How to Start a Hedge Fund in the U.S.

Starting a hedge fund requires more than just an impressive track record of consistently beating the market. There are registration and regulatory requirements that you’re expected to meet to ensure your fund is operating legally. You’ll also need sufficient capital and a strong support team to help pull it all together. If you’re interested in starting a hedge fund in the U.S., here are some specific steps you’ll need to follow.

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Understanding Hedge Funds

A hedge fund is a privately offered investment that pools funds from multiple investors with the goal of delivering maximum returns. Hedge funds are similar to mutual funds, but they’re exempt from certain registration requirements that are outlined in the Securities Act of 1933 and the Investment Company Act of 1940.

While mutual funds may center investment strategies on stocks or bonds, hedge funds can take a broader approach. For instance, in addition to or in place of stocks, a hedge fund might invest in real estate or land, foreign currencies, commodities or derivatives. A hedge fund manager is responsible for directing fund investments.

Hedge fund managers have the potential to collect substantial fees for their efforts. A typical hedge fund management fee is 2% of assets under management (AUM). Hedge fund managers can also collect a separate performance fee that’s equal to a percentage of the fund’s profits. The larger the fund the more lucrative it can be for the fund manager.

Hedge Fund Investment Strategies

Before diving into the specifics of how to start a hedge fund on paper, it’s important to consider what the fund’s investment strategy will be. Your strategy will determine how the hedge fund drives returns.

There are different ways to categorize hedge fund strategies, based on the investments they target. Some of the most common groupings include:

Equity strategies
Event-driven strategies
Relative value strategies
Credit strategies
Macro and managed futures
Niche strategies

You can further differentiate between strategies within each category. For example, if you’re interested in developing an equity fund, you might choose to focus exclusively on value-oriented investments or take a market-neutral approach.

Fleshing out your investment strategy first is important for developing your broader business plan. Your strategy needs to be workable as well as scalable so that your fund has the best chances of long-term success and sustainability.

How to Start a Hedge Fund in the U.S.

Once you have your investment strategy down, you can take the following steps to start a hedge fund. Here’s what you’ll need to do, regardless of what your investment plans are:

Incorporate

A typical hedge fund structure requires one business entity for the fund itself and a separate entity for the hedge fund manager. For instance, you may use a limited partnership (LP) structure, in which the hedge fund manager is a general partner and fund investors are limited partners. You may also choose a limited liability company (LLC) structure for your hedge fund.

Once you’ve decided on a business structure, you’ll need to register with the secretary of state and file articles of incorporation. You’ll also need to apply for a federal employer identification number (EIN) with the IRS. This number is used to identify your business for tax purposes. You can apply for an EIN online through the IRS website.

Register With Regulatory Agencies

After incorporation, you’ll need to register your hedge fund with the proper regulatory agencies. That includes the Securities and Exchange Commission (SEC) and state regulators.

First, you and any representatives of the hedge fund will need to register as an investment advisor. Registered investment advisors must complete and pass the Series 65 exam. As an RIA, you have a fiduciary duty to your clients that requires you to always act in their best interests.

Once you’ve obtained RIA registration, you’ll still need to register the hedge fund itself. To do that, you’ll need to complete SEC Form D for each state where you plan to offer the fund. This form, which includes details about the fund’s partners, investors and investment strategy, must be filed online using the SEC’s Electronic Data Gathering, Analysis and Retrieval (EDGAR) system.

Draft an Investment Agreement

Your investment agreement outlines various aspects of the hedge fund and how it will operate. For example, some of the items that should be covered here include the duties and responsibilities of the fund manager, the fund’s fees and expenses and the processes that will be used for reporting information about fund investments.

This document can end up being quite complex, so you may want to seek the help of an attorney in drafting one. A hedge fund attorney should have the necessary knowledge and expertise to assist you in creating an investment agreement, and they may also be able to help with other aspects of the startup process.

Develop Your Marketing Strategy

For any hedge fund to be successful, it requires capital. To get that capital, you’ll need to be able to effectively market the fund to prospective investors.

Rule 506 of Regulation D allows hedge funds to market to an unlimited number of accredited investors, as well as a limited number of non-accredited investors who can demonstrate that they possess sufficient knowledge and experience to invest. You’ll need to familiarize yourself with the SEC rules for accepting non-accredited investors if you plan to open the fund up to them.

There are also SEC rules regarding how you can market and what you can say to investors. For example, you’re prohibited from providing any misleading or false information as a matter of course. Any documentation that you provide to accredited investors, such as financial statements, must also be made available to non-accredited investors.

Again, a hedge fund attorney can help you navigate the legalities of marketing your fund in a way that’s compliant with SEC guidelines.

Build Out Your Team

A hedge fund is not a one-person show and it’s important to have the right support in place to keep things running smoothly. For instance, you’ll need a prime brokerage to facilitate the most essential activities of the fund, such as trading securities. Portfolio managers and research analysts are also integral in executing the fund’s objectives.

On the back office side, you’ll need staff who can handle compliance, accounting, day-to-day operations and IT tasks. Filling in those roles can ensure that there are minimal hiccups once the fund is officially ready to launch.

Bottom Line

Having an overview of how to start a hedge fund can give you an idea of what you expect should you decide to take that step. Talking to other advisors who have started a hedge fund can offer additional perspective on the pros and cons, which could make it easier to decide if it might be right for you. While hedge funds have the potential to be highly lucrative, it’s important to understand the full scope of what’s involved.

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Starting an RIA firm is something you might consider if you’d like to operate your own business, but it can require a significant amount of time and capital. If you’d like to advise clients without having to jump through all the hoops of launching your own firm, you might choose to work with an RIA aggregator instead. Partnering with an aggregator can offer access to turnkey solutions while allowing you to focus on serving your client base.