Starting a hedge fund: how to choose your vendors

Starting a hedge fund these days isn’t just about raising capital and running trades. Today’s regulatory environment, alongside investor scrutiny, means hedge funds need to have reliable and independent partners that will support them in setting up and running their operations. This is especially important for institutional fundraising, and can pave a path to growth. Here are just a few main partners you’ll need to get your fund up and running.

Lawyers

You will need a reputable, knowledgeable law firm to guide you through the process of setting up. Before you go off calling the biggest names in the space, however, ask yourself whether you’ll need any specialized expertise, such as multi-jurisdiction reach or knowledge of special structures. There are many top-tier law firms dominating the space, but you don’t necessarily need to be a client of the biggest (and most expensive) in order to take care of basic set-up. Many of our clients work with larger, well-known law firms for important tasks such as offering documents, but also work with smaller firms on one-off issues.

Whatever you choose, make sure you are choosing a reputable firm with a recognizable name: your law firm will be your key partner for making sure your legal, tax and compliance structures are set up correctly.

Auditors

Ideally, your law firm can recommend a few potential audit firms that can take you on as a client. Auditors will be looking at your policies and procedures, as well as verifying your performance, to vet them for institutional investors, so make sure you choose reputable firms with solid knowledge of your structure and strategy type.

Administrators

A fund administrator will manage the majority of your back-office functions, such as trade allocation and reconciliation, but their role is even more important in the context of attracting institutional money. In essence, your admin will independently value your assets and report them to your investors, serving as your fund’s official book of record.

From the technology perspective, pick an administrator that will be able to scale up its support of your operation as you grow. For instance, if you add investment structures with complex reporting requirements, will your administrator be able to accommodate them? If you add complex instruments, such as derivatives, does the administrator have the expertise to handle allocation and reporting? If you expand into new jurisdictions, is the administrator well equipped to deal with foreign tax regimes? These are all questions to ask before you choose your provider.

Prime broker

The prime broker relationship, is, arguably, one of the most important relationships you will need to set up before starting your fund. As the prime point of your trade information, your prime broker serves as your main point of contact with the market. Needless to say, your chosen prime broker should have an excellent trading platform, and great relationships across the market. Specifically, your prime broker should be well versed in your strategy, as well as strategies you are hoping to add as your business grows.

Beyond trading, prime brokers will serve as the central source of securities lending and financing. This becomes a particularly important consideration if you’re dealing with esoteric, hard-to-borrow securities, or strategies that require greater leverage, make sure that your prime broker will be able to accommodate you most of the time. Run through scenarios ahead of time, and ask for concrete examples of how the prime would handle those scenarios.

Another big selling point of prime brokerage services is capital introduction, but it shouldn’t be confused with asset raising. You will still have to do the heavy lifting. However, do ask your potential PB about access, what level of support you can expect, geographic reach, and figure out exactly what you’ll be getting out of the relationship.

Last but not least, get a full run-down of fees. Beyond commissions, consider exchange fees, data fees, support riders, and other add-ons. Understand what portions of fees are variable, and which are fixed.

Third-party marketers

Third party marketers can make a big difference in taking a hedge fund’s fundraising from an uphill battle to a running start. Some of the top firms in the space can significantly bolster your brand in the beginning stages, setting up introductions for your sales force, providing access to investors, and providing consulting on how to improve your position.

Reputable, well-connected third-party marketers can greatly aid your sales force at the institutional stage of fundraising. While capital introduction may be achieved by your prime broker, that’s the extent of the service – after you’ve met the investor, you’re on your own. Third-party marketers, on the other hand, will work with you to provide comparative analysis of risk, performance and fees, and work with you to answer any questions the investor might have.

Make sure you pick a reputable firm with experience in your strategy and contacts among your desired target base. Decide on compensation early on, and figure out how you will be compensating your third-party marketer, and what extra fees, if any, need to be considered for specialized marketing services.

IT and technology providers

Few hedge funds start out thinking about their technology. However, in today’s environment of increased investor due diligence, technology can make a big difference in how attractive your fund is to institutional investors, as well as save you significant cash and headaches as your operations get off the ground. Gone are the days when you could wait until after launch to implement systems for trading, accounting, reconciliations and other operations—to attract institutional investors today, you need institutional-grade infrastructure at inception.

Even if you are not in a position to have all of your systems in place during the fundraising process, investors will want to know early on in your fundraising who you are planning to hire, and how that technology will support your critical functions. While there is no one-size-fits-all when it comes to investment management systems, you will need to assess vendors’ performance e in these key areas when selecting your technology providers:

Features and functions

The number one consideration for selecting your technology is what functions you are automating, and what ultimate goals you want to achieve via the automation. Unless you are building in-house, most start-up hedge funds will use a single system at launch to sit at the heart of their investment operations. Ideally, you want that system to be able to handle as many core functions as possible, such as trade management and allocation, reconciliation and shadow NAV, portfolio management and modeling, compliance and risk management. It should also integrate well with third-party systems you are using to help run your business, and any proprietary in-house technology you may be building.

For an in-depth look at features and functionality hedge funds need to succeed in today’s market, click here.

Deployment

How your system will be deployed, and the depth and breadth of your vendor’s hosting capabilities can make a big difference to your workflows, capacity and security. There is a number of options for supporting your hardware, with a number of options falling anywhere on the spectrum between in-house and outsourced IT, and all of them should be discussed with your investment technology vendor.

Whether you choose to deploy on-premise or via a public or private cloud, make sure your vendor can draw you a complete picture of how this infrastructure will impact your operations. For instance, if you choose to support an on-premise solution, how expensive will it be to maintain and what in-house resources will you need to do so? If you choose an in-the-cloud solution, how will the security measures of that system impact day-to-day workflows? What redundancy measures will be in place? Last but not least, ask for real-life examples of prior implementation and references, if possible; it will help you assess whether the timeline you’ve drawn for yourself is realistic, and what measures, if any, need to be put in place to ensure you can deploy smoothly in the shortest possible timeframe.

Total cost of ownership

While it’s nearly impossible at the moment to estimate the return on technology investment, anecdotal evidence suggests there are vast rewards to be reaped from implementing the right technology platform to support your critical operations functions. The key to selecting the right platform lies not only in fit, but the total cost of ownership over the years you will be using the platform. Too often, buying a cheap solution “for now” just doesn’t pay.

For instance, in years past arguments have been made that a hedge fund could do trading with only a Bloomberg terminal for market data. However, if you want to execute trades, you will have to pay for additional execution system capabilities. Similarly, you will have limited allocation flexibility, and would have to pay extra for sourcing positions from third-party accounting systems or administrators. In the end, these costs add up, weighing upon your budget long after you’ve started your operation.

But this phenomenon doesn’t stop at Bloomberg terminals. Any time you select a limited system that’s just good enough to serve your current needs, you run the risk of paying more in the long term to ensure your technology keeps up with your business development. Ideally, you will want to select a platform that will be able to make available additional capabilities to you as your operation grows, without incurring high implementation costs. In the same vein, your vendor should be able to offer pricing commensurate to your platform usage, not just your assets under management.

Service and support

The total cost of ownership is also impacted by the level of service and support that’s built into your contract. Service should be a crucial part of your vendor selection, as even the best technology cannot solve all of your day-to-day questions alone.

Look for a technology provider with a history of getting clients implemented quickly. Before you make your selection, ask: do you pay for implementations? Upgrades? How long do they usually take, and what’s required of you, the end user? Get a detailed sense of how training is handled, and what documentation and other resources are available.

Even more importantly, find out what post-launch support entails. Who will you call when you have issues or questions?

All of these questions should be answered before you engage in contract discussions. You want a vendor that will be your technology partner, consulting you on best practices and ensuring you can run your business in a way that helps you derive maximum operational alpha for your firm.

Reputation

When you approach institutional investors, or their due diligence partners today, don’t be surprised to hear them asking about which service providers you are retaining for your technology. Even a few years ago, this wasn’t a top priority, but today, institutional investors want to ensure you are being supported by reputable technology. They expect to hear names with a long track record in the industry, and a reputation of support that’s impeccable.

• Pick vendors with experience and expertise in implementing firms like yours. Find out what happened to those clients, and how the vendor was able to keep up as they grew.
• Ensure that they put security and reliability of the system first. One good way to find firms that are committed to protecting your data and that of your clients is to ask whether the vendor is ISO certified. ISO certification means that the firm you’ve chosen has met the highest international standards for security and data protection.
• Pick vendors that are committed to innovation. As your business grows, you’ll want your technology partner to be in a position to respond to your needs, and the demands of the market, with timely and effective product updates. This is why it’s a good idea to ask about R&D investments and culture. Does the firm devote a significant part of budget to R&D? How is client feedback taken into account when developing new features? Are the product updates frequent? How scalable is the platform infrastructure to be able to accommodate future updates you might need?

Setting up a hedge fund has evolved into a complex process in the last decade. The expression “two guys in a garage with a Bloomberg terminal” can hardly ever apply to any start-ups today. If your ambition is to raise institutional money, you will do well to do your homework on your supporting network of service providers, and choose well. Having the right partners in your corner can not only help you attract the capital you seek, it can also make a big difference in how your fund operation fares over the years. Choose well.

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