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The Birth of a Hedge Fund

By Shaheen Pasha - Jan 13, 2016 at 3:25PM

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The barrier to entry is low, so those with the best compliance are in the best position to grow.

The year 2015 was not kind to hedge funds. Assets under management in the nearly $3 trillion industry took a $95 billion hit in the third quarter of the year -- the worst decline since the 2008 financial crisis, according to tracking firm Hedge Fund Research (HFR).

Fears over China's growth prospects as well as the European debt crisis spooked global markets and put a damper on a number of new hedge funds that were set to launch this year.

But even as HFR warned in October that the industry is pacing to have the lowest level of new launches since 2010, many remain enthusiastic. Some industry players are not deterred by the challenging economic environment and plan to move forward with starting up new funds. Among the more notable industry entrants is Nobel Prize-nominated physicist George Zweig, who announced over the summer that, at 78 years old, he was planning to throw his hat in the ring and launch a fund with two younger partners.

Just how difficult is it to start a hedge fund? On paper, at least, it doesn't seem that hard.

"On the surface, it's really easy to start a fund," said Eric Wagner, partner and chairman of the corporate department at Kleinberg Kaplan Wolff and Cohen. "You need to form a partnership and a brokerage account, both of which you can do on the Internet. You need to find people that are willing to give you money and allow you to manage it on their behalf."

"But," Wagner added, "those things don't necessarily create a viable business."

Wagner said the real test of viability for a hedge fund lies in its ability to attract significant funding from large investors. Like mutual funds, hedge funds pool investors' money, but are usually only open to accredited investors who meet certain income and net-worth requirements.

In today's world, investors with the deep pockets are looking for infrastructure to be in place: an office, competent staff to handle financial administrative issues, a lawyer to put together disclosure documentation and proper registration of investment advisors.

And because it is so easy to start a hedge fund on paper, investors have to be particularly wary of fraud. The lack of transparency at some funds can make fraud hard to detect, particularly if funds send out false financial statements, as was the case of a Connecticut-based fund that disseminated account statements that hid multimillion-dollar trading losses.

Fraud occurs more frequently at small hedge funds, but the world of larger funds is also not immune. Perhaps the most infamous examples of the latter were the hedge funds that invested with disgraced investment manager Bernie Madoff, who in 2009 was convicted of running a $50 billion Ponzi scheme. (Learn the warning signs of hedge fund fraud at the FBI's Hedge Fund Information for Investors page.)

Given the risk of fraud, it also takes a certain personality to win the trust of wary investors. Aron Gottesman, chair of the department of finance and economics at Pace University's Lubin School of Business, said hedge fund entrepreneurs can come from any background -- as seen with Zweig's foray into the field -- but they share some common traits.

"They usually have some type of experience within the hedge fund industry already, they have to be well connected and extremely confident in their own ability to generate returns for their clients," Gottesman said.

For a hedge fund getting off the ground, industry reputation is currency in attracting capital. Institutional investors such as pension funds will often base their decisions on the investment track record of the managers and their real-world experience in the industry.

They also look for a potentially innovative strategy, something that sets the newbie fund apart. But again, even that doesn't guarantee success.

"There are risks involved," Gottesman said. "Hedge funds can take risks in the amount of leverage they use. Setting aside any fraudsters that are able to fool the market into giving them money, even those that are experienced and well-meaning can lose a lot in this market."

Earlier this year, $60 million hedge fund Canarsie Capital LLC, a two-year-old fund run by industry veterans, imploded spectacularly after a series of aggressive transactions and a high leverage position left the fund with just $200,000 in less than three weeks.

In a letter to investors, the fund's founder wrote that he acted "in an attempt -- however misguided -- to generate higher returns for the fund and its investors," adding that he "acted overzealously."

Rules and compliance
Hedge funds aren't as regulated as mutual funds, which have a long list of rules that govern how they trade, place strict limits on leverage, lay out diversification requirements, and mandate certain disclosures.

But hedge funds do face some limitations on how they do business. There are still market rules that involve all securities trading, and hedge funds are not exempt. For that reason, start-up hedge funds typically need to have their compliance measures in order before attracting investors.

"The barrier of entry into the industry is low," said Todd Cipperman, managing principal of Cipperman Compliance Services, which provides such vehicles with regulatory compliance support. "But I think it is a much harder industry to make money in than what it looks to be on the face of it."

Cipperman said that investors often focus on market risk, which is inherent to any investment product. But the true risk for hedge funds -- particularly fledgling firms -- is any weakness in their compliance structure. "The way you hedge risk is through due diligence," he said. "It involves engagement with management, review of documents, interviewing of people, sampling of transactions, turning over rocks, and looking behind doors."

Those with the strongest compliance are in the best position to grow their start-up. But in a competitive market, new hedge funds face an uphill battle.

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