How to launch a hedge fund or boutique investment firmseaanalytics.com.au/Sea_Analytics_how_to_launch_a_hedge... · 2014-05-11 · Minor tweaks to your investment process can demonstrate

Author: Clinton Joyner

Sea Analytics Pty Limited

Sydney, Australia

Web: www.seaanalytics.com.au

Email: [email protected]

Last Updated: 10 March 2014.

How to launch a hedge fund or boutique investment firm

http://www.seaanalytics.com.au/

mailto:[email protected]


Se a An a l y t i c s P t y L i m i t e d C o p y r i g h t 2 0 1 4

Page 2 of 24


This paper is intended for anyone considering launching their own hedge fund or boutique investment firm.

As you can imagine there are myriad matters to address when launching a new firm (start-up) and this pa-

per aims to address the important aspects, particularly those that can lead to costly consequences if exe-

cuted poorly. We appreciate that everyone is busy so we have tried to avoid waffle and keep each topic

brief.

We have endeavoured to tailor this paper to an Australian audience although many of the challenges and

considerations apply to start-ups all around the globe.

Since the global financial crisis (GFC) the economics for investment firms has changed significantly. Specifi-

cally, management fees and performance fees are lower, operating expenses are higher due to ongoing

compliance and regulatory costs and there is a greater expectation for transparency, sound operational

systems and robust processes.

If you choose to only read this page, the top 10 thoughts to take-away are:

1. Don’t underestimate the importance of a live track record;

2. Everyone claims they offer low correlation to market so differentiate yourself from the pack;

3. Poor systems and processes will cost you money;

4. The wrong service provider reflects badly on you;

5. You can outsource a function but you can’t outsource your responsibility;

6. Make a realistic fund raising plan, then double the timeframe and halve the expected flows;

7. Perception is reality in the world of marketing;

8. Generally speaking 2%/20% is a thing of the past;

9. Find a reasonable balance between minimal information and complete transparency; and

10. Invest time in documentation and streamline the ODD process with a virtual data room.

We hope you find this paper instructive and we welcome the opportunity to work with you on any of the

matters discussed herein.

Please email any constructive feedback and let us know if there are any future topics that you would like us

to write about.

Clinton Joyner

Director

mailto:[email protected]



Page 3 of 24

Table of Contents

Why do people launch their own firm? 4

Investment Process 5

Team Development 6

Obtaining your Licence 7

Investment Structure 9

Risk & Compliance 11

Insurance 13

Service Providers 14

Investment Operations: In-House Versus Outsourcing 16

Technology 17

Raising Funds 18

Marketing 20

Fees 22

Investor Reporting 23

Due Diligence 24

Disclaimer:

These materials have been prepared solely for information purposes and must not be considered tax, investment or

legal advice. If you are interested in any subjects discussed in this document we encourage you to contact us or seek

independent advice. Sea Analytics Pty Limited disclaim any and all liability relating to these materials including with-

out limitation, any express or implied representations or warranties for statements or errors contained in, or omis-

sions from, these materials. These materials must not be used for the purposes of avoiding penalties that may be im-

posed by any law. Sea Analytics Pty Limited and its employees and officers shall not be liable for any loss or liability

suffered by the use of any information contained in these materials.



Page 4 of 24

Why do people launch their own firm?

Many successful firms have been launched by professionals who spent many years establishing a distin-

guished track record managing other people's money, perhaps in equities, commodities, currencies, fixed

income or indeed a combination. A handful of prominent examples within the Australian market include:

i. Kerr Neilson (ex-BT and founder of Platinum Asset Management);

ii. Anton Tagliaferro (ex-BNP and founder of Investors Mutual);

iii. David Paradice (ex- Mercantile Mutual and founder of Paradice Investment Management);

iv. John Sevior (ex-Perpetual and founder of Airlie Funds Management); and

v. Morry Waked (ex-BGI and founder of Vinva Investment Management).

According to the 2013 ‘BRW Rich 200’ list, the first 3 names above were estimated to be worth a staggering

$2.43b, $240m and $235m respectively.

Numerous other successful firms have been established by lesser known rising stars with the ambition and

conviction that their distinctive investment proposition will deliver superior returns.

It is also not uncommon for start-ups to be established by a spin-off from their investment bank, hedge

fund or proprietary trading desk. These firms tend to gain traction early as they already have a team in

place with a proven track record. Their departing firm may also provide seed capital and access to existing

infrastructure which can greatly enhance their journey towards break-even.

Regardless of how a start-up is formed, these entrepreneurs seek longevity rather than focussing on their

next bonus cheque and they are committed to having ‘skin in the game’ by investing a large portion of their

personal wealth alongside investors.

Most successful fund managers from large investment firms are sheltered from operational matters and

are therefore unaware of the complexities that can occur behind the scenes. For this very reason it is criti-

cal that start-ups surround themselves with a team of talented individuals to navigate through the numer-

ous operational and business challenges that will be uncovered throughout this document.

https://www.platinum.com.au/

http://www.iml.com.au/

http://www.paradice.com.au/

http://www.airliefm.com.au/

http://www.vinva.com/

http://www.brw.com.au/lists/rich-200/2013/



Page 5 of 24

Investment Process

An investment process typically starts with an objec-

tive such as adopting a fundamental, bottom-up

approach to identify a basket of strong companies

with compelling prospects for future growth.

According to the Basis Point Consulting, Australian

Investment Managers Directory 2013, “there are

138 investment managers investing predominantly

in Australian equities” and therefore the key to mak-

ing your fund attractive to potential investors will be

your ability to differentiate your offering from the

pack.

Since the GFC, more investment firms emphasise to

investors that their fund has low correlation to the

market and due to the frequent use of this state-

ment; it is no longer a differentiating factor.

In simple terms an investment decision to buy, sell

or hold is commonly determined following the out-

come of several components/criteria being satisfied.

Articulating these components in the appropriate

sequence with a combination of illustrations, text

and real examples will go a long way to breaking-

down the steps. If an investor doesn’t understand

your investment approach they won’t invest, nor

will they be confident it can be replicated success-

fully in the future.

Being able to articulate your investment process

verbally is equally important and your success will

impact the ability of others to convey your message

in an accurate manner to their superiors and poten-

tially other investors.

Minor tweaks to your investment process can

demonstrate your willingness to fine tune and fur-

ther polish your process based on experience,

missed opportunities or changing market conditions.

Risk management should also be a core component

of your investment process as investors will want to

understand how you intend to navigate your fund

through periods of extreme volatility.

On a separate note, extensively back testing your

investment process can provide you with confidence

that your investment approach is working but this

means very little to investors as they want to see

real results before investing. You should consider

the cost-benefit of prolonged back testing given the

consequent delay to collecting your first manage-

ment fee.

http://www.basispoint.com.au/funddirectory.html

http://www.basispoint.com.au/funddirectory.html



Page 6 of 24

Team Development

Building a team of experienced individuals is critical

to the success of a start-up as investors aren’t just

buying the founder’s experience but the complete

package. Most start-ups tend to hire past colleagues

or people that come with strong recommendations

because they can’t afford to choose the wrong can-

didate.

It is not uncommon for founders to draw a zero sal-

ary for the first 2-3 years and therefore rely on their

savings nest-egg and investment returns as income

received by the firm tends to go towards rent, sys-

tems and other staff.

Start-ups generally require additional research, ad-

ministration or technology staff but they are unable

to match salaries paid by more established invest-

ment firms. Instead they might offer a reduced base

salary (often 50%-80% less than market) but allocate

some equity in the firm. This carrot provides key

staff with skin in the game as they will ultimately

share in the firm’s success.

Prior to joining a start-up, individuals tend to calcu-

late the opportunity cost of accepting a below mar-

ket salary and set themselves a timeframe by which

they expect their equity component to start gener-

ating a return. Therefore, although an equity stake

can help to retain staff this is only meaningful while

the firm is profitable and/or while a positive outlook

for the future remains.

Hiring a part-time or full-time Chief Operating Of-

ficer (COO) can save founders a tremendous amount

of time otherwise their attention is diverted to deal-

ing with operations, compliance, reporting, technol-

ogy, service providers, due diligence questionnaires

and various administrative tasks. Many investors will

not consider a firm unless they have appointed a

COO because without one the founder will be dis-

tracted by business matters rather than focusing on

generating performance.

Start-ups with only 1 or 2 people should consider

hiring part-time resources as required because you

simply can’t manage everything. Remember, mis-

takes in the early days of a start-up can not only be

costly but destroy your reputation and hence your

ability to succeed.

Firms should also leverage from their broad industry

connections and strive to build a strong Board of

Directors and Investment Advisory Committee of

talented individuals to challenge and debate issues.

Close associates may even be willing to donate their

time gratis.

When marketing your team, it is obviously wise to

highlight your stars but it is equally important to

emphasise the team to limit the perceived reliance

on key players. Although challenging for small firms,

you will also be expected to appease investors by

demonstrating the existence of succession planning.



Page 7 of 24

Obtaining your Licence

When you are involved in the provision of financial

services in Australia, you must hold an Australian

financial services licence (AFS licence). The Australi-

an Securities and Investments Commission (ASIC) is

the regulator that issues AFS licences and they de-

scribe a financial service as:

i. providing financial product advice;

ii. dealing in a financial product;

iii. making a market for a financial product;

iv. operating a registered managed investment

scheme;

v. providing a custodial or depository service; or

vi. providing traditional trustee company services.

AFS licences are regulated under the Corporations

Act 2001 and when ASIC assesses a licence applica-

tion they seek to ensure you are competent, have

sufficient financial resources and that you can meet

all AFS licensee obligations.

The AFS licence application form (FS01) is electronic

and can be completed online. Your application must

also be supported with proofs (sent to ASIC via

email), of which the quantity and type will depend

on the complexity of your services, products and

business in general.

The core proofs required are:

A5 Business Description

Provides an overview of the financial services you

intend to provide, whether your clients will be retail

and/or wholesale clients and an organisational

chart. This helps ASIC to understand your business.

People Proofs for each Responsible Manager (RM)

RM’s are the people you nominate as being respon-

sible for significant day-to-day decisions about your

business. ASIC generally expect that a licensee will

have at least 2 RM’s. For most start-up entities, ASIC

will also require at least one of the RM’s to be iden-

tified as a Key Person under the AFS licence. This

means that if the Key Person no longer works at the

licensee, the AFS licence could be cancelled unless

another appropriately skilled person is identified.

This proof helps ASIC to assess the organisational

competence and the good fame and character of

RM’s.

ASIC also require a national criminal check which

can take up to 6 weeks to obtain so this should be

arranged before commencing an application.

B1 Organisational Competence

This details the experience and qualifications of

each RM. This helps ASIC to assess whether there is

adequate organisational competence to provide the

desired financial services and products.

B5 Financial Statements & Financial Resources

Serves to demonstrate how you will comply with the

financial requirements to satisfy ASIC that you have

adequate financial resources.

While assessing an application, ASIC may request

additional proofs to gain a greater understanding on

a particular matter in which case these need to be

completed and returned to ASIC within 10 business

days.

http://www.asic.gov.au/

http://www.asic.gov.au/

http://www.asic.gov.au/afsl



Page 8 of 24

Should you wish to vary your AFS licence at a later

date to modify a service, product or RM, a similar

process to the above is required.

Some firms rely entirely on lawyers to manage an

AFS licence application thereby leveraging their ex-

perience gained from previous applications. While

this approach can save time and effort, you will still

need to be actively involved to ensure the proofs

are accurately tailored to your business. Considering

the AFS licence application is generally a significant

start-up cost, others choose to manage the process

themselves and engage lawyers on specific matters

as required.

AFS licencees are subject to financial resource re-

quirements. This includes being solvent (being able

to pay your debts as and when they are due and

payable), cash flow and net tangible asset require-

ments. At a base level these are not overly onerous

however depending on your activities, these in-

crease quite significantly. Recent changes coming

into effect on 1 July 2014 will have particular im-

pacts on trustees of wholesale schemes and respon-

sible entities. Amongst other things, these entities

will typically be required to hold at least 10% of the

last 3 years gross revenue as net tangible assets.



Page 9 of 24

Investment Structure

Determining an appropriate investment structure

will depend primarily on the tax requirements and

risk preferences of your investors. This section is

not intended to be exhaustive but rather provide

some general information on the commonly used

investment structures.

An Australian unit trust structure is a prevalent in-

vestment vehicle when investors predominantly re-

side in Australia. Each investor receives units in the

trust which rank equally among other investors.

Trusts are created by a trust deed or constitution

which outlines the purpose of the trust, rights and

obligations of the trustee and powers of the trustee,

amongst other things.

These unit trusts are generally referred to as man-

aged investment schemes which are subject to cer-

tain regulatory requirements. If you intend to pro-

mote a trust to retail investors then the scheme is

required to be registered with ASIC whereas a

scheme that is only promoted to wholesale inves-

tors is not required to be registered.

Firms licensed to deal solely with wholesale inves-

tors may nevertheless opt to register their scheme

as this serves to demonstrate a commitment to-

wards the more onerous compliance regime. For

registered schemes the trustee is known as a re-

sponsible entity which must be established as a pub-

lic company, have at least three directors and main-

tain certain net tangible assets.

Australian law provides that retail clients must be

provided with enhanced disclosures and consumer

protections. This means that it is very difficult to

obtain an AFS licence that authorises you to deal

with retail clients or operate a registered scheme

unless you are able to demonstrate you have the

skills and experience to comply with these enhanced

obligations.

Offshore investment vehicles are typically estab-

lished as a limited partnership (LP) or a company.

Under the LP structure the investment firm operat-

ing the fund assumes the role of general partner

(usually a limited liability company or LLC) while in-

vestors are limited partners in the sense that they

are only liable for their investment amount. Under

the company structure, a board will have to be ap-

pointed and investors will hold shares in the com-

pany.

Offshore funds are usually domiciled in jurisdictions

to avoid adverse tax consequences for foreign and

tax exempt investors. The Cayman Islands has been

the most popular registration location for a number

of years because:

i. Funds can be established quickly and cost ef-

fectively;

ii. There is an established and stable legal sys-

tem;

iii. There are few obligations on Cayman Islands

Monetary Authority (CIMA) regulated funds

(annual audited financials and Cayman based

administrator); and

iv. There are quality service providers.

Care should be exercised before establishing an off-

shore fund structure. For Australian based manag-

ers, there is a risk that the structure could be

brought within the Australian tax regime due to the

delegation of investment management to an Aus-

tralian entity. Whilst the Federal Government’s In-

vestment Manager Regime may reduce these risks

by providing a regulatory safeharbour, the pre-

conditions to this safeharbour are quite significant.

http://www.cimoney.com.ky/

http://www.cimoney.com.ky/



Page 10 of 24

For example, the offshore fund must be widely held

and not closely held, as defined. The European Un-

ion (EU) Alternative Investment Fund Managers Di-

rective (EU AIFMD) also poses an obstacle for those

wishing to distribute offshore funds in the EU. The

pre-existing exemptions allowing these funds to be

marketed within the EU are being dismantled. To

fall within the EU AIFMD rules requires careful plan-

ning and documentation. There are increased hur-

dles if the manager of the offshore fund is not EU

based.

Pooled vehicles offer greater economies of scale and

investment firms sometimes take advantage of a

master-feeder structure by establishing feeder

funds that comply with specific jurisdictions. These

funds then feed into a larger pool of assets known

as a master fund. Hedge funds in particular take ad-

vantage of master-feeder structures to accommo-

date the tax intricacies of US and non-US investors.

Within the EU, Undertakings for the Collective In-

vestment of Transferable Securities (UCITS) are

popular. This is a public limited company that allows

the investment firm to operate freely across the 28

EU membership states on the basis of an authorisa-

tion from only one member state.

UCITS are more heavily regulated than offshore

funds and there are restrictions on their investment

strategies. UCITS are however exempt from AIFMD

and can be more easily marketed in the EU, espe-

cially for non-EU based managers.

Now back to Australia, a listed investment company

(LIC) is a fund listed on the Australian Securities Ex-

change (ASX) and can be another attractive vehicle

for retail investors. LICs are closed-ended vehicles

as the number of shares on issue is fixed which

tends to allow investment firms to adopt a longer

term investment strategy without being concerned

with fund redemptions.

Separately managed accounts are popular among

institutions and family offices as they are literally

separate from the investment firm while also ex-

pected to perform consistently with the flagship

fund. Investors are able to achieve greater liquidity,

transparency and control as they usually appoint

their own custodian. Some investment firm’s resist

managed accounts due to the additional work asso-

ciated with trade allocations, dealing with multiple

counterparties and client reporting although ignor-

ing these opportunities may be perilous.

http://www.asx.com.au/

http://www.asx.com.au/



Page 11 of 24

Risk & Compliance

Firstly it is important to highlight that risk and com-

pliance are very different. Risk management refers

to a set of processes used to identify and analyse

risks such as operational or financial and the devel-

opment of controls to mitigate or reduce the impact

of the risk transpiring. Compliance on the other

hand is the conforming of certain requirements, for

example law and regulations.

ASIC expect you to identify and address all risks as-

sociated with your business and a risk matrix is the

ideal tool in this regard. A risk matrix is constructed

by assessing the probability of a risk occurring and

the harm this may cause. For example, if a seed in-

vestor was to redeem their funds, this could be cat-

astrophic to the firm however, the likelihood of this

occurring might be considered low if the investor

committed to a lock-up period and/or the seed in-

vestment is now a small portion of your total assets

under management. Once you understand your risks

it is much easier to design controls to mitigate them.

ASIC take the view that unless you have documenta-

tion in place outlining your structure, key processes,

systems and measures you will apply to ensure you

meet all compliance obligations, it will be very diffi-

cult for you to demonstrate compliance.

Developing and maintaining a compliance plan is an

effective way to promote your compliance program

and this ultimately serves to reduce the risk of

breaching obligations, including the Corporations

Act, AFS licence conditions, financial services laws,

industry standards, etc. In the case of registered

schemes, the compliance plan must be audited an-

nually by an external auditor.

Ideally, staff should acknowledge each year that

they have read and understood your compliance

plan and therefore it is important to avoid legal jar-

gon, clearly describe who is responsible for tasks,

the task frequency, specify how tasks will be moni-

tored and by whom. A compliance plan should be a

living document and updated as new rules and regu-

lations are introduced. Alternatively, it should be

reviewed at least annually and endorsed by the

Board to ensure it is integrated into business opera-

tions.

In addition to a compliance plan, internal policies

provide a framework for making decisions or dealing

with certain matters which help to protect the firm,

employees and clients. These typically include a

code of conduct, outsourcing, dispute resolution, IT

protocols, conflicts of interest, soft dollar guidelines,

marketing and personal account dealings to name a

few.

The Anti-Money Laundering and Counter-Terrorism

Financing Act 2006 (AML/CTF Act) requires you to

have an AML/CTF Program when you provide a des-

ignated service such as acquiring or disposing of a

security on behalf of a person. AML/CTF programs

help investment firms identify, mitigate and manage

the risk of their products or services potentially facil-

itating money laundering or terrorism financing.

AML/CTF programs have two key parts. Part A re-

lates to the identification, management and reduc-

tion of AML and CTF risks. Part B addresses custom-

er identification procedures.

http://www.austrac.gov.au/aml_ctf.html

http://www.austrac.gov.au/aml_ctf.html



Page 12 of 24

There is no denying that compliance has added sig-

nificant cost to business and this section could easily

span another 20 pages if we were to discuss other

regulations imposed by ASIC, APRA, the US Securi-

ties & Exchange Commission (SEC), the UK’s Finan-

cial Conduct Authority (FCA) and so on.

Keeping up with regulatory changes and under-

standing how they are relevant to your business can

be daunting so you may wish to consider the ser-

vices of a part-time compliance consultant. Other

ways of keeping informed are by attending industry

forums and asking legal and accounting firms to in-

clude you on their distribution list for free regulato-

ry updates.

Large firms strive to achieve a strong compliance

culture by ensuring clear and consistent communi-

cation and by integrating compliance across the

business. This is equally important in a small firm as

failing to comply may result in fines, court action

and potential withdrawal of your AFS licence. Re-

member, a pilot can’t fly without their licence and

you can’t manage funds without yours.

http://www.sec.gov/

http://www.sec.gov/

http://www.fca.org.uk/

http://www.fca.org.uk/



Page 13 of 24

Insurance

If you are licensed to provide financial services to

retail clients, ASIC require you to maintain adequate

professional indemnity (PI) insurance to compensate

clients for any losses they may suffer if you breach

your obligations under the Corporations Act.

To determine the adequate level of cover, refer to

the ASIC Regulatory Guide 126: Compensation and

insurance arrangements for AFS licensees. From our

experience start-ups tend to seek minimum cover-

age of $5m but it is important to assess your own

requirements. While firms providing financial ser-

vices to wholesale clients are not obliged to main-

tain PI insurance, they often obtain coverage any-

way for peace of mind.

Investment Managers Insurance (IMI) is offered by

some insurance firms and combines PI, Directors

and Officers (D&O) and crime coverage into one pol-

icy cover. D&O insurance serves to protect man-

agement from claims that may arise as a result of

actions or decisions made while conducting regular

duties.

Other insurances such as property (to protect your

property and contents), Worker Compensation (to

protect the firm in the event of an employee work-

place injury) and other policies should be discussed

with your insurance broker.

http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/rg126-20Dec2010.pdf/$file/rg126-20Dec2010.pdf

http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/rg126-20Dec2010.pdf/$file/rg126-20Dec2010.pdf



Page 14 of 24

Service Providers

ASIC expects AFS licensees to have appropriate pro-

cesses in place to ensure service providers are cho-

sen with due skill and care. The ongoing perfor-

mance of a service provider must also be monitored

and any issues are to be dealt with effectively.

Most firms will require a prime broker/custodian,

fund administrator, lawyer, auditor and will proba-

bly also need to consider an outsourced IT provider,

web designer and perhaps a marketing firm. Ap-

pointing service providers that are inexperienced or

have a poor reputation can reflect badly on the im-

age of your firm and therefore you should invest

time and effort to avoid making errors.

Firms often outsource functions that are beyond

their core competencies which is sensible but can

also make it difficult to separate the services of one

provider over another so consider seeking the ser-

vices of a consultant to assist with the process.

Look beyond the polished presentations and com-

pile a list of 20 questions known as a Request for

Proposal (RFP) and ask your preferred 2-3 service

providers to respond. You must also describe your

business, product offering, instruments being trad-

ed, your expected turnover and type of investors,

etc so the prospective service provider can tailor

their responses. Questions are typically aimed at

understanding matters such as:

i. Team structure, experience/qualifications, staff

turnover and ongoing training;

ii. Detailed list and explanation of services of-

fered;

iii. Detailed description of specific tasks such as

the corporate action process or client on-

boarding;

iv. How the provider will service your firm/fund;

v. Will a dedicated account manager be appointed

to look after you?

vi. Differentiating factors of their firm;

vii. Do they use institutional grade technology or

are manual processes rife?

viii. How many clients do they serve and average

length of a relationship?

ix. Additional services offered e.g. capital intro-

duction, technology, discounted office space;

and

x. Costs and timing of key service deliverables.

Before you analyse the RFP responses, build a ma-

trix and assign a weighting to each question as this

simple approach can help you identify the service

provider that ticks the most boxes and is therefore

more likely to satisfy your needs. This method will

also help to ensure you don’t focus entirely on cost

but rather a range of factors.

Also obtain a list of client contacts from each service

provider and meet a few over coffee to understand

the strengths and weaknesses.

Prime Broker / Custodian

The core services provided by a prime broker in-

clude financing, securities lending, custody, trade

clearing and settlement, corporate action processing

and reporting.

Hedge funds generally borrow securities as a means

of facilitating a short sale and therefore the ability of

your chosen prime broker to source the stocks that

enable you to implement your investment strategy

is of ultimate importance. Obtaining a certain de-

gree of leverage may also be critical so understand-

ing the use of margin accounts, swap accounts, risk

offsets and re-hypothecation limits will also be vital.



Page 15 of 24

Since the GFC, major investment bank prime brokers

have become very cautious and it is not unusual for

start-ups with less than $50m in assets under man-

agement to rely on the services of a non-investment

bank prime broking arrangement for their initial 1-2

years or until fund raising efforts gain traction.

Fund Administrator and Unit Registry

Since the Madoff scandal, investors have increasing-

ly demanded that firms appoint a fund administra-

tor to protect their interests.

A fund administrator serves as an independent third

party by reconciling cash and holdings with custodi-

ans, independently pricing holdings at current mar-

ket values, calculating fund income, calculating ex-

penses (including management and performance

fees), payment of fund expenses, preparation of

regular fund accounting reports and net asset values

(NAVs).

In Australia, fund administrators also maintain the

unit holder registry and most importantly manage

the required Anti-Money Laundering / Know Your

Client (AML/KYC) checks when investment funds are

received.

Hedge funds typically appoint specialist fund admin-

istrators whereas firms managing traditional assets

often rely on their custodian to also provide admin-

istration and unit registry services.

Fund Audit & Tax

A reputable audit and tax firm with proven expertise

in your field will provide great comfort to investors

that their work is reliable. Ensuring the creation of

appropriate tax structures and acting as advisor to

on-going tax matters is also critical.

Legal Counsel

Lawyers can assist with the set-up of your manage-

ment company and the creation of fund structures

that comply with the necessary regulation and legis-

lation. AFS licence applications and fund offer doc-

uments tend to inspire greater investor confidence

when prepared by recognised firms.

In practice, it is not uncommon for start-ups to en-

gage legal consultants to draft offer documents and

review agreements before passing these to a top-

tier law firm for final review and sign-off as this can

generate meaningful cost savings.



Page 16 of 24

Investment Operations: In-House Versus Outsourcing

Like with all outsourcing arrangements there are

many pros and cons that need to be considered.

Reduced overheads and the ability to focus on core

activities can be advantageous although you lose

control and flexibility.

Typically the decision whether to build an in-house

operations team or outsource is driven by the com-

plexity of your business, the need for timely data

and your desire to invest in technology as poor sys-

tems and manual processes ultimately lead to errors

which can be costly to your reputation and bank

balance.

Implementing an internal operations function will

require you to deploy specialist software (to be dis-

cussed further in the next section). This software

can be expensive and require resources to imple-

ment effectively whereas outsourced providers tend

to operate established systems that have been tried

and tested by other firms.

The operations function is often described as the

engine room of the firm as it is responsible for run-

ning and managing the day-to-day processes in an

efficient, controlled, risk-free and timely manner.

This internal knowledge is invaluable to your busi-

ness. You can obviously play a key role in the reten-

tion of this knowledge within your firm whereas this

is almost impossible when functions are outsourced.

At the end of the day, there is not one correct ap-

proach. It is best to carefully evaluate your business

desires and then identify the strategy to meet your

needs. It is important to remember that you can

outsource a task/function but you can’t outsource

your responsibility so either way you will still need

to understand what’s happening.



Page 17 of 24

Technology

Appropriate systems are another key component to

a successful investment firm.

Most start-ups simply can’t justify implementing

expensive systems from day one and realistically it

doesn’t really make sense to implement a Rolls

Royce when a Toyota will probably suffice. That is,

until your business becomes profitable and complex

enough to require the additional bells and whistles

that expensive systems offer.

Quantitative funds tend to be more technology sav-

vy compared to most other investors given technol-

ogy plays an important part in their investment pro-

cess. The functionality offered by system vendors

can vary, however we have split technology into 4

core areas:

Portfolio Management

A portfolio management system (PMS) will typically

store trade history, interface with custodians and

fund administrators, prepare cash and position rec-

onciliations, provide automatic corporate action

processing, value positions at end of day and possi-

bly real-time, calculate accruals, calculate NAVs and

enable reports to be customised. A more advanced

PMS may also provide fund accounting, tax report-

ing, greater performance and risk analysis and the

ability to programmatically access data stored in the

system.

Market Data

Depending on the instruments you trade and your

investment approach, you might need access to re-

al-time and/or historic market data such as price,

economic releases, company financials, currencies,

commodities, etc. These systems integrate data

from global sources and deliver the data to your

desktop or mobile device.

Trading

Historically an execution management system (EMS)

was used by a trading team to facilitate direct mar-

ket access (DMA), algorithmic trading and access to

dark pools whereas an order management system

(OMS) provided portfolio modelling, trade alloca-

tions and pre/post trade compliance monitoring.

Over the last several years OMS vendors have ex-

panded functionality to include live market data and

electronic execution so an OMS can now be consid-

ered a more complete package.

Risk Management

Risk systems enable firms to monitor risk on a regu-

lar basis, potentially both pre and post investment

decisions. The type of instruments and markets that

you trade will tend to dictate the type of risk moni-

toring required. For example, you may require Val-

ue-at-Risk (VAR), analysis of Greeks, counterparty

analysis, concentration exposure analysis and liquid-

ity analysis. Some firms implement off-the-shelf sys-

tems whereas others develop their own proprietary

models when risk is a direct input into their invest-

ment process.

Don’t assume the system used by one of your com-

petitors is the right one for you. Otherwise you

might pay for expensive functionality that is not

necessarily required.

As mentioned earlier, start-ups are not expected to

invest in institutional grade technology but rather

ensure their infrastructure is appropriate given the

stage and complexity of their business. It is well

known that businesses need to spend money to

make money in order to remain relevant and tech-

nology can certainly have an enormous bearing on

the attractiveness of your business.



Page 18 of 24

Raising Funds

Initiating a track record with real funds (as opposed

to paper) is imperative to proving that your invest-

ment process and operational framework is effec-

tive. Fund raising is an arduous process that requires

you to plan and set targets along the way. Once you

have developed a plan, we recommend you double

your expected timeframe and halve the anticipated

inflows as this will probably result in a more realistic

outcome.

Common sources of initial funding are:

i. Founders are usually seed investors as this

demonstrates a clear alignment of interests

with other investors and increases the incentive

to achieve strong performance.

ii. Family and friends can be a tremendous source

of capital for start-ups as you will have already

formed close and trusting relationships.

iii. Fund incubators and investment partners can

also provide early stage capital and in some

cases may offer additional services such as op-

erational support, marketing and corporate

governance in exchange for a minority equity

holding in the firm.

It is customary to offer preferential terms to early

investors in the form of reduced management fees

and/or performance fees in exchange for a mini-

mum investment term or lock-up period. These ar-

rangements are usually maintained as a separate

class of units.

Once you have raised some start-up capital you

need to keep your foot on the accelerator by con-

tinuing to meet potential investors and developing

sound relationships with your target audience.

According to the Australian Prudential Regulation

Authority (APRA), Australia’s superannuation pool as

at 31 December 2013 was worth A$1.8 trillion, an

increase of almost 20% on the prior year and a re-

markable A$543 billion of this belongs to self man-

aged super funds (SMSF). Further afield, only the

UK, Japan and the US surpass our market with

US$2.7 trillion, US$3.7 trillion and US$16.85 trillion

respectively, as detailed in the Towers Watson

Global Pensions Asset Study - 2013.

Raising capital from these significant assets pools

(and others) can be challenging yet tremendously

lucrative for your firm if you succeed. Here are a few

ways to tap into these pools:

i. Third party marketing firms promote your

firm/fund to their network of potential inves-

tors. They commonly operate on a monthly

retainer and receive a percentage of fee in-

come from the funds raised. Some third party

marketers prefer to acquire equity in your

firm so that their interests are aligned while

others don’t charge a retainer but expect a

larger cut of your fee income.

ii. Prime brokers can also provide capital intro-

duction services to assist with your marketing

efforts although they tend to expect a mini-

mum 2-3 year track record before they active-

ly engage.

iii. Investment Consultants are the gatekeepers

that stand between investment firms seeking

to raise funds and the large institutions wish-

ing to invest. These consultants act on behalf

of clients and can be highly influential with

regards to investment decisions. Most in-

vestment consultants expect at least a 3 year

track record and are therefore generally re-

http://www.apra.gov.au/Super/Publications/Pages/quarterly-superannuation-performance.aspx

http://www.apra.gov.au/Super/Publications/Pages/quarterly-superannuation-performance.aspx

http://www.towerswatson.com/en-AU/Insights/IC-Types/Survey-Research-Results/2013/01/Global-Pensions-Asset-Study-2013

http://www.towerswatson.com/en-AU/Insights/IC-Types/Survey-Research-Results/2013/01/Global-Pensions-Asset-Study-2013



Page 19 of 24

luctant to invest time investigating start-ups

unless pushed by their client so maintaining

pressure will help to ensure consultants moni-

tor your progress and ultimately provide a rat-

ing for your fund. A positive rating places you

on the radar and boosts your chances of rais-

ing institutional funds.

When you receive an introduction from your mar-

keting firm or prime broker, this will typically start

with a phone call or meeting for a high level chat

about your investment strategy. If you’re lucky, your

firm might get added to a list for further review. Af-

ter 3 months or so, you might get another oppor-

tunity to present your investment process in more

detail and possibly be asked to provide some histor-

ical data for detailed analysis by the potential client.

This phase of discussions may continue for several

months and possibly up to a year or more.

If the investor is still interested, they might com-

mence operational due diligence to further assess

your firm, investment process, operations, compli-

ance etc. Assuming you satisfy all their due dili-

gence requirements, you may then be offered an

opportunity to pitch at the investment committee or

board of trustees which usually meet 4-6 times a

year. By this point, the investor should be close to

making a decision but it only requires one commit-

tee or trustee member to have reservations for the

deal to blow-up in your face.

Family offices are also frequently targeted because

there are fewer bureaucratic hurdles to leap but

these investors rely heavily on relationships and

recommendations from fellow colleagues.

High net worth (HNW) and sophisticated investors

are other avenues to explore particularly if you are

able to tap into the financial advisor network.

Wealth Platforms contain a wide range of investors

with varying risk appetites and can generate a plen-

tiful flow of assets if your firm/fund meets the crite-

ria.

Regardless of your target investor market, be pre-

pared to devote major time establishing and build-

ing relationships. Airport lounges will seem like a

second home and your patience will be constantly

tested while jumping over the countless obstacles

placed in your way. Hopefully though, the process

will be gratifying and fruitful.



Page 20 of 24

Marketing

Obtaining a professional looking company logo can

promote instant recognition of your firm and there

are many online sites now that offer this service at a

reasonable price. Your company branding will also

become essential for all of your documents and

marketing material.

There is no standard approach to marketing alt-

hough we encourage you to invest considerable

time and effort into ensuring the following 3 key

marketing documents are of high quality:

Pitch book

This is usually developed in Microsoft PowerPoint

(or Keynote for the Mac users) and in essence is a

~20 page presentation.

A pitch book serves to describe the firm, biographies

of the team, investment strategy and process, risk

management, trading examples, service providers,

performance history and why you believe the pro-

cess can be successfully repeated throughout all

market cycles. Quite often the pitch book includes

visual aids like flow diagrams, charts and tables as

these help to enhance your message.

Most firms favour walking potential investors

through each slide to ensure their message has been

understood although some investors prefer to ab-

sorb the information in their own time before decid-

ing whether to meet the firm. For this reason, it is

important to ensure the pitch book is comprehen-

sive otherwise essential characteristics will be easily

overlooked.

Although we naturally want to focus on our winning

trades, it is also important to describe some of the

losers as this helps potential investors understand

what you learned and how your risk strategies have

been modified to mitigate future losses. Presenting

a mixed bag of stories can demonstrate how your

process takes advantage of market opportunities,

risk management, hedging and/or leverage tech-

niques.

Developing your pitch book will consume a signifi-

cant amount of time and you need to balance some

of the granular details without overwhelming or

confusing investors. You will probably also find

yourself constantly fine-tuning your pitch book.

One or two page flyer

This is a lighter version of your pitch book and pro-

vides a flavour for your investment offering and ide-

ally promotes a desire to learn more.

Offer Documents

Offer documents formally outline the terms and

conditions of the investment offering including a

description of the various risks and a fee summary.

Offer documents are usually also prepared in a

manner that complies with regulation and/or indus-

try standards so will require a legal and tax sign-off.



Page 21 of 24

Depending upon your investment structure the offer

document might be termed an Information Memo-

randum (or IM for unregistered unit trusts), Product

Disclosure Statement (or PDS for a registered unit

trust), Private Placement Memorandum (or PPM for

LP/LLC structures), Key Investor Information Docu-

ment (or KIID for UCITS), Prospectus (for a listed in-

vestment company (LIC)) or an investment man-

agement agreement in the case of a managed ac-

count.

Other effective ways of marketing your firm include:

Websites are open 24/7 and are a cost effective way

of marketing to attract new clients. Existing clients

can also benefit when fund information and perfor-

mance history is available via a secure login feature

on the website.

Whitepapers can be authored internally or external-

ly and are most effective when the topic relates to

the investment strategy employed by your firm.

Presenting at industry conferences where your au-

dience is likely to include competitors and potential

investors can be a useful way to gain new contacts

and stimulate interest in your firm.

Social media is ubiquitous and has become a power-

ful low-cost medium by which to engage a large au-

dience. Blogging and tweeting allows you to convey

a message to an audience who respect and admire

your work and are likely to promote your words of

wisdom to an even wider audience.

On a separate note, as you work towards expanding

your investor pipeline it would be wise to consider a

Client Relationship Management (CRM) System

which may initially be managed in Excel. A CRM can

be very useful to track your marketing success,

manage your various communication distribution

lists and remind you to follow-up leads. For an add-

ed personal touch, you can also record the preferred

tea/coffee order of your client so that it’s ready up-

on their arrival.

Finally, perception is reality in the world of market-

ing so a professional looking website, pitch book and

offer document can change the way a start-up is

perceived and inspire confidence.



Page 22 of 24

Fees

Domestically there has been substantial pressure

placed on investment firms to reduce fees as indus-

try super funds in particular actively seek to reduce

costs on behalf of members.

Devising an appropriate fee structure is ultimately

achieved by balancing your revenue needs with the

competitiveness of your investment offering. Some

firms successfully charge more than others but gen-

erally speaking 2%/20% is a thing of the past.

A management fee is usually a monthly charge paid

by the investor to the investment manager and is

calculated as a percentage of the NAV. Some insti-

tutional investors believe that investment firms

should charge a management fee sufficient to cover

the operational costs of running their firm.

Performance fees are intended to reward an in-

vestment manager for the performance (or alpha)

they generate above a specified benchmark/hurdle.

Most investors are willing to give up 10%-20% of

their net gains to incentivise the manager when they

outperform which in turn can generate significant

profit to the investment firm.

In order to level the playing field, most firms also

incorporate a high watermark which means the firm

must recover prior losses or underperformance be-

fore they collect any further incentives.

Typically, start-ups impose a 1-3 year lock-up com-

mitment to prevent investors from redeeming until

after a specified period. This allows time for the

start-up to properly implement their investment

strategy but also secures a certain level of manage-

ment fee income which is critical to their financial

survival. More established firms also seek to impose

lock-ups but investors may resist.

Investors can still redeem before the expiration of

the lock-up but, the firm would be entitled to levy a

specified exit fee. The fund directors have the power

to waive the fee at their discretion. In September

2011 the Supreme Court ruled that Military Super-

annuation and Benefits Scheme were required to

pay a 5% exit fee for redeeming $150m from the

Agora Absolute Return Fund II so it cannot always be

assumed that the fee will be waived.

Some firms specify in their offer documents that the

management company will pay for certain fund re-

lated expenses such as fund administration, audit,

tax, legal, etc and in these cases it is not uncommon

for the manager to levy an administration fee to

contribute towards fund expenses.

When operating pooled investment vehicles it is

also common to charge a buy/sell spread to contrib-

ute towards transaction costs associated with the

buying/selling required for applications and with-

drawals. Thus buy/sell spreads are for the benefit of

investors rather than the firm.

You should also consider your redemption terms.

Depending on your investor base, clients may re-

quire daily liquidity otherwise hedge funds typically

permit redemptions following 30-90 days notice

which allows sufficient time to raise cash to fund

withdrawals.



Page 23 of 24

Investor Reporting

You can expect investors to demand a newsletter

outlining your performance each month. Generally

those investing into an existing fund will receive the

same material as all other investors unless they in-

vest via a separately managed account in which case

the investment terms may stipulate additional re-

porting.

Hedge funds have traditionally been accused of lack-

ing transparency although pressure from institu-

tional investors has led to greater transparency. In

addition to reporting fund and benchmark perfor-

mance, investment firms are increasingly providing

additional information to investors such as, top

holdings, top/bottom contributors, long/short/net/

gross exposures, the use of derivatives, risk statistics

and a detailed commentary describing the prior pe-

riod and future outlook.

The Global Investment Performance Standards

(GIPS) outline the best practices for calculating and

presenting investment performance although in

Australia start-ups tend not to follow these due to

the lack of performance history and adequate sys-

tems.

Open Protocol Enabling Risk Aggregation (OPERA) is

an industry initiative to standardise the reporting of

hedge fund exposure and risk information. Many

large international firms are supporting the initiative

and a handful of software vendors have already de-

veloped reports to comply with the OPERA require-

ments so you can expect this initiate to rise.

Most firms aim to find a reasonable balance be-

tween minimal information and complete transpar-

ency otherwise the administrative burden becomes

too great. It is also important to verify the contents

before you distribute your newsletter and ensure it

contains the appropriate disclaimers.

http://www.gipsstandards.org/Pages/index.aspx

http://www.theopenprotocol.org/top/home



Page 24 of 24

Due Diligence

Due diligence is the process whereby potential in-

vestors seek to gain a comprehensive understanding

of your firm and investment proposition. The 2 main

due diligence practices are Investment Due Dili-

gence (IDD) which focuses entirely on your invest-

ment process and Operational Due Diligence (ODD)

which focuses on all non-investment matters.

Due diligence has become a key component of an

investor’s decision making process and they will

walk away if unsatisfied. Despite the greater focus,

the information gathering process can seem ineffi-

cient.

Some investment firms attempt to streamline the

process by using virtual data rooms. Once you have

granted on-line access to your virtual data room, the

potential investor can download your documenta-

tion as opposed to you feeding the information. This

approach helps to demonstrate transparency alt-

hough on the flipside you need to ensure the con-

tent remains current.

Inconsistent questioning can also be a source of

frustration and to this end The Alternative Invest-

ment Management Association (AIMA) and Financial

Services Council (FSC) have developed a standard

investment management questionnaire for invest-

ment firms.

The due diligence process involves a questionnaire,

supporting documentation, on-site interviews with

key staff, a demonstration of certain tasks, refer-

ence and background checks of key staff and intro-

ductions to service providers. Some of the investiga-

tion areas will include:

Firm: Ownership structure, financials, insurance ar-

rangements and board minutes.

Staff: Bios, qualifications, compensation structure

and leaving notice periods.

Investment: Legal structure, offer documents, risks,

fees, valuation methods.

Operations: Segregation of duties, demonstration of

trade confirmations and automatic trade alloca-

tions, daily reconciliations and the age of outstand-

ing items, adequate resourcing, NAV calculations,

collateral management, cash transfers.

Service providers: Legal agreements, process docu-

menting how/why the service provider was ap-

pointed and evidence of on-going monitoring.

Compliance: Compliance manual and internal poli-

cies, copy of your AFS licence, details of any author-

ised representatives, breach register, procedures,

pre & post trade monitoring, committee minutes,

AML/KYC and corporate/fund governance.

Performance: Track record, attribution, liquidity

management, counterparty management, portfo-

lio/market risk reporting.

Technology: Determine adequate/recognised soft-

ware or the extent to which the firm relies on Excel.

Also data protection, network backups, virus protec-

tion and BCP/DRP are covered.

Due diligence can be intrusive and much of the in-

formation may be considered confidential so you

may wish to consider executing a Non Disclosure

Agreement (NDA) with the potential investor.

http://www.aima-australia.org/

http://www.aima-australia.org/

http://www.fsc.org.au/standards-guidance/the-investment-management-questionnaire.aspx

http://www.fsc.org.au/standards-guidance/the-investment-management-questionnaire.aspx