New regulatory requirements under the Dodd-Frank Act and the attendant infrastructure build-out are forcing emerging hedge fund managers to decide at the outset whether to attract institutional investors or remain exempt from SEC registration by committing to manage less than $150 million during their first few years.
Under the new rules, managers have to commit to building out their infrastructure to support an SEC-registered fund if they want to attract institutional capital, according to Ellen Schubert (left), chief advisor to Deloitte’s hedge fund practice. “This requires the manager to commit to a specific strategy as well as a major financial outlay before the first trade.”
In the past, fledgling hedge fund managers had the flexibility to move fairly quickly from managing the money of their friends and family to institutional capital as soon as the time was right—generally, a three-year track record and a certain level of assets under management.
Someone could hang out a shingle and call himself a hedge fund, Schubert said in an interview with AdvisorOne. “That’s no longer the case. It’s difficult anyway to get money these days as a startup because institutional investors are very wary of somebody without a track record, someone who isn’t registered and whose pedigree is unclear. And in any case, Madoff changed the whole industry.”
The increasing barriers to entry have dramatically altered the dynamic for hedge fund startups, Schubert said. “You need to have seed capital, and the seeders are in the driver’s seat right now. They can attract new portfolio managers to their platforms much more easily than they have in the past because they can afford to set them up with an infrastructure that is compliant out of the gate. But that means they get more ownership of the fund.”
The SFO Carve-Out
Schubert, who advises hedge fund clients on operations, product structuring and regulation issues,sees a potential trend among startup managers resulting from the new regulations. “Since single family offices (SFOs) are not subject to the same regulations as hedge funds, managers may decide to forgo institutional capital altogether and stay the course with ‘friends and family’ money rather than commit to a infrastructure strategy before their investment strategy is proven.”