In what follows, we explain how setting up your own hedge fund is less daunting and expensive than often assumed, and can be done in a week.
Michael Lewis’ book The Big Short and the movie it is based upon became instant classics.
The main hero of the story is Michael Burry, an outsider who places high-conviction bets with the small fund he runs from his basement. He shows how anybody can be right, alone, against the world, despite — or perhaps because of — being shunned from the big boys’ table on Wall Street.
Many of our clients trade crypto but don’t have a vehicle to express their views. A subset is coders who have developed proprietary algorithms for systematic trading, which show very encouraging results.
What they don’t have is meaningful amounts of capital of their own. At what point is setting up a fund to attract outside investors worth the expense?
We’d say if (1) you got some verifiable track record — even if only in an exchange account held in your personal name — and (2) you’re ready to seriously dedicate yourself to managing outside money. Both will go a long way in persuading outside investors to give you capital to deploy.
Investors break down the risks of farming out money into investment risk and infrastructure risk.
Investment risk comes from being exposed to the market and the manager’s strategy.
An investor who decides to stay passive, e.g., by just holding BTC, still takes market risk. An investor who allocates capital to you will add active portfolio management risk — even if you run a risk-neutral strategy. That risks could come, e.g., from your algos not performing as expected, your risk management blowing up, or even a fat finger order entry mistake.
Investors, therefore, will want comfort about your strategy, which will include how it performed in the past, your team and their roles, your risk management policies etc.
The second risk comes from your setup. This infrastructure risk includes where you decided to set up your fund, who you custody with, who is your fund admin, and who did the legal work.
Here, investors will want to see two things: a stable of recognizable names, e.g., custodians, legal counsel, and fund admin, and best practices, i.e., a structure they recognize. Crypto is already a new asset class, therefore adding an innovative structure may scare off investors. Better stick to tried and tested.
In what follows, we’ll break down the main infrastructure risks, list solutions we know to be working, and share ways you can save money.
Take it until you rake it
Before we dive in, let’s talk money first.
For many aspiring managers, whether or not to set up a fund may be a simple matter of budget. But how much do you need?
The good news is that many service providers will take it that they don’t get paid until you rake the money in and can share in your fees.
As a result, the upfront expense can be drastically reduced. Count about USD 5k to incorporate the actual vehicle and 15k — 18k for the fund’s legal documentation.
On the latter, here are some dumb things we’ve seen people do:
- If you don’t have the budget, don’t go with some snooty white-shoe counsel who does not come out of bed for less than 50k: some legal firms only deal with the Blackstones and Goldmans of this world and can afford to say no to penniless clients. For what you need, second-tier counsel will do.
- Don’t let counsel tell you that your setup is unique, and their template documents won’t be relevant: they’ve used the same set of documents many times over, and there are only that many variables in a setup. We all know that after your initial call with the partner, a low-level associate will pretty much press “print screen” to generate your suite of documents with your fund’s name slotted in. That should not cost 40k.
- What will cost 40k or more is if you use billable hours to educate yourself about the basics of a fund setup. We have seen clients eat through their entire legal budget by asking questions they could have googled (or got the answers from us for free!). Instead of clocking up time to get a Hedge Fund Structures 101 course from a-thousand-dollars-an-hour Partner at a legal firm, you could spend some time reading up and save yourself five figures.
A. The Typical Setup
To get you started, we put together the diagram of a typical hedge fund setup, which we’ll use as a guide for the discussion to follow. We will use the Cayman setup as a reference as over 85% of the world’s hedge funds are incorporated there:
1. The Fund
The Cayman open-end fund is typically set up as a limited company with variable capital. This company form lends itself ideally to issue shares as more investors come in and buy back shares when they redeem.
In contrast with a VC fund, this liquid fund structure has no closing at a pre-determined size (hence “open-end”), and no defined investment horizon or “vintage.”
Instead, investors subscribe by continually purchasing shares from the fund company and redeeming shares back to it at Net Asset Value (“NAV”), which is calculated at regular intervals to coincide with the fund’s subscription and redemption windows. This typically happens quarterly but for crypto funds also monthly or even daily). This NAV is, in essence, your fund’s share price and captures the capital gains (if any) of the fund minus the management and performance fees you charge.
This setup optimally caters to positions in liquid assets, including crypto assets. However, the structure also allows for non-core allocations to illiquid assets, including stakes in private companies or illiquid tokens, and even a buffer of good old fiat.
2. The Investment Advisor (“IA”)
Top right in the diagram above is the entity that provides the “brain” to the fund, advising what to invest in.
The IA is generally based in one of the world’s financial centers, e.g., New York or London, where it is fun to spend one’s money, but as such, this is not a requirement.
What clients too often overlook and/or underestimate is that typically the IA will need a local license to manage money on behalf of third-party investors. Such a license may be expensive and may take a long time to acquire, but there are hacks, e.g., a license can be borrowed for an initial period from another licensed entity until the fund applies for its own.
The Fund contracts directly with the IA under an Investment Advisory Agreement (IMA), which is one of the key documents in the legal suite. This IMA is essentially a mandate to the IA to take the investment decisions over the fund’s assets.
3. Third-Party Service Providers
In addition to the IMA, the fund will have to enter into agreements with third-party service providers who will assist with the administration of investor subscriptions and redemptions, calculation of the fund’s NAV, custody of its assets, etc. Each of these third-party service providers contracts directly with the fund, and their fee is paid out of the fund’s AUM.
The three key service providers to the fund are the Fund Administrator (“fund admin”), the fund’s custodian, and its accountants/auditors.
The fund admin
The fund admin’s primary role is to handle the onboarding of subscribers, including KYC/AML checks, and to provide an independent source for the calculation of the fund’s Net Asset Value (“NAV”). The fund admin’s overall functions include ongoing services such as:
- Maintaining the accounting records for the fund including general ledger and original books of entry;
- Maintaining shareholder capital accounts;
- Maintaining shareholder information, including tax and contact information;
- Calculating distributions from the fund;
- Calculating management fees and other contractual fees;
- Preparing quarterly account statements for the fund;
- Calculating year-to-date and life of fund internal rates of return (IRR);
- Distributing financial statements, account statements, etc. to investors;
- Maintaining an online reporting portal.
Also, the fund admin’s year-end services include:
- Audit liaison for the year-end audit process for the fund
- Handle any accounting-related questions from investors.
- Distribute audited financial statements and tax information.
- Complete audit confirmations for investors.
A fund admin would typically charge a capped monthly fee up to a determined level of assets under management (“AUM”) for its services, with basis points (bps) share in the AUM when the fund reaches a certain size.
This may be your saving grace since their fees only kick in once you’re up and running. From what we’ve seen, fund admin fees range between USD 2,500–5,000 a month for a medium-size fund up to USD 50mm. Once the fund grows in size, expect the basis points to be in the low teens.
Note that as of today, only a select number of fund admins take on crypto hedge funds clients. Fewer still will let you take subscriptions from investors in crypto, since they perceive the compliance risks to be higher — even though the technology for whitelisting crypto investors online is much more robust than the analog process!
Eventually, smart contracts and blockchain should be able to replace a lot of what the fund admin does at a much lower cost.
Custodian and accountants/auditors
As with the fund admin, only a few custodians specialize in crypto hedge funds; however, the number is growing steadily. Also, some legacy players like Fidelity are now carving out a name for themselves in the digital asset space.
As mentioned earlier, investors will expect you to work with recognized players, either boutiques that specialize in the custody of crypto assets or established players that branch into this new space.
In this context, self-custody is a total no go, as is the lack of outside accountants and auditors to the fund. At least some lessons from the Madoff scandal have percolated into the crypto space!
Expect to pay high single-digit bps sharing in your AUM to your custodian. Auditor fees are typically high (into the 20k) since the big four accounting firms abuse their dominant position. We recommend going with a second-tier name until you rake in the assets.
4. Performance fee vehicle
The above diagram is a simplified structure. More convoluted setups sometimes have a Cayman-based AI, which in turn, sub-contracts with a sub-advisor based outside Cayman. A myriad extra entity can be added, typically for tax planning purposes. We usually recommend clients not to optimize for tax from day one and rather rejig their structure once performance fees start kicking in.
Performance fees are where the juice comes from. Management fees (typically 2%) typically only cover the AI’s overheads like office and staff in high-cost centers. The performance fees are what may propel you into the three comma club of hedge fund billionaires if you do well.
Therefore, we do think it is essential to have a Performance Fee Vehicle in place from day one to optimize not just for tax but also to have the flexibility of how the performance fees are paid out. Most likely, your investment team will be promised a share of the performance they contributed to the fund. When paid out to a Performance Fee Vehicle, fees can then flexibly be redistributed by way of dividends out of the company or partnership payouts.
In both cases, you want to use an offshore entity and then let the shareholders or partners in that entity deal with their respective tax at the personal income level. Often, they use a company to hold their shares in the Performance Fee Vehicle.
If initially, you are the only portfolio manager, performance fees will go integrally to you. Still, you want to make sure you have a vehicle in place to receive them when your fund makes its quarterly payout.
B. Fund Registration and Regulations
The above structure reflects the typical Cayman setup. Other jurisdictions will be similar; however, the regulations and tax may be very different.
1. Why Cayman
From our comparison, Cayman remains the jurisdiction of choice for a credible fund setup, despite new kids on the block like Singapore and perpetual contenders such as Luxembourg or Mauritius:
- The Cayman Islands remain the uncontested leader for fund domiciles: on best estimates, over 85% of the world’s hedge funds (and VC and PE funds) are registered there. At the end of 2017, there was $3.5 trillion in net assets under management in close to 11,000 registered funds on Cayman.
- There is excellent infrastructure in the Cayman Islands compared to lesser jurisdictions: There are 106 fund administrators, 48 fund auditors, and 35 law firms who all specialize in fund work. Most are legacy players, but some have started to build crypto capacity, which they then subcontract to their other offices outside Cayman.
- As a result, most investors you pitch should be familiar with a Cayman setup and will be comfortable subscribing to a Cayman fund, either directly or — in the case for US-based investors — via a master-feeder structure (see below).
2. Light regs allow for quick setup
Like most Cayman hedge funds, your fund would be an “exempted fund” under Section 4(4) of the Mutual Funds Law (2015 Revision).
Such funds do not need to appoint a Cayman-based manager and fund administrator and are not subject to registration with the Cayman Islands Monetary Authority (CIMA).
The regulatory regime for an Exempted Fund is light compared to “registered funds.” They are exempt from notification to CIMA regarding certain changes in their offering particulars and are not required to file a Fund Annual Return along with audited financial statements.
On the other hand, an Exempted Fund cannot have more than 15 investors, the majority of whom should be capable of appointing or removing the operator (i.e., the directors).
However, most of these restrictions can be structured away. For instance, CIMA does not look through the number of shareholders in a feeder entity but instead treats it as one investor. So as part of your 15 investor cap, you can have several feeders with thousands of investors each.
Please note that the light-touch regime for 4(4) Funds is changing with new requirements set to kick in by August this year. However, here’s a hack: a single-investor fund — this could be a single feeder! — would still be benefiting from the light-touch 4(4) regime.
As draft regs currently stand, the new requirements do not look overly burdensome. For instance, funds located in Cayman will remain entirely unrestricted in the type of assets they invest in or what strategies they pursue. Such a strategy will be wholly defined by the fund’s private placement memorandum and legal documents, which is what we will be discussing next.
3. The fund documents
The first step in your setup is to form the actual fund entity. This is, in many ways, a standard limited company with a specialized operating agreement.
These “Articles” form part of the wider suite of investor and operational documents required to raise money for the fund and operate it day-to-day, which includes:
- Offering memorandum;
- Subscription agreement;
- Certified copy of Certificate of Incorporation/Registration;
- Constitutional documents (Memorandum and Articles of Association of the limited company);
- Investment management agreement;
- Administration agreement;
- Prime brokerage/custodian agreement;
- Organizational and directors’ resolutions.
This is where your initial legal spend will go, and it is the major fixed cost in setting up a hedge fund — or any type of fund for that matter.
However, it is accepted practice that fixed setup costs are paid back to you as sponsor out of the fund’s initial assets. To make it fair to early investors, these costs are then amortized over the first year of the fund.
4. Feeder entity
We referred to feeder entities above. They are special entities that funnel subscriptions into the “master” fund, and they are typically set up in a jurisdiction that is different from that master fund. Subscription monies at the feeder level get bundled, and the feeder, in turn, becomes a subscriber in the master for the aggregate amount.
To get started and attract seed investment for your fund, no feeder should be required.
However, when we help clients set up their fund, we make sure that their fund documents come standards with feeder “ports,” which allows for an instant master-feeder setup. Think of this port as a USB plug, which allows seamless connection with feeders if and when they are put in place. This helps avoid expensive reverse-engineering.
For funds that cater to US investors, mainly for US tax reasons, there will always be a feeder, typically a Delaware LLC that offers shares on a private placement basis.
So if you plan to tap into a US investor base, you will need to add US counsel fees to your legal spend since all subscriptions and offering documents will have to be duplicated at the LLC level. However, there is a 90% commonality between feeder setups, so we are typically able to cap fees with counsel we work with at around 15k.
An eventual second feeder could be a Europe-domiciled company, e.g., in Ireland or Luxembourg, to accommodate European investors who cannot subscribe directly to shares in an offshore entity, typically as a result of restrictions in their investment mandate. Asian investors, however, typically subscribe directly at the Cayman level.
C. The Economics
The economics of a hedge fund deserves a separate post as there are a lot of moving parts.
Here, we limit our discussion to three key areas where we have seen a lot of mistakes being made and which can become a matter of dead or alive for your fund: (1) the level of fees, (2) how performance fees are defined, and (3) the redemption notices and window. We close this chapter with some thoughts on tokenization of the fund’s shares or issuing tokens that give token holders the same economic rights as direct subscribers.
1. Level of fees
This is delicate. Here are some pointers:
- Investors are typically not buying the narrative that because crypto is a new asset class, higher fees can be justified, at least not until you have proven yourself as an outstanding manager.
- Legacy hedge fund fees, too, have come under pressure in the least years, with the standard 2% management fee and 20% performance fee negotiated down. Besides, seasoned traders who recently started their fund have to content themselves with lower initial seed money.
- You will typically only have a very short track record if any. Most likely, it will be a non-audited Excel spreadsheet showing transactions from your Coinbase or Kraken account together with some back-tested results. Hence you may have to be flexible on initial fees or rebate early investors.
2. Performance fee calculation
Your performance fee in itself is a meaningless number unless you indicate how you calculate it.
If you charge, say, 20% on absolute performance, then only when you have a down month or quarter will you *not* be able to charge your investors performance fees. This makes your 20% performance fee look high.
By contrast, if you only charge fees on outperformance over some previous performance record (the so-called “high-water mark”), you can go fee-less for a long time until you do better than your past record. This can come back to bite you, and some stellar funds have died as a result.
However, investors like high water marks since they don’t have to pay you when you “climb out of a through,” a scenario in which you lost them say 40% in one quarter and charge them performance fees while you’re making your way back over the next quarters.
Instead of a high-water mark, we typically ask clients to consider a hurdle rate. This is simply a rate of return over a defined period (typically a quarter), below which no performance fees can be charged. For example, if you expect a passive BTC holding to return 20% over the year and use that as your hurdle rate, you would only be able to collect quarterly performance fees on returns that exceed 5% per quarter.
In summary, fees require careful consideration, and it is good to pulse with your early investors what they’d accept.
The same applies to redemption notices and terms, something investors have discovered can work to their detriment when markets seize up.
As a money manager, you want to be able to hold on to people’s money as long as you can to avoid fickle investors, a.k.a “hot money” that jumps ship as soon as you show some underperformance.
Investors, however, want liquidity: ideally, they want to be able to get their money back at short notice.
It is these two interests that need balancing, and this balance is reflected in redemption notices and, secondarily, gating, and side-pockets.
Most crypto hedge funds have monthly instead of quarterly redemption notices, on the basis that the fund’s positions are all assumed to be liquid. If, say, you require an investor to give you notice latest by end July to come out of the fund on 1 September (minimum 30 days), you should have enough time to adjust and rebalance your fund.
Still, if that investor holds 40% of your fund’s AUM and wants out, good assets will have to be sold to meet this massive redemption request. This will impact other investors, possibly leading to a downward spiral. Some funds, therefore, “gate” redemptions by imposing a limit on how much any single investor can redeem per notice. Investors typically frown upon such gates, but most funds have them.
More frowned upon still is when the fund documents allow for “side-pockets”: assets that the fund manager can declare illiquid or hard-to-value (e.g., when markets are in free-fall or seize up) and that are held in a separate account. Existing investors usually cannot ask for liquidation of such side-pocket. They may only get their money back after all assets have been sold, and the proceeds disbursed, effectively denying them their redemption right.
As a general point, it will be more difficult for you as a crypto hedge fund manager to justify long redemption notices, gating, and side-pockets than in the traditional hedge fund space: crypto is all about tokenizing everything to create new markets. Liquidity and ease of transferability are touted as one of the main advantages of such tokenization. This creates the expectation with investors that they can easily trade in and out of crypto funds, and traditional redemption terms may be controversial.
4. Should you tokenize your fund?
Before we conclude, some observations on tokenization.
We have seen that most of our clients who initially considered tokenizing the shares of their fund— or create a token that gives exposure to their fund’s net performance —ultimately decided against.
Whilst technologically doable and intellectually appealing, tokenization is not trivial from a commercial and operational point of view and on the whole may act as a complexifier.
First, we are not convinced that giving investors extreme exit rights will benefit the fund as a whole and is in the best interest of the manager.
Second, we are not sure if, in this early stage of crypto investing, investors demand or even expect a token to represent their ownership in a fund. This may change as the space develops and institutional investors become more familiar with the use of digital wallets, but unless you think your fundraiser will benefit from tokenization, why bother?
That said, accepting crypto as a means of payment for investor subscriptions makes total sense. However, this is simply an alternative or additional payment facility you give your investors, not a token.
Finally, you may want to be careful what you wish for when spinning up a token. Once it is traded on the secondary market, your token will start leading its own life and show its own price. This price may have a disconnect with your fund’s NAV and may attract hyper-speculation.
On balance, as a fund manager, tokenization may be more distractive than accretive. For investors, it may discourage them from subscribing directly to your fund and seeking indirect exposure instead via a tradable token.
If one day we will use a token to gain exposure to the performance of an investment fund, let it be the day we have transformed the way we pool capital in the first place and smart-contractified how such pooling is governed. That day may still be some time away.
Until then, we expect investors to seek the safety of the familiar, even when they seek exposure to the very asset class that will ultimately change everything!
Invest when everything is depressed
If John Templeton’s famous aphorism to “invest when everything is depressed” is true, now may well be the best time to gear up to deploy capital.
A fund vehicle is the sports gear of the investment pro. Without a fund, your trading remains a chess game against yourself, your track record unacknowledged, your ammunition limited.
Every private banker we speak with tells us their client is looking to put some money into crypto, but they lack investment-grade instruments.
If you’ve been trading crypto over the last years, you already have an edge over a myriad of legacy investment managers in traditional asset classes. What they have and you don’t is a fund.
With this in mind, we hope this posting helps lower your threshold towards setting up your own fund as the natural next step. Do look us up when you’re ready to take it!