Hedge Fund Launch: The Due Diligence and Operations Perspective
To help emerging hedge fund managers we are running a 6-week Hedge Fund Launch Webinar Series. This week we were joined by Frank Napolitani, Director, Financial Services at EisnerAmper. During the 30-minute interview, Frank shared insights on the benefits of outsourcing to service providers as well as advice on how to conduct proper due diligence on front, middle, and back office operations.
The Learning Curve
“There is a learning curve to get your hands around what it takes to run a business,” Frank began. Often, he said, a portfolio manager that has left a larger hedge fund complex or investment bank knows perfectly how to run a book, but has little knowledge about how to run a business. The smartest managers, Frank said, are the ones who “sit back, listen, and consult a number of different service providers in the space before moving forward.”
He went on to note that the operational due diligence (ODD) industry has grown dramatically post-Madoff. While a manager’s pedigree, investment process, and performance used to take precedence, it is now front, middle, and back office operations plus legal compliance that are most important.
Frank warned: “Keep everything up to date.” Sophisticated investors will follow up quarterly, twice a year, or annually. Because they collaborate with many ODD teams, research teams will immediately have a feel for what is right and what is wrong with a manager from a front, middle, and back office perspective. “They won’t waste too much time on someone they won’t seriously invest in,” Frank concluded.
Criteria to Consider When Selecting a Service Provider
Given the importance of outsourcing from an investor perspective, service provider selection must be carried out carefully. Frank listed a number of criteria in selecting quality service:
Brand Recognition – There are managers of all shapes, sizes, and strategies. Find the best fit.
Knowledge and Experience in Investment Strategy – Can they do bank debt, trade claims, etc.?
Partner Interactions/Employee Turnover – You do not want to continually have a new team to bring up-to-speed on a new strategy.
Breadth of Services – Can they provide audit and tax services under one umbrella or compliance and technology services?
Client Base – What are the size of the funds? How does it break down between emerging, maturing, and large bracket firms?
Strategies - Is it only long short equity? Only credit?
Years in Business/Industry
Size Matters in Designing Operations
Frank acknowledged that the operational pattern for startup hedge funds will vary. The differentiating factor, he explains, is AUM, and in turn the number of employees and the portion of labor that is outsourced versus internalized. Larger launches, perhaps those with more than $100 million, will typically have an in-house CIO, 2-4 analysts, a CFO/CCO, head of operations, controller, and an executive assistant. OMS, EMS, PMS, middle office software, and IT will all likely be outsourced.
Comparatively, a smaller launch, one with less than $100 million in AUM, may have a CIO/founder and up to 2 analysts, outsourcing everything else. These firms will rely heavily on their prime broker and administrator for real-time reports, EMS and OMS for trade execution, and in some cases IT.
Frank noted, however, that “even though a function might be outsourced, someone at the firm is responsible for the oversight and delivery of that function internally.”
A Hedge Fund Launch Timeline
Following are three elements that were identified as having the potential to impact a fund’s launch timeline:
A seed deal with an institutional investor: The negotiation of operational agreements for general partner and/or management company entities can take anywhere from 3-6 months
Fund structure: Is it a domestic LP or full blown master feeder structure with onshore offshore feeders and an offshore master?
Size of organization: This will determine whether an organization launches in a hedge fund hotel or rents their own office space.
Frank described a typical launch time as 4-6 months.