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Getting Started In The Glamorous World Of Hedge Funds!

Dec 21 2013, 12:06pm CST | by

Getting Started In The Glamorous World Of Hedge Funds!
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A surprisingly wide cross-section of individuals and organisations establish and manage hedge funds, private equity funds and other alternative investment vehicles. Leading investment professionals often leave successful merchant banks, investment management firms and other financial institutions in pursuit of the increased investment flexibility and higher rewards that can be gained from independence and entrepreneurship. No one likes seeing perfectly good talent walk out the door, though. Increasingly, traditional fund management firms have also entered the frame, either by establishing their own range of alternative investment funds or by joint venturing with independent firms.

But who are these men and women who decide to leave the security of large firms and set up on their own?

It would be a careless mistake to simply categorize hedge fund managers and private equity professionals as just the same as anyone else working on Wall Street or in the City of London. There are significant differences between an investment banker or a stockbroker on the one hand, and the men and women who establish and run alternative investment firms. These distinctions stem from the structure and operation of private equity and hedge funds, and need to be recognized in order to understand how these firms operate both internally and in the financial markets as a whole.

Private equity and hedge funds tend to be entrepreneurial businesses that are established as new and independent ventures. The process of launching a new fund is a complicated and risky process, as is the start of any new business. Whenever individuals trade certainty for uncertainty, there will be a lot of concerns and fears and doubts. All must be addressed. This process will inevitably draw out a number of issues concerning the future structure and operation of the fund management firm, as well as the proposed fund, including allocation of economic rewards (such as carried interest or performance fees) among team members; succession issues for senior team members; and documenting and calculating track records.

The same issues that drive fund structuring – pass-through taxation and limited liability – are also of importance when structuring the new fund management business. To the extent feasible, individuals providing the investment advice through the fund manager will seek to escape double taxation of their performance fee allocation and to receive as beneficial a treatment of these payments as possible. Equally, these individuals will want to ensure that they are protected from any claims against the fund manager, whether from the fund itself or from other third party creditors.

A key distinction between alternative investment funds and much of the rest of Wall Street is the relationship between a fund and its fund manager. This relationship is an important one that is easily misunderstood or misconstrued. Therefore, it is important that these arrangements are laid out unambiguously to ensure that the roles and responsibilities of each individual involved are clearly demarcated.

Decisions regarding the purchase and sale of investments are made by the fund manager. However, it is not the fund manager’s money that he or she is investing. Fund managers do not typically enter transactions as a principal, but rather as an agent on behalf of the fund. This distinction is crucial and its importance cannot be overstated. The fund itself is the principal and subject to any and all duties or obligations involved in the transaction.

If the fund manager says “buy”, then the fund must buy. If the fund manager says “sell”, then the fund must sell. The risk is wholly on the fund. As a result, the fund manager is able to significantly limit its own risk exposure. Simply losing money for a client is not enough, by itself, to see a lawsuit succeed against an investment manager.

This arms-length portrayal of the relationship between a fund and a fund manager, however, is an over-simplification. One or more vehicles established and owned by the fund manager often participate in the fund structure in order to provide investment advice, execute resulting investment decisions and receive fees from the investors for such services.

A fund manager may act as a general partner to a fund formed as a limited partnership or may simply enter into a bilateral investment management agreement with the fund formed as a company to provide advice in return for fees. The precise role will be determined by the ultimate fund structure designed for the investors. In many fund structures, therefore, there may be a number of legal entities, all owned by the fund manager, playing similar or overlapping roles.
The need for multiple management entities in the fund structure is often driven by either particular tax concerns relating to the characteristics of the remuneration being received; the commercial relationships between the promoters of the fund and the ultimate portfolio managers; or the regulatory status (or lack thereof) of the management company.

Although the fund and the fund manager are separate vehicles, subject to separate ownership structures, the line between them can easily be blurred. Blurring can result from either an investor’s ownership of an equity stake in the fund manager or the fund manager’s ownership of an investment interest in the fund. Any attempt to critique the operation of these funds must bear in mind the potential for multiple roles, and the risks that they bring.
For example, as discussed earlier, a significant investor that provides a cornerstone investment in a new fund may request an equity participation in the fund manager as well, in order to capture a portion of the franchise value that its investment has created. This participation recognizes the value brought to the fund manager as a result of this ‘concept validating’ investment. In this regard, the investment of a well-respected investor (such as, for example, a CalPERS or a Kuwaiti Investment Authority) can be seen as functionally equivalent to a celebrity endorsement. The terms of the participation are highly negotiable and can include rights to only the initial fund in which the investment was made or to all funds launched by the fund manager. Either approach may be counterbalanced by time limits or earn-out provisions.

Regardless of how the participation is structured, to the extent that one or more particular investors have both an interest in the fund and a stake in the fund manager, the governance issues facing the remaining investors can become very complicated very quickly. As a result of this dual role, investors who also have a stake in the manager may be less willing to ensure that the fund manager is subject to adequate oversight and accountability in all areas.
Often, a fund manager will also invest in the fund, alongside the fund investors. This demonstrates the faith that the fund manager has in his or her ability to make investment decisions. In these cases, the fund manager is simply putting its money where its mouth is.

As a result, any direct investment that the fund manager has in the fund will be in addition to its receipt of management fees and performance fees, which is discussed in more detail in the following chapter. This investment may consist of interests in the same vehicle as the investors or in another vehicle which co-invests in parallel with the main fund. Historically, for funds set up in the United States as partnerships, tax rules once required a 1 per cent investment by the general partner in order to receive partnership tax treatment. Although no longer applicable, the 1 per cent investment standard has lingered in some corners of the alternative investment market.

So a little bit of cash-in-hand would be useful!

So how does someone actually get their first job at a hedge fund manager or a private equity professional? What makes a young boy or girl decide that when they grow up they want to work for an alternative investment firm?

The individuals who work for (and succeed at) these entrepreneurial firms are both products of the traditional financial service firms, and in many important ways reactions to those traditions and stereotypes. Often, the same things that motivate investment bankers or stock brokers or traders also motivate a hedge fund manager or a private equity professional. This might include compensation, prestige or just the raw pleasure of being demonstrated again and again to be correct. But the differences in self-perception are important, and in many ways have shaped these industries and made them culturally distinct.

They are different, but perhaps most importantly, they are in short supply.

In the case of hedge funds, one of the most difficult tasks for a start-up, or rapidly growing, firm is recruitment. Hiring the right people can be particularly difficult when the founder’s would much rather sit in front of a Bloomberg screen and test out new investment ideas than sift through stacks of resumes and interview large numbers of applicants. Not to worry, though – Wall Street’s largest investment banks are here to help!

Prime brokerage teams at leading bulge-bracket firms such as Goldman Sachs and Morgan Stanley have added “talent introduction” to the long list of services that they offer to their more lucrative hedge fund clients. By placing senior professionals into a hedge fund, the banks hope to reap the benefits of those relationships for years to come. Of course, the potential for conflicts of interests abound. The risk that am aggrieved fund manager may claim that a prime broker has “poached” a key employee from them to place at a more lucrative fund client is ever present.

Banks active in talent introduction are keen to claim, however, that what they actually do is function simply as a clearing house for potential applicants and nothing more. They do not see themselves as “head hunters” luring otherwise happy employees away from their current jobs.

By some estimates, hedge funds amount to as much as 35% of the brokerage commissions paid of the leading investment banks, so winning and maintaining trade relationships with these funds is an important source of profits for many banks since the financial crisis began. Creating extensive data bases of industry personnel and skill sets is a simple way to maintain close ties with key decision-makers. And unlike headhunters, the prime brokers do not demand recruitment fees of 25% of the first year’s compensation package. Instead, they provide these services for free, simply in the hope of earning future commissions.

Free is a good price. In fact, it is a very good price!

So get that resume polished, make sure your name is in the database of at least of couple of the big prime brokers as someone ready and willing to deliver alpha and perhaps one day soon you too will have the opportunity to start down the path of becoming a successful hedge fund manager.

The author’s book, “ONE STEP AHEAD – Private Equity and Hedge Funds After the Global Financial Crisis,” is published by Oneworld and is available in bookstores across the United States and Britain.

Click here for more information.

Source: Forbes

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