An account of how to set up a hedge fund professionally and ethically

1. When Larry Smith and Robert Birnbaum decided to start Greenwich,
Connecticut-based hedge fund Third Wave Global Investors, their reasons were
not that different from other entrepreneurs’ motivations. Both had extensive
experience—they had worked together for 15 years at JPMorgan and Credit
Suisse Asset Management with Smith on the investment side and Birnbaum on
the business side. Both desired to excise themselves from large organizations.
And finally—just like someone who opens a corner bakery or java joint—they
saw a gap in the marketplace and believed they could fill it better themselves.
“We thought we had something to offer on the product side, which is where the
concept of Third Wave came from,” says Birnbaum, seated at a long conference
table in the fund’s nearly year-old office. “The first wave of hedge fund invest-
ing was going short in order to protect capital. The second wave was to get a
good investment idea and leverage the heck out of it. The third wave is putting
the risk and return side together and creating more consistent returns through a
combination of quantitative and qualitative techniques.”
So it was in early 2004 that Birnbaum, who is the firm’s president and chief
operating officer (COO), was leaving his post as Columbia Management’s head
of institutional business as it was being acquired by Bank of America. (“It was
going from a large firm to a huge firm,” he says.) And Smith, Third Wave’s chair-
man and chief investment officer (CIO), had just ended a four-year stint as CIO
at Credit Suisse Asset Management, which was being folded into CSFB. Wanting
to do something different and invest on the years of intellectual capital earned at
these established institutions, they founded Third Wave in June 2004.
In the soon-to-be-
regulated hedge
fund industry,
setting up shop
means selecting
the right providers
to attract the
right investors.
This is how Third
Wave did it
Illustration by Sam Webber
Architecture
The
of Trust
Global Custodian 2005
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2. Global Custodian 2005
But before the first trade could be made Third Wave had to set
up shop, and the task of fund architecture diverged from typical
business endeavors. The two had to establish an efficient and reg-
ulatory compliant vehicle that could also deliver the desired port-
folio to investors. “This is the general balance you must attain,”
says Birnbaum, whose fund has had positive returns for 10 of the
past 11 months, growing from $11 million to $47 million.
Completing The Vendor Puzzle
“After incorporating the fund, we spent those next few months
on fund architecture: getting the firm set up and getting our
infrastructure set up,” Birnbaum says. This ranged from the
mundane—office supplies and workable telephone lines—to the
mandatory. Birnbaum and Smith also wanted to be able to offer
the fund to US and non-US investors, but recognized the need
to build up a track record first. “The idea was, let’s prove our
concept and show this consistent pattern of returns, and let’s
get all the infrastructure and architecture issues taken care of
before we open the fund to outside investors,” he says.
The first challenge was to put in place three basic building
blocks: a fund, a fund adviser and a partnership. Third Wave
hired law firm Seward & Kissel to set up the fund structure,
which included the creation of three entities: a US limited part-
nership (which is the actual fund), an investment adviser (the
operating firm that pays rent, owns the furniture and, impor-
tantly, trades the portfolio) and a general partner (who controls
the firm and, in this case, is Smith and Birnbaum). The fund
also selected an auditor, PricewaterhouseCooper (PwC), whose
role will not become imperative for the fund until it completes
its first year, when, at the end of 2005, PwC will issue the fund’s
official financial statement and valuation. However, it was still a
necessary decision to make during the fund architecture phase.
With the three entities in place in September 2004, Birnbaum
and Smith began trading with their own money in Birnbaum’s
basement on a pingpong table-turned-trading desk with
dedicated computer and telephone connections. “We were fully
functional,” he recalls with a laugh.
To fulfill their longer-term ambition of opening the fund to
outside investors, Birnbaum and Smith called back Seward &
Kissel to provide offshore counsel and structure for two new
vehicles: an offshore fund in the Cayman Islands and a master
fund that the limited partnership and Cayman operation could
both invest in. “The master fund contains all the assets of both
funds and is where we trade the portfolio,” Birnbaum says.
“US investors come into the limited partnership [LP], but the LP
“When setting up, you don’t have to
have all your resources inside the
firm. In fact, you want to have most
of them done outside to allow you
to focus on the product and working
with clients”
sends its assets to the master fund.”
For Third Wave, it was vital to make choices that gave investors
confidence: experienced vendors that were an appropriate match
for the fund and that would attract potential investors performing
due diligence on the fund.
So first came the search for a hedge fund administrator, which,
according to Birnbaum, is a key piece of the vendor puzzle.
“Choosing an HFA is a big deal,” he says. “All the leading
firms perform the same functions—they have to—but for us the
differentiating factor was the level of service and the cost of
the administrator. That cost is borne by the fund, so if its too
high, it can hurt returns.” Third Wave chose Olympia Capital
Management. “Olympia had the right level of cost and service,
which were our main criteria” he says. Olympia administers the
master fund as well as the two feeder funds and then allocates
the returns to the various accounts.
Attentiveness was just as important to the two when it came to
choosing prime brokers. Third Wave selected Citigroup as its
primary broker and Fimat as its futures prime broker. “There
are many firms that could execute our trades,” he says, “but
these two made it very clear that they wanted our business and
would be committed to us even while we were small.”
With vendors in place, the legal entities created and a three-
month track record of trading, Smith and Birnbaum found a
more permanent space for Third Wave in December 2004. “In
terms of space, we wanted a place that was the right size for us,”
Birnbaum says, “but it is often difficult to predict growth when
you are starting.” With this in mind, Smith and Birnbaum found
an office in Greenwich already built and available to them on a
three-year basis, as opposed to a five-year or even decade-long
lease. “Maybe we will need more space later, but for three years
we could definitely envision ourselves here.”
Once they had the space, it was time to fill it. From office
furniture to the company letterhead, someone had to order it.
“There are all these small-business types of things that need to
get done in order to enable you to function,” Birnbaum says,
“But it was important for us to make sure we had the high-level
infrastructure done.”
‘The SEC Is Going To Come Visit’
These days, high level infrastructure includes regulatory com-
pliance. As the hedge fund industry has grown—there are now
more than 8,000 hedge funds representing an industry worth
$1.025 trillion, according to Hedge Fund Research (HFR), a
research group in Chicago, Ill.—and sought institutional
money, it has attracted the attention of regulators. From Feb-
ruary 1, 2006, the US Securities and Exchange Commission
(SEC) will require all US hedge fund managers—with few ex-
ceptions—to be registered with the it as investment advisers
under the 1940 Investment Company Act.
“The big issue in fund architecture these days is SEC registration,”
Birnbaum says. Nascent managers may have an advantage over
their established counterparts if they choose to tackle these issues
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3. during the architectural phase and, like Third Wave, complete
the task so they can focus on investors. “We voluntarily regis-
tered in March,” he says. “And we basically think it is a good
idea for the industry—Larry and I are both very used to working
in a registered environment. It wasn’t a scary thing for us.
“Registration itself is an easy thing to do, but as a registered ad-
viser you must have a more detailed set of procedures that have
to be written down and verified,” he adds, sliding an innocuous-
looking, three-ring binder across the buffed table. The white
notebook is a compliance manual (“Which is about as much
fun as it sounds,” Birnbaum jokes) that compiles every proce-
dure from how the fund allocates a trade, reports performance
and deals with brokers. While many firms start with somebody
else’s manual and go from there, a compliance manual has to be
tailored to each individual firm. “This is an important process—
and therefore an important part of fund architecture—because
eventually the SEC is going to come visit, and it will want indi-
cation that you have followed the procedures,” he says.
Though the responsibility of compliance falls on the firm (Birn-
baum appointed himself chief compliance officer), there are a
number of ways that a hedge fund administrator can help a
fund, Birnbaum says. “We have to ensure they do it right,” he
says, “but together we can get it done.” One of those measures
where an administrator can help is the anti-money laundering
program, a requirement extended to investment companies in
2002 under the US PATRIOT Act, following recommendations
by the SEC, the US Treasury and the Federal Reserve later that
year. “Our hedge fund administrator checks our investor list
against the government’s list,” he says, “to guarantee the money
we are taking is not from illegal sources.”
Construction Continues
Fund architecture is not a finite process. Like homeowners who
make repairs and improvements on their investment, fund man-
agers need to remain alive to possible improvements to their
fund. “To us, everything that is not investment oriented is part
of fund architecture,” Birnbaum says. “Investments are prima-
ry, but then we must make sure we can serve our clients proper-
ly,” he says. This means regular communication with investors
(monthly letters and quarterly conference calls) as well as with
prospective investors (due diligence and sample questionnaires).
As part of a keen customer-management system, Third Wave
maintains a list and history of all accounts and clients, track-
ing materials sent to and from them. To reinforce this dialogue
with investors, Third Wave is launching a password-protected,
informational Web site, not to attract new clients, but to serve
existing investors.
Of course, it is always a good idea to know when to call in the
professionals. As COO, Birnbaum says he is aware of all the
qualified people available to funds. “When setting up, you don’t
have to have all your resources inside the firm. In fact, you want
to have most of them done outside to allow you to focus on the
product and working with clients.”
Although oversight of outsourced functions is not a trivial
responsibility—ultimately Third Wave is responsible—keeping
resources such as administration outside of the fund increases
transparency and allows the fund to maintain a lean staff: Third
Wave operates with a total staff of six. “We don’t think we need
to grow past that for a long time,” Birnbaum says. “Starting
this firm with our own resources caused us to want to keep our
fixed expense base as low as we can while we’re growing the
firm.” And it has been growing. Along with the $37 million
increase in assets, Third Wave has brought in new investors
every month since it opened.
Birnbaum attributes the months of growth to positive fund
returns, experience and sound fund architecture. “As Larry
likes to say, the biggest surprise has been that there haven’t been
any surprises,” he says. “We planned out everything we needed.
Larry and I have had a lot of experience, and we knew what we
wanted and how things ought to be done.” The biggest obstacle,
he observes, was launching the fund in a challenging capital-
raising environment. “While asset flows in hedge funds have
slowed or turned negative, we feel very good that we’ve grown
and attracted new assets,” he says. This confidence is reinforced
by potential clients who have told Third Wave that the fund is
on their radar. “We have many prospective clients who say, ‘We
want to place money with you. You are the next manager on our
list, but we are currently having redemptions,’” Birnbaum says.
“There’s not a lot we can do about that, but we are confident in
our product. We think hedge funds are here to stay.”
And it appears Third Wave is as well. Birnbaum and Smith are
introducing a new share class with double the exposure—twice
the gains and twice the losses. “The existing fund has done
well and been so stable that some potential investors came to
us and asked us to crank it up,” he says. Fund architecture
re-enters the picture, he adds, and it is back to the lawyers, the
administrators and the brokers to aid Third Wave in creating
this second share class. It should be up and running by year’s
end, further entrenching the two in the hedge fund industry.
“Yes, we’re in it for the long term,” Birnbaum says, “and from
a business perspective we’re very confident of even greater
success.”
—Alexandra DeLuca
Robert Birnbaum,
president and
COO of Third Wave:
“To us, everything
that is not investment
oriented is part of
fund architecture.
Investments are
primary, but then we
must make sure we
can serve our clients
properly.”
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