Fund. 3 sets of financial accounts. More work for auditors. Complicated tax reporting. And on top of that, you need a US fund lawyer to draft another PPM for the US investors. Basically, expect to pay a lot more.

There are other paths one can take though. One way is to start with an incubator fund instead of a full fledged hedge fund. Another is to look at joining a hedge fund platform who have the expertise and economies of scale to negotiate better deals with the service providers. I did not explore those paths so I will not comment much here. In any case, anyone serious about it should do their own homework and consult the relevant professionals. However, I do hope this post let you have a glimpse into how hedge funds work and some of the challenges that start up hedge funds faced.

Originally published at investmentcache.com on February 1, 2019.