HF Survival Guide 08

JANUARY 2008 • emii.com
The New Reality
Start-up managers need to temper capital raising
and growth expectations amid a glut of funds.
Choose Your Weapons Wisely
The first and most important choice for a start-up
fund is selecting the right investment strategy.
HF SurvivalGuide-laydown 1/3/08 12:54 PM Page 1

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The Hedge Fund Start-Up Survival Guide
JANUARY 2008 THE HEDGE FUND START-UP SURVIVAL GUIDE 3
6 Choose Your Weapons Wisely
By Andrew Bloomenthal
The first and most important choice a start-up man-
ager needs to make is selecting the right investment
strategy, but that choice is anything but simple.
12 The New Reality
By Eric Rosenbaum
With the market clogged by nearly 10,000 hedge
funds, start-up managers must accept a new reality
about capital raising and marketing, one that requires
them to better understand the true prospects for
growing assets in the first few years of operation.
18 The Potential of Emerging Economies
By Gregory Morris
With more investors looking abroad for better returns
and the Israeli market receiving an upgrade in its risk
assessment, one local investment house sees an
opportunity to attract foreign investors.
20 Think Like An Owner
By Eric Rosenbaum
Despite a host of complex legal and regulatory issues
to deal with, lawyers say the most critical issue for
first-time managers is often more basic: the change of
mindset from an employee of a corporation to a busi-
ness owner.
24 Competent Service Providers
Are the Key to Credibility
When it comes to technology and operations, nascent
managers can quickly gain respect by outsourcing to
qualified providers.
The New
Reality
Table of Contents
12
18
The Potential of
Emerging
Economies

4 THE HEDGE FUND START-UP SURVIVAL GUIDE JANUARY 2008
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Editor’s Note
Welcome to the Hedge Fund Start-Up Survival Guide, an indis-
pensable manual to everything first-time managers need to know
about creating, growing and managing a successful hedge fund
in today’s market.
The Start-Up Survival Guide is chockfull of insight and advice from
throughout the hedge fund universe, beginning with the first thing
every manager needs to consider when they are starting a new fund:
strategy. A plethora of investment choices, as well as a number of
available hybrid models, have made the task daunting, but our guide
simplifies the process with a breakdown of the strategies and some
practical advice from industry experts (see story, page 6).
Next, the Start-Up Survival Guide
addresses the second most important
consideration: capital. Not only does the
guide provide advice on how to make a
fund attractive to capital providers, it also
explains how to continue attracting money
post-launch through a focused marketing
strategy (see story, page 12). Beyond that,
the guide also includes articles on legal
and regulatory requirements and techno-
logical and operational considerations, giv-
ing managers a complete compliment of
advice on the issues most relevant to their success.
The Hedge Fund Start-Up Survival Guide is the latest in a series of
special supplements produced by Institutional Investor News exclu-
sively for our newsletter subscribers. It is part of our commitment to
bringing our readers the freshest news and in-depth analysis on
important sectors and timely topics within the financial markets.
All the best in 2008,
Erik Kolb
Editor of Business Publishing
Institutional Investor News
The New Reality
Start-up managers need to temper capital raising
and growth expectations amid a glut of funds.
Choose Your Weapons Wisely
The first and most important choice for a start-up
fund is selecting the right investment strategy.
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WHEN FINANCIAL SCHOLAR
Alfred Winslow Jones first con-
ceived the idea for hedge funds back
in 1940, his philosophy was
straightforward: create an invest-
ment vehicle that combined leveraging capabilities with the
power to sell stocks short, thereby allowing investors to thrive in
any market condition. Winslow reasoned that such a paradigm
would attract top-tier management talent, who would flourish
based on the strength of their stock-picking prowess regardless of
market direction.
Almost 70 years and 7,000 hedge funds later, Winslow would be
surprised at the breadth of the industry resulting from his ideas.
But he might be equally surprised at just how specialized and
expansive modern hedge fund investment strategies have become.
In fact, less than 20% of the funds in existence employ the classic
long/short approach. Instead, many choose from a bevy of alter-
native categories and subcategories. And with nearly every known
investment approach folded into the universe of hedge fund
methodologies, start-up managers face overwhelming choices
when creating their models.
According to Brian Snider, senior vice president of New York-
based hedge fund consultancy Hennessee Group, it’s not an easy
decision to make. “The most appropriate thing for a start-up
manager to do is to determine his strengths, then tailor the fund’s
investment strategy around them,” he said.
Snider discourages managers from modeling their funds based on
themes of the moment or simply because they are popular with
investors. “That’s bad practice,” he added. “Investment decisions
should be made based on the skill of the manager and the quali-
ty of the organization.”
Increased Choices, Increased Complexity
An expanded strategy spectrum can complicate the playing field
for unseasoned players, who may fail to anticipate that most
investment strategies with high performance potential will invari-
ably experience periods of drought at one time or another. This is
particularly true for strategies targeting more cyclical sectors.
Take credit-oriented strategies, for example. Though most thrive
amid an abundance of cheap debt, the lack of defaulted corporate
debt opportunities in today’s market would make such a strategy
dicey at best, particularly for managers who don’t adequately
hedge their positions.
“You can make the case that if you maintain a relatively well-
hedged portfolio with low correlations to the equity markets, you
should be okay,” said Snider. “But if you’re a long-only value man-
ager, there’s going to be times when your strategy falls out of
favor. It’s inevitable.”
When San Diego-based Context Capital Management was gear-
ing up to launch a global distressed debt hedge fund in November
2007, it brought on board veteran distressed debt manager Jack
Hersch to run it. With about $30 million currently under man-
agement, the Context Python Master Fund invests in some 35
companies experiencing some degree of legal, financial or opera-
tional difficulties. Hersch longs the names that have meaningful
recovery potential while shorting those deemed beyond repair.
On the operational side, Hersch studies a company’s history, com-
petitors and structural mechanics. He examines the location of a
company’s plants, and he profiles its customer base to better
understand consumer trends. When a company faces litigation,
Hersch often attends court proceedings in an effort to understand
the nuances of a case. Once he achieves clarity on these issues, he
compares a company’s current trading levels with what he projects
they’ll be once the problems are resolved, then longs or shorts the
name accordingly.
With more than 20 years of experience investing both proprietary
capital and other people’s money in distressed opportunities,
Hersch is confident in his ability to accurately gauge a company’s
Choose Your
Weapons Wisely
Selecting the right investment strategy is the first and most important choice
start-up managers need to make

potential for resurrection. “It’s a triage process,” he noted. “We
analyze troubled companies to determine what’s causing their
breakdowns. Everything has a resolution, but there may not be
enough value after employing the solutions to make the action
worth it, in which case we short the name or avoid it altogether.”
Though Context Python has no geographical bias, Hersch steers
clear of investing in bankruptcies in Asia, claiming he’s less com-
fortable operating there than he is in dealing in Western
European and North and South American countries. “I’m not
convinced that if I show up in certain Asian countries with a lien
and try to collect collateral, they won’t put me in a tiger cage until
I change my mind,” he joked.
Combining Disciplines
Not content to stick with a single investment theme, some man-
agers rely on a multi-strategy approach to running their funds.
In managing his firm’s flagship fund -
Full Value Partners - Steve Samuels, gen-
eral partner at Bulldog Investors,
employs a pastiche of strategies for the
$185 million portfolio. This includes
investments in REITs and other real
estate interests, distressed debt and,
interestingly, a 20% allocation to special
purpose acquisition corporations
(SPACs), which are shell companies
with no operations that go public with
the intention of using the proceeds to
acquire or merge with other companies.
Though Samuels was dubious of SPACs
when they were first brought to his
attention, upon further inspection, he
found their profit potential to be com-
mensurate or higher than many other
investment offerings on a risk-adjusted basis. “I primarily like
the fact that the SPAC promoter - who raises the money -
must find a vehicle, make a deal and bring it to shareholders
within a timeframe of something like 18 months to two years,”
said Samuels. “If they don’t find anything by then, the money
is returned to shareholders. Until that happens, the money
goes into a trust that can’t be pierced. Worst case scenario: they
can’t find a deal and we get our money back, plus what the
trust earns in interest. But since the promoters are so incen-
tivized to find something viable, something good invariably
come out of it.”
Full Value Partners likewise invests widely in closed-end mutu-
al funds, which attracts Samuels on the basis that they trade on
exchanges and often at significant discounts to their net asset
values. And all of that is easily measurable. “You and I could
argue all day whether Citigroup is a sound investment idea,”
said Samuels. “But if a closed-end fund is trading at $8 and it’s
worth $10, that’s a discount of 20%. It’s irrefutable.”
Targeting Other Funds
In talking about hedge fund investment strategies, funds of funds
must inevitably be part of the discussion, given that that their
numbers dominate the industry. With nearly 3,500 presently in
operation, funds of funds represent nearly half of all hedge funds
in existence. And although their fundamental concept is straight-
forward, narrowing down the universe of sub-managers to invest
in is anything but.
Brian Chung, senior portfolio manager at the Stamford,
Connecticut-based SSARIS Multi-Manager Absolute Return
Fund, doesn’t rely on track record in choosing managers.
Contrarily, he characterizes his approach as highly opportunistic,
pouncing on trends and themes.
After the fund’s investment committee met
last year, Chung decided to adopt a more
neutral stance on the U.S. equity markets,
which ultimately resulted in their shift away
from long-biased managers and a shift
towards managers who could go net short if
the right situations emerged.
“We take a top-down approach and add to
that by meeting with the best minds in
money management,” Chung explained.
“This generates good ideas we wouldn’t have
thought of ourselves. In 2006, for example,
one fund manager showed us that the sub-
prime mortgage market was fraught with
structural inefficiencies, prompting us to take
a neutral - even slightly negative - stance on
the U.S. housing markets. This investment
philosophy made sense to us.”
“The most
appropriate
thing for a start-
up manager
to do is to
determine his
strengths,
then tailor the
fund’s invest-
ment strategy
around them.”
— Brian Snider
From Left to Right: Jack Hersch, managing partner of Context Python
Master Fund, and Steve Samuels, general partner at Bulldog Investors

The Diversification Rule
In order to maximize diversification, an academic principal dic-
tates that funds of funds should strive to invest in 20 underlying
managers. Brad Balter, whose $150 million fund of funds - BCM
Discovery Fund - houses about 18 underlying managers, agrees
with this philosophy.
“Anything beyond 20 dilutes performance,” said Balter. “If
you’re carrying 70 managers, where each one represents 1% to
2% of your portfolio, even a manager who’s up 10% for the
year will give you only a couple of basis points. That does
nothing for you.”
Balter furthermore believes that keeping the numbers low lets
fund of funds managers better focus on the underlying managers’
day-to-day operations, making it easier to detect inefficiencies
and potential blowups. “I’d rather allocate my time to doing my
homework, so I don’t permanently impair capital,” Balter noted.
But in this age of increased specialization, Chung believes it is
necessary to breach the 20 manager rule and employ some 45
funds in his fund. “Within convertible arbitrage, for example,
there are at least three sub-strategies: traditional arbitrage, volatile
arbitrage and credit-related arbitrage. You need all three to be rep-
resented,” he explained.
Emerging Managers: Leading the Pack
Even in a realm where low correlation is the driving force, a hier-
archy exists among the performance of different hedge fund
investment strategies. According to statistics from BarclayHedge,
emerging markets managers dominate the space, averaging
returns of 18.6% through September of last year (see chart, page
10). Equity long-only managers fared second best, bringing in an
average return of 14% for the same time period. Rounding out
the top three were merger arbitrage players, who collectively aver-
aged 12.9%. Meanwhile, fixed income arbitrage players fared the
worst, averaging just 0.65%, while equity market neutral funds
did slightly better, bringing in 3.1%.
Sol Waksman, president of BarclayHedge, offered some perspec-
tive. “Given that the stock markets of emerging market compa-
nies had an excellent year, it’s not surprising that emerging mar-
ket managers have done well as a result,” he said. “Just look at the
four biggest emerging market countries: Brazil, Russia, India and
China. They’re off the charts.”
Maintaining Maneuverability
In November 2004, Toronto-based hedge fund operator Selective
Asset Management had three distinct funds: a long-biased fund, a
short-biased fund and a fund of funds, which essentially combined
the first two offerings into a single investment for those investors
seeking simplicity and ease of operations. But without a great deal of
assets under his belt, firm president Robert McWhirter grew frus-
trated that he was spending so much on accounting and other oper-
ational fees to maintain the three offerings.
So, after receiving approval from investors, McWhirter made the
decision to roll all of the investments into the long-biased fund,
which is called the Selective Assets Long Biased Equity Hedge Fund.
“We’re happy with our decision and with the way it’s going,” he said
of the $8 million fund, which takes a quantitative approach.
Meanwhile, McWhirter still maintains the legal structures of the
two other funds, given that he already spent the money and ener-
gy to facilitate their paperwork. “Besides, if a $50 million investor
shows up and wants a short-only portfolio, we can just re-open
the short-bias fund and away we go,” he said.
Furthermore, McWhirter advocates building as much flexibility
into offering memorandums as possible to prepare for any contin-
gency. “In our long-bias fund, we can still legally do hedging,” he
said. “There are expectations from our investors that we won’t,
but it’s within our parameters to do so. Also, right now we invest
in North American stocks. But if we wanted to shift focus to third
world countries, we’d put it to an investor vote and make it hap-
pen. Or else we’d start up a new fund so we could allow customers
to keep their original investment, plus give them something new.”
Controlling Risk
In the theoretical realm, shorting positions provide enough
intrinsic risk control in the hedge fund space. But in practice, this
may not be enough. Therefore it behooves managers to rely on
other risk control measures as well.
For starters, taking care to educate investors on the differences
between risk and volatility is crucial. That may be easier said than
done, given that this distinction often confounds the fund man-
agers themselves, according to Snider. But failure to grasp this can
be hazardous to a fund—especially if skittish investors hastily
R
It
Is
R
e
s
In
L
•
•
•
W
40
R
C
From Left to Right: Brian Chung, senior vice president at SSARIS Advisors,
and Robert McWhirter, president of Selective Asset Management

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10 THE HEDGE FUND START-UP SURVIVAL GUIDE JANUARY 200810 THE HEDGE FUND START-UP SURVIVAL GUIDE JANUARY 2008
Assets in Dec 06 # of Funds Assets in Sept 07 # of Funds Average Returns
Strategy (in Millions) in Dec 06 (in Millions) in Sept 07 for 07 (through Sept)
Convertible Arbitrage $34,710 164 $35,820 175 3.97%
Distressed Securities $95,250 178 $138,780 210 3.72%
Emerging Markets $261,420 786 $330,300 973 18.60%
Equity Long Bias $186,780 846 $215,520 1030 10.41%
Equity Long/Short $250,020 1102 $273,360 1268 7.42%
Equity Long-Only $63,270 198 $76,230 210 14.04%
Equity Market Neutral $58,560 226 $62,220 225 3.08%
Event Driven $115,230 268 $163,770 315 8.50%
Fixed Income Arbitrage $158,790 636 $161,700 708 0.65%
Macro $77,820 280 $82,230 328 7.79%
Merger Arbitrage $22,440 66 $39,840 83 12.91%
Multi-Strategy $210,990 286 $228,930 320 8.17%
Other $34,290 312 $38,520 368 4.81%
Sector Specific $95,250 612 $118,290 738 10.94%
Fund of Funds $971,700 2913 $1,211,100 3460 7.11%
Total Industry $1,660,500 5978 $1,974,900 7000 8.88%
Hedge Fund Assets and Performance by Strategy
Source: BarclayHedge
withdraw their investments following a downturn in performance,
when in actuality it may be the best time to add to their investments.
“If a manager is fully invested at $100 million and a sudden peri-
od of poor performance causes $30 million in redemptions, this
manager is now a forced seller of those positions,” Snider
explained. “That is the last thing he wants to be when there are
ample opportunities to exploit.”
The key to making certain investors understand the difference
between risk and volatility is explaining to them that a high standard
deviation doesn’t necessarily imply high risk. Conversely, low standard
deviation doesn’t automatically signify low risk.
“Look at the implosion of the mortgage-backed market, where triple
B-rated securities showed no volatility up until this year,” Snider noted.
“Then this year happens and it becomes clear that there’s tons of risk
inherent in these securities. The low volatility these securities experi-
enced in years past was not reflective of their true risk, and investor fail-
ure to understand this can be highly detrimental to a fund.”
There are other risk control mechanisms. In the Context Python
Master Fund, Hersch refuses to initiate a position larger than 5% of
the overall fund and will rebalance the fund should an existing posi-
tion swell beyond 8%. “The two worst trades you can make are to be
long and wrong and to not to be long enough,” Hersch said. “A 5%
position is big enough that it moves the needle if we’re right, and if
we’re wrong we’re comfortable enough with the downside that we
won’t be badly hurt.”
Conclusion
When all is said and done, what’s the best way for a start-up manager
to determine his or her strategy? Simply stated, it is by staying within
the realm of the discipline he or she knows best and by resisting the
temptation to model the fund based on current trends. “You may ini-
tially be able to bring in assets by exploiting fad strategies,” Snider said.
“But if your organization doesn’t have the ability or experience to gen-
erate decent returns over the long haul, the fund will be short lived.”
Another lesson to heed: keep the language of the strategy simple and
easy to understand. “When choosing managers to invest in, we avoid
quantitative strategies and technical trend strategies,” Balter said of his
fund of funds product. “If their approach can’t be described in a sin-
gle sentence, that’s a huge red flag. Computer codes don’t mean a
thing when things go awry."
Naturally, most quant managers feel more confident in their tech-
nique, especially those that augment computer-selected names with
their own due diligence efforts. “It’s not just about hitting a comput-
er key and stopping there,” said one such quant manager. “We take
the names provided, overlay them with questions about liquidity and
determine their ability to be shorted, if necessary. It’s all about apply-
ing filters to names and heightening our focus on those companies.
Any manager worth his salt will do this.”i

Convertible Arbitrage - This strategy entails procuring long-only posi-
tions in convertible bonds or warrants and the subsequent shorting of
the corresponding stock. The bond and warrant pricing is based on
several criteria, including price of the underlying stock, and the expect-
ed future volatility of returns. Such pricing is often inaccurate due to
illiquidity in the convertible debt and warrant markets, giving rise to sig-
nificant profit opportunities as positions are acquired in anticipation of
the market price eventually reflecting true value.
Distressed Securities - This strategy looks to public companies or a
country’s central bank for securities that are either in default, in dis-
tress, under bankruptcy protection or are likely to soon descend into
such unfavorable status.For fixed income instruments, which comprise
the lion’s share of the overall asset class, distressed securities typical-
ly are classified as being below investment grade, have a yield in
excess of 1000 basis points over the risk-free rate of return on U.S.
Treasuries and may include corporate credit as well as issuance by
emerging market governments.
Emerging Markets - This strategy focuses on traditional fixed income
and equity markets outside the United States and Western Europe,
including those in Asia, Latin America, Eastern Europe and Africa.
Considered highly volatile, with less reliable and less standardized
information available about their securities, these markets tend to
exhibit inefficiencies resourceful managers can exploit.
Equity Long Bias - Simply stated, this strategy takes predominantly long
positions that are minimally hedged, thereby making it more vulnera-
ble to market declines. Most funds typically have a long bias because,
over the long term, stock markets tend to rise along with general eco-
nomic growth.
Equity Long/Short - Managers of this strategy typically buy stocks they
perceive to be undervalued while shorting those they perceive to be
overvalued. They routinely target competing companies within the
same industry sector for opposing positions, which theoretically pro-
vides downside risk protection in any market climate. While the long
side generally outweighs the short side in most directional equity
funds, a small group of funds exhibit short sides that exceed the long
sides - sometimes by significant margins.
Equity Long-Only - Containing absolutely no short positions whatsoev-
er, this strategy appeals to managers who believe there are limits to
the number of compelling short ideas and that the recent flood of
money into hedge fund investments has hampered their ability to
exploit those rare short ideas that do arise. Though some argue that
long-only funds betray the definition of hedge funds by failing to exploit
their ability to generate returns independent of the underlying assets
they invest in, others maintain that long-only funds still fit the definition,
given that they may employ leveraging techniques and that they
impose the traditional 2% management/20% incentive fee structure.
Equity Market Neutral - This strategy aims to capitalize on invest-
ment opportunities unique to some specific group of stocks while
maintaining a neutral exposure to a broader group of names
defined by sector, industry, market capitalization or geographical
region. Such a strategy is a favorite among managers with a
propensity for ferreting out solid stock picks, particularly those who
can identify a virtually equal number of names to both long and
short within a larger group. Overall sector performance is largely
immaterial because, no matter what happens, the gains and loss-
es of the selected stocks will offset one another.
Event Driven - This strategy involves investments - both long and
short - in the securities of corporations experiencing significant
events of note, such as mergers, acquisitions, liquidations, bank-
ruptcies or reorganizations. Such tangible events can catalyze
changes in the expected value of the underlying security.
Significant profits may be enjoyed by savvy managers who can
correctly interpret what the projected corporate event will mean
for a company’s bottom line and take positions accordingly.
Anticipating timelines for the effect of such events to take place
can be hard to predict, making the event-driven game one of the
more speculative strategies.
Fixed Income Arbitrage – This strategy aims to exploit the price dif-
ferences between related short-term bonds from either public or
private issuers. These mispricings, which may be exploited on a
leveraged basis, yield a contractually fixed stream of income, let-
ting arbitrageurs adhere to their mandate of achieving steady
returns with a low degree of volatility. Most managers who employ
this strategy trade on a global basis and tend to focus on interest
rate swaps, U.S. Treasury securities and yield curve and credit
spread trading, as well as volatility arbitrage.
Macro – Managers of this strategy invest in a bevy of different
investments - including long and short positions in various equity,
fixed income, currency and futures markets - basing their decisions
on the present economic and political climate that a particular
region is experiencing. For example, if a manager believes the U.S.
is headed into recession, he might elect to sell short U.S. stocks or
futures contracts on certain U.S. indices.
Merger Arbitrage - This strategy involves a transaction-specific
event, in which the stocks of two merging companies are simulta-
neously bought and sold to create a riskless profit. Specifically, the
manager examines the risk of the merger deal failing to close on
time—an uncertainty that typically causes the target company’s
stock to sell at a discount to the price that the combined company
will fetch when the merger is closed. Where a regular manager
focuses on the profitability of the merged entity, a merger arbi-
trageur cares about the probability of the deal’s approval and the
likely timetable for the deal to transpire.
Multi-Strategy – Managers of this strategy employ several hedg-
ing techniques within the same pool of assets, with the objective
of delivering consistently positive returns regardless of the direc-
tional movement in equity, interest rate or currency markets. An
alternative to funds of funds, the multi-strategy paradigm targets
a wide scope of asset classes, including long/short equities, real
estate investments, event-driven strategies and convertible bond
arbitrage, and relies on diversification to reduce volatility and
decrease single-strategy risk. Only funds with significant capital
on their balance sheets have the resources needed to effective-
ly employ this strategy.
Fund of Funds - A portfolio of underlying managers, this strategy is
also known as multi-manager investing. The advantage of such a
vehicle is its built-in diversity, but the higher fees associated with
this product have made some investors leery.
Glossary of Strategies

The
New
RealityA glut of funds forces start-up managers to be more sober about
capital raising, growth prospects
By Eric Rosenbaum

START-UP HEDGE FUND managers
must take a slew of considerations into
account before going ahead with a
launch, many of which have nothing to
do with investment performance. Capital
and the ability to attract assets are paramount to a nascent
fund’s ability to survive. Indeed, it’s the fund’s lifeblood. But
with the market clogged by nearly 10,000 hedge funds,
start-up managers must accept a new reality about capital
raising and marketing, one that requires them to better
understand the true prospects for growing assets in the first
few years of operation.
Among the critical factors distinct from the ability to gener-
ate returns, the manager’s specific investment style must be
analyzed relative to the already glutted market. It is safe to
say that the days when yet another long/short U.S. equity
hedge fund could gather assets in a hurry are long gone, and
managers should analyze how their choice of strategy fits into
the overall market. Start-up funds also need to put together
a business plan that includes access to a network of family
and friends, high-net-worth investors and small institutions
within their geographic footprint, as big institutions for the
most part will be disinclined to invest with the fund during
early marketing efforts. In addition, first-time managers
must consider their pedigree and how it will help or hinder
those marketing efforts.
Furthermore, personal capital to back the new venture is an
essential consideration. A manager’s personal investment in
the fund from day one is critical, but even more important is
sufficient funds in the bank to keep the fund afloat in the
early days, before any profits roll in. In today’s market, the
period during which even a strong performing fund may go
without significant assets, and therefore profits, can be meas-
ured in years, not months. And this reserve of capital is a
make or break issue for most new funds. For more complicat-
ed strategies, the start-up also must expect higher trading
costs as part of the initial operating expenses, often during
this period of time before profits are generated.
It is only after all of these initial considerations have been
accounted for, that start-up hedge funds can begin in earnest
to consider how to gain specific marketing traction. Most
often, this analysis takes the form of enlisting the support of
third-party marketing organizations, seed capital firms and
multi-strategy hedge fund shops that can help push a manag-
er over the threshold of success. However, today’s reality is
that these partners may not even look at a fund with less than
two or three years of experience under its belt, because third
parties can’t effectively market a start-up fund in today’s glut-
ted market. Therefore, a business plan that accepts a reality
in which the fund may be on its own for up to three years
will place first-time managers on the side of caution, good
judgment and proper business risk management. And when
the time does come for the start-up fund to enlist the support
of third-party relationships, the manager must place empha-
sis on not giving up so much control in the rush to raise
assets that the entrepreneurial spirit behind his or her entry
into the hedge fund game is diminished.
Myth Understandings
It has been typical in hedge fund circles to maintain a belief in the
mantra: ‘If you build it, they will come.’ Today, however, the first
order of business for new hedge funds must be the casting off of
this myth and an acceptance that today’s market presents more
challenges and obstacles than easy money. The pervasive mystique
about hedge funds - that outsized returns generated by a talented
individual are a sure-fire path to success - is no longer a viable
business plan. In fact, that type of thinking is evidence of a lack
of a business plan, according to hedge fund executives.
“Production of good performance does not beget assets,” said
Patrick Keane, managing director of third-party marketer
Liability Solutions. “Even if you put up 30-40% returns, it does
not mean assets will come.”
Ultimately, the most important analysis for today’s start-up
fund is the exact nature of its goals. Hedge fund managers
must ask themselves what, in their minds, would equate with
success. For those whose goal is growing from $10 million in
assets to a billion dollar-plus fund on the radar of major
institutional investors within two years’ time, the reality of
today’s market makes that scenario the extreme exception to
the rule. For those whose goal may be growing to $50-100
million in their first two years—itself not an easy task—the
goal may be harder to achieve, but it is still available to those
funds that develop a smart business plan. “People are eternal-
ly optimistic,” Keane said. “Someone who is absolutely com-
mitted to opening a hedge fund is convinced that, as long
From Left to Right: Adi Raviv, head of the alternative investments group
at Northeast Securities, and Patrick Keane, managing director of third-
party marketer Liability Solutions

they put up the numbers, assets will flow to them, but it is
just not that simple. There are lots of funds out there with
great numbers sitting at $20 million in assets.”
Star Power
One hedge fund asset-gathering dynamic that has not
changed in today’s market is that a first-time manager who
can leverage experience at a well-known hedge fund brand or
investment bank trading desk is more likely to raise assets
and gain the attention of institutions in a shorter period of
time. Even here, though, there have been chinks in the
armor, as recent launches that could leverage brands such as
Goldman Sachs and the Carlyle Group encountered obstacles
to asset growth. While that doesn’t change the basic equation
- the better the pedigree, the better the chance that pedigree
will be a determining factor - it does highlight the difficul-
ties for even the best-positioned new funds.
“Even with a significant pedigree, it is a difficult world, and
there have been significant new launches that recently came
up woefully short of intended targets,” said Scott Prince of
seed capital firm Skybridge Capital. “More and more of the
institutional capital coming into the business is flowing to
the experienced managers - particularly those already up and
running for a long time - with huge institutional-like infra-
structures.” While he stressed that it is still viable to start a
hedge fund with any amount of capital, that manager has to
be extremely patient about prospects for asset growth.
Pedigree, however, is a tricky word. In today’s market, it is
wrong to assume that an academic pedigree is going to go a
long way. Experience at a well-known hedge fund trading
desk or investment bank is much more important when start-
ing a new fund than an academic pedigree, the likes of which
once made funds like Long Term Capital Management the
investment world’s darling. “Unless you have a legendary
reputation behind you - say you were the right hand person
for a multi-billion dollar hedge fund manager - it is pretty
hard,” said Howard Altman, co-managing principal at
Rothstein Kass. “And it will take a lot of time, particularly to
gain the attention of institutions.”
Only Fools Rush In
The patience that Skybridge’s Prince alludes to comes from
the fact that few start-up funds can leverage a marquee hedge
fund. Many without this ability to ‘self-credentialize’ may
have the investment talent, uniqueness of strategy and smart
business plan that will allow asset growth, just over a longer
period of time. “One of the first things I ask start-up funds
is, assuming you raise no money for the next two years, how
long can you do this? How much have you put aside to pay
people and keep the fund afloat?” said Chip Perkins, princi-
pal of third-party marketing firm Perkins Fund Marketing.
“If they say less than two years, it probably won’t work for
them. People that don’t understand that start swinging hard-
er at the ball out of panic and miss it.”
The challenge of raising assets in the first few years of oper-
ation makes it that much more critical for start-up funds to
prepare a business plan that initially includes an informal
network of family and friends, their own personal investment
in the fund and, possibly, small institutional investors in
their geographic footprint, such as family offices and high-
net-worth individuals. To that point, Rothstein Kass recent-
ly completed a survey that indicated family offices could be
one of the largest potential markets for new hedge funds,
although Altman believes that, for start-up funds, this
opportunity will still be difficult to exploit.
The bottom line formula for survival in the first few years is
relatively simple: temper your expectations about asset
growth and, as a result, make sure to have enough operating
funds on hand to keep the fund afloat even if profits are non-
existent. While market experts shy away from placing an
exact number on how much a start-up fund needs to survive,
they indicate that having operating funds on hand for at least
18 months of operation is essential for any new business.
Start-up funds have to understand that it is going to be at
least a two-year process to gain the traction that will allow
them to approach the investors that are large enough to take
them to the next level, said Adi Raviv, head of the alternative
investments group at Northeast Securities. An optimistic tar-
get for new funds is to gather between $50 million and $100
million in assets in the first two to three years of operation.
The $100 million mark, in particular, is considered by many
hedge fund experts to be point at which a fund has the crit-
ical mass to begin a true institutional marketing effort.
“If your goal is to be a $25 million fund for friends and fam-
ily and you aren’t paying Manhattan or Greenwich rents, you
can make a living,” Perkins said. “There are plenty of excep-
Howard Altman, co-managing principal at Rothstein Kass

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16 THE HEDGE FUND START-UP SURVIVAL GUIDE JANUARY 200816 THE HEDGE FUND START-UP SURVIVAL GUIDE JANUARY 2008
tional managers who are at $25-50 million today. However,
if you want institutional money, you have to get north of
$100 million.”
According to Daniel Dorenbush, managing director and
global head of hedge fund services at RBC Capital Markets,
a common mistake made by new funds is to spend lavishly
on appearances, as opposed to focusing on the critical costs.
He noted that he has seen as many managers become success-
ful starting with a bare bones mentality as those who spend
heavily in the early days. “I’ve seen guys start with nothing
and guys start with the gold package and both have been suc-
cessful,” he said, “but only when they focus on a target mar-
ket and on building the appropriate institutional infrastruc-
ture for the long term. You don’t need to start day one with
an office on Fifth Avenue.”
Frank Duffy, head of business development at hedge fund
service provider Price Meadows, added that start-up funds
should be very cost-conscious in the early days and that
building an institutional-quality business does not necessari-
ly mean a fund has to pay for the most expensive real estate,
legal firm, accountant and auditor. The reputation of the
service provider is more important in building institutional
infrastructure than merely choosing a brand name vendor at
the highest price.
Helping Hands
For most start-up funds without a marquee pedigree, the
road to gathering assets among institutions will require the
assistance of third-party marketing firms and seed capital
firms. However, with the glut in the marketplace today and
institutions’ preference for more estab-
lished funds, it is unlikely that these
firms will be of much help to a start-up
fund in its first few years of operation.
Today’s reality is that most start-up funds
should expect to be on their own for two
to three years. If they can reach the $50-
100 million threshold in that period of
time, then it makes sense to start looking
at third-party marketers. As it is, howev-
er, the environment no longer exists in
which a third-party marketing organiza-
tion can go out and raise institutional
assets for a fund with $25 million or less
in assets and a limited track record.
“If you don’t have the contacts and the
resume to find at least the first $25 mil-
lion in assets on your own, you shouldn’t
even start a fund,” Duffy said. “Placing
huge confidence in a third-party mar-
keter as a savior for your fund is a big
mistake,” he added, noting that it also would be a huge waste
of money.
Third-party marketers can work with a fund at any level, but the
smaller the fund, the greater the challenge. For example, Liability
Solutions only works with a brand new fund when the fund has
a particular pedigree and unique investment niche that would
allow it to generate interest among institutions. However, that is
the exception to the rule. “The buy side is overrun with funds try-
ing to raise money, and the selection criteria will continue to get
more and more difficult,” Keane said. Todd Goldman, principal
in Rothstein Kass’ Bay Area office, concurred, adding that “the
best marketers in the world can’t take a fund from $5 million to
$50 million.”
The two other main options for start-up
managers are traditional seed capital organi-
zations and multi-strategy hedge fund shops
that are looking to take stakes in new funds.
While these relationships can be essential for
start-up funds, it is critical to structure the
deal in a way that does not force a first-time
manager to forsake the entrepreneurial spir-
it that brought him or her to the hedge fund
business in the first place. “Plenty of seed
groups will give money to a $10 million guy
if he is willing to give up a huge percentage
of the business,” Perkins said. “Unless you
have $100 million, these seeders have you
over a barrel.”
Nonetheless, because third-party mar-
keters are not a realistic option for the
first two to three years of operation and
because a start-up fund most likely can’t
reach the $100 million threshold on its own,
seeding arrangements are critical. “If you
“If you don’t
have the con-
tacts and the
resume to find
at least the
first $25 million
in assets on
your own, you
shouldn’t even
start a fund.”
— Frank Duffy
From Left to Right: Frank Duffy, head of business development at hedge
fund service provider Price Meadows, and Daniel Dorenbush, managing
director and global head of hedge fund services at RBC Capital Markets

don’t have a legendary background or come into the game
extremely well connected with investors at a large institution, it is
really hard to be successful without the help of a seeding firm
today,” Altman said.
While many start-up funds worry about giving up the keys to
the house when signing seed agreements, Altman emphasized
that a seed organization should not just be viewed as a wal-
let. The best seeders are strategic partners that are positioned
to help a start-up manager build a viable, long-term business
with an institutional-quality infrastructure and not just pro-
vide some upfront cash, he explained. Furthermore, good
seed organizations know it is not in their best interest to kill
the entrepreneurial spirit of nascent hedge fund managers, so
this hesitation should not be difficult to overcome through
arms-length negotiations.
As the market becomes more saturated and third-party mar-
keters find it more difficult to take brand new funds to insti-
tutions, seed organizations are evolving to meet the needs of
start-up funds. One example of a seed organization that is
bridging the traditional seed model with a private equity
fund approach is Skybridge Capital. Skybridge will place
between $25 million to $50 million of its capital in a group
of eight to 10 funds in exchange for a percentage of the man-
agement and incentive fees during a three-year lockup.
However, Skybridge provides more than just the initial capi-
tal push. It performs full-time marketing on behalf of its
fund of funds, as well as operational support. For many start-
up funds that do not have the time or expertise in marketing,
this model can be very beneficial.
“The smaller you are in terms of fund assets, the longer the
time frame in which to grow your business,” Prince said. “We
can help by creating institutional legitimization for start-up
funds and accelerating the fundraising effort,” he added, not-
ing that most first-time managers do not have the expertise,
time and resources to go on road shows targeting the high-
net-worth and family office markets.
In its first fund of funds, Skybridge raised four times the
amount of money it provided in seed capital from outside
investors. For example, a manager that Skybridge funded
with $50 million at the beginning of 2007 had raised a total
of $250 million by year-end. For its purposes, the pedigree of
the individual can be among the most important factors,
which is why Skybridge focuses on talent that is coming out
of an investment bank or larger hedge fund. It also will help
managers who have not yet left the bank or hedge fund for
which they currently work to start up their funds.
Many big multi-strategy funds that already see large asset
flows and have full-fledged marketing arms are now serving a
similar role for start-up funds: bringing them under their
umbrella and leveraging their existing institutional market-
ing infrastructure. However, hedge fund executives caution
first-time managers about actually becoming part of a multi-
strategy fund shop. “It is best for a start-up fund to attempt
to attract an allocation from a multi-strategy fund rather
than actually join the shop,” said Raviv. “It is difficult if you
are actually within the multi-strategy hedge fund to reconcile
its needs with your desire to run your own fund and build
your own brand and track record.”
For their part, third-party marketers don’t have an invest-
ment in the underlying fund, according to Prince.
Furthermore, the cost of hiring a seasoned full-time marketer
would be prohibitive, as well as the fact that there is a scarci-
ty of that talent available to start-up funds. Therefore,
Skybridge believes its model combining the seed capital with
marketing creates greater institutional legitimacy. “Capital
alone has become somewhat commoditized,” he added.
Stable Start-ups
Whether a start-up fund decides to go it alone or work with
a seed capital firm, a third-party marketer or a multi-strate-
gy hedge fund manager, the final lesson for new managers is
that marketing is an ongoing process. According to hedge
fund executives, one of the classic mistakes made by new
funds is to believe that their initial investors will be perma-
nent investors. As in any asset gathering business, it is the
‘stickiness’ of assets that allows a viable long-term business
model to be built. In the hedge fund context, this means that
start-up managers must constantly be in the mindset of
replenishing assets.
Initial investors may have needs that change over time and
investment boards may reshape investment policy, leading to
redemptions. Furthermore, if funds are not careful in the
rush to raise assets, they may attract too much capital from
‘fast money.’ For example, many hedge fund marketers
believe that funds of funds move in and out of single strate-
gy funds rapidly, either due to the tactical nature of their
investment allocation or the pursuit of the style du jour. A
start-up manager that is too reliant on funds of funds as an
investor base - or any one client type, for that matter - may
place itself at a high risk of mass redemptions. It is important
for new funds, and any partner organizations, to develop a
diverse investor composition so that assets remain stable.
“I don’t necessarily believe that funds of funds are faster
money than other investor types, but you do need to have a
good balance between investor types and remember that mar-
keting is a 24/7 job,” Keane said. An investor base will
change over time, and those changes will not necessarily be a
related to a fund’s investment performance, but rather to the
complex nature of today’s investor base. “No investor is for-
ever,” he added. i

LATE LAST YEAR, the FTSE Group
said it would promote Israel from
‘emerging’ to ‘developed’ status as of
June. No other index manager has fol-
lowed suit yet, but the shift by such a
major institution gives investors in Israel some unusual lever-
age. Investors from outside the country can still expect emerg-
ing market returns while reasonably expecting safety more
akin to that of a developed market. At the same time,
investors and asset managers in Israel can point to the catego-
ry shift as evidence of soundness for the overall economy
while still attracting the kind of venture capital that seeks
higher returns.
Over the past few years, the expansion of Israel’s economy has
been mirrored in the rapid growth of its capital markets. The
major indices of the Tel Aviv Stock Exchange (TASE) have
consistently risen over the past three years, with the Blue
Chip TASE 25 index rising 140% in dollar terms during that
period. That, in turn, has led to growing foreign investment
in the Israeli market and the rise of exchange-traded
funds (ETFs) as the preferred tool to access it.
One of the companies at the epicenter of this
market in transition is KSM, based in the business
center of Tel Aviv. The firm is the largest market
maker for index-linked certificates (ILCs) in Israel
and manages more than 80 ILCs tracking diverse
commodities, currencies and leading share indices
in Israel and globally. ILCs are similar to ETFs,
except ILCs are fully obligated to the index price
rather than to its underlying asset value.
Co-founder and chairman of KSM, Roy Regev,
said the company’s ILCs - and especially its hedg-
ing tools - offer a “sophisticated yet simple” gate-
way to emerging markets. He noted that the tran-
sitional nature of the Israeli economy, as well as
those of larger advanced emerging markets like
China and India, make both straight index vehicles and shorts
more useful and important.
“Emerging markets have been popular in recent years as
investors in developed countries are seeking outlets beyond
their own economies,” said Regev. “The Israeli GDP has
grown about 5% over the past few years. That is not as great
as China’s 10%, but it is considerably higher than the 2% we
have seen in the developed economies. Of course, risk is
expected to be greater in emerging markets, but with the sub-
prime problems in the U.S. affecting Europe there also is risk
within developed markets.”
SPONSORED ARTICLE
The Potential of
Emerging Economies
Israeli investment house sees a shift in market perception as an opportunity
to attract foreign investors
By Gregory Morris
Leading Economic Indicators for the Israeli Market
2007 2008
Growth in GDP 5.1%* 3.8%*
Growth in CPI 2.8%* 2.0%*
Interest Rate 4% 5.5%**
(end of year)
* IMF estimate
** Excellence Nessuah forecast

As a result,
three trends are
c o n v e r g i n g .
First, there is
the natural flow
of investments
to emerging
economies due
to the accept-
ance of higher
risk for higher return, Regev said. That is now being joined by an
almost ironic flight to quality from the troubles in the developed
economies to the soundest of the emerging markets, he
explained. The new impetus, plus the long history of expansion
in emerging markets, increases the urgency that hedging strate-
gies are in place. Few expect a serious problem to develop in
China, India, Israel or other advanced emerging markets, but the
size of the foreign exposures in those economies make hedging
the prudent move, he said.
Part of the Excellence Nessuah group, one of the largest invest-
ment houses in Israel, KSM accounts for more than half of the
total market in ILCs and covered warrants on the TASE. The cer-
tificates have been traded since 2003 and have increased the daily
volume in market indices. KSM has developed more than 80
products, including 25 custom made for the Israeli market, and
daily trading in the firm’s ILCs is substantial, representing 20%
of daily trading volumes on the TASE.
A good deal of that success can be ascribed to Regev’s expertise.
He grew up in Israeli investment circles,
earning an MSc in finance from Tel Aviv
University. Prior to co-founding KSM,
Regev was a partner in a strategic con-
sulting firm and worked with leading
technology companies in the Israeli mar-
ket. Today, in addition to running KSM,
Regev is a member of the TASE market-
ing committee.
“In 2003, we decided to combine our
expertise in index trading with our
entrepreneurial spirit to establish KSM
within the structure of Excellence
Nessuah,” Regev said. “We were not
the first with an ETF in Israel, but we
were the first to show the market what
the ETF could do.”
KSM’s main expertise for non-Israeli
investors is its wide range of local reverse
strategies. “We currently have more than
10 different reverse trackers to hedge
almost every angle of the Israeli market,” Regev said. “To have those
available is very unusual for an emerging market of our size. We
have the TASE 25, TASE 100 and even a small-cap hedge, which is
the only reverse tracker on any small-cap index outside the U.S.
Beyond Israel, we have a unique reverse tracker on the CNX Nifty
index, which is based on the National Stock Exchange of India, and
shortly we will have a reverse tracker on the Chinese market.”
One of the most unique features of the Israeli market is its Sunday
trading, and KSM offers its international clients an opportunity to
trade most of the world’s leading indices on a Sunday. “To date, our
main customers have been hedge funds that invest in Israel, but we
hope to expand to a larger pool of investors in 2008,” Regev said.
Regev believes the wider use and utility of reverse trackers has
allowed some investors to reduce their use of derivatives for hedg-
ing. “This has occurred for three reasons,” he said. “First, you don’t
need to roll a reverse strategy as you do with derivatives. Not only
is the roll a complication, it exposes you to interest rate and divi-
dend risks. Second, the liquidity within the reverse trackers is far
greater than other hedging tools in the market. And third, our
reverse trackers cover every angle of the Israeli market.”
Regev noted that the low correlation of emerging markets to
developed markets does not mean zero correlation. “Due to the
subprime problems and the slowing of the worldwide economy,
we will see some effects too,” he said. “GDP growth in Israel will
go from 4.5% to about 3.8%, but not much lower. China will
continue to grow, at least through the Olympic Games this sum-
mer. However, volatility everywhere will be much higher, and we
will see some hard corrections in 2008. As a
result, the use of hedge solutions will grow.”
In reclassifying Israel, FTSE noted that the
country’s economy “meets all quality of markets
criteria for a developed market and has done so
since being included on the watch list in 2006.
A new FTSE Index for developed markets in
Europe, the Middle East and Africa will be
introduced for those investors wishing to inte-
grate Israel within their existing Developed
Europe portfolios.”
The promotion of Israel from emerging to
developed market does have some conse-
quences, but the outlook is broadly positive.
“In terms of the economy, it is great to have
an objective firm say that the economy is get-
ting better,” Regev said. “That is good for
direct investment.”
For more information on KSM, visit their website
at www.ksmci.com.
“To date, our
main customers
have been
hedge funds
that invest in
Israel, but we
hope to expand
to a larger pool
of investors in
2008.”
— Roy Regev
SPONSORED ARTICLE
$inmillions
0
5,000
10,000
15,000
20,000
Foreign Direct Investment in Israel
2005 2006 *2007
Source:Bank of Israel *as of Nov 1,2007
4,792
14,301
8,902

THE BEST PART OF creating a new
hedge fund may be the entrepreneurial
spirit of the endeavor, yet that very
mindset can result in a host of legal
headaches for funds not careful from
the outset. While there are a plethora of legal complexities
related to the tax implications of the fund structure and advi-
sor incorporation that fill legal tomes longer than any hedge
fund manager could ever want to understand on their own,
lawyers say the most critical issue for first-time managers is
often more basic: the change of mindset from an employee of
a corporation to a business owner.
Prior to starting up their new hedge funds, most managers
were traders at an investment bank or junior managers and
analysts at an established hedge fund. Therefore, lawyers
stress that, while these managers may be investment geniuses
and whizzes with complex derivatives, their biggest legal
issue is transitioning into the mindset of running a business
on their own.
“Most new managers are largely clueless when it comes to
regulatory issues and structuring concerns,” said George
Mazin, partner in charge of the hedge fund practice at
Dechert. “They know how to put in buy and sell orders, but
everything else has been done for them.”
Case in point, many traders come out of a bank or larger
hedge fund where they were part of a team, and they start
advertising the performance of that team as if it was their
own, placing it up on web sites or in marketing materials.
This is the type of basic mistake that is obvious to lawyers
and seems as if it should be obvious to hedge fund managers,
but often it is not because they have never had to concern
themselves with running their own business. The good news
from the standpoint of hedge fund lawyers is that legal and
regulatory risk are two risks that funds can actually have con-
trol over and can do a lot to minimize. In other words, while
minimizing these risks will never make a fund a lot of money,
it may very well save the fund a lot of money when consid-
ered from a more nuanced, long-term perspective.
David Nissenbaum, a partner at Schulte Roth & Zabel, said
the number one issue for new hedge funds is to make sure
they understand what it means to operate as a fiduciary. By
law, this means they have to act in the best interest of
investors, and that is very different from the environment
most new managers come from, working for an investment
bank or hedge fund shop that has been the fiduciary assum-
ing all of the risk related to managing clients’ assets. The
fiduciary responsibilities under investment law are unique
and distinct from the environment in which these traders
have come up. “When you are the fiduciary yourself, your
thinking has to be permeated by much more careful analysis,
whether it is related to making a trade, hiring a service
provider or managing pools of money on behalf of multiple
clients,” Nissenbaum said.
Furthermore, when a trader, analyst or junior manager is
working for a larger institution, all of the reputation risk also
is at the level of the corporation. Proper understanding of
reputation risk and client trust is a critical mindset shift for
new funds. All of the decisions made by hedge fund man-
agers - from their approach to client disclosures to due dili-
gence on investments and service providers - circle back to
the heart of the risks of starting up your own investment
business. “Many new managers don’t fully realize that even if
they are doing the same type of trading they were doing at
another fund or investment bank, it is completely different
in the context of their own shop,” Nissenbaum said.
The fiduciary equation also means preparing yourself for
investor challenges unrelated to actual fraud. Ron Geffner, a
partner with Sadis & Goldberg, explained that one of the key
Think Like
An Owner
Having a start-up mindset can place first-time managers in a legal minefield
By Eric Rosenbaum

initial components of shifting the mindset of start-up fund
managers is getting them to understand that legal challenges
are likely when investors lose money. This is not limited to
cases in which the manager has committed securities fraud,
but also cases in which a manager may have a bad stretch of
performance or made overly aggressive bets. Traders do not
come out of a background where they have had to assume
this risk themselves and, as a result, it is critical to prepare
the hedge fund for times when investors may try to legally
attack it in response to poor performance.
Pre-Nups for Start-ups
Beyond the shift of the legal and reputational burden away
from a large corporation to the start-up
fund, another critical aspect of forming
a hedge fund business is settling on an
appropriate operating structure for key
personnel and an appropriate structure
for relationships with third-party mar-
keting firms and seed capital providers.
Lawyers stress that these are decisions
that many first-time managers will not
be at all familiar with, but if they are
not dealt with in a proactive way, they
can come back to haunt the fund with
a vengeance.
Structuring the hedge fund in the con-
text of long-term business planning
probably has changed the most in recent
years. Before the last decade, hedge
funds were most often synonymous with
the individual managers, and therefore
there was no real exit strategy put in
place from a legal perspective. Over the
past few years, as large institutions have
gobbled up hedge fund shops—most notably the watershed
deal by JPMorgan for Highbridge Capital Management—the
issue of exit strategies has become a critical part of the legal
framework for new funds, and not an issue that can be easi-
ly tackled retroactively. As institutions remain as hungry as
ever for alternative investment acquisitions, deciding on an
ownership structure that is prepared for the long-term future
of key personnel is increasingly important. Furthermore, as
competition for hedge fund talent is intense, deciding on an
exit strategy for key personnel at the firm, as well as the firm
as a whole, also is an important issue on the legal checklist
from day one.
“The most prevalent issue for start-up funds launched by
more than one individual is that they fail to execute a well
thought out agreement among principals and, in the event of
a divorce, don’t know how to extricate themselves,” Geffner
said. “There is a misconception out there that these legal
documents are boilerplate. They are not, and you can’t go
back and easily modify them either.”
Not long ago, it was just the year-to-year income of key
personnel that hedge funds had to be concerned with, but
now they are following the path of the brokerage industry
two generations ago, with various legal approaches to part-
nerships, participation in firm equity and the need to pre-
pare for the exit of senior managers, as well as the potential
sale or merger of the firm. Lawyers stressed that not proac-
tively dealing with these issues at the time of structuring
the business often means having to buy out officials, and
that is never profitable. “No one wants
to be part of these back-end divorces,
and it can be nasty from the perspective
of your investors as well,” said Jamie
Nash, an associate with Kleinberg,
Kaplan, Wolff & Cohen.
Seeds of Discontent?
In today’s saturated hedge fund market,
start-up funds also are more and more
dependent on the support of third-party
marketers and various types of seed capi-
tal organizations in order to grow assets.
The days of the proverbial garage-run
hedge fund growing to billions of dollars
on the strength of investment perform-
ance alone are a distant memory. From a
legal perspective, this means that start-up
funds have to spend a good deal of time
settling on the legal nature of their rela-
tionships with third-parties, in particular,
with seed capital organizations. And if
not dealt with proactively, this is another
From Left to Right: George Mazin, partner in charge of the hedge
fund practice at Dechert, and David Nissenbaum, a partner at
Schulte Roth & Zabel
“There is a mis-
conception out
there that these
legal docu-
ments are boil-
erplate. They
are not, and
you can’t go
back and easily
modify them
either.”
— Ron Geffner

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structural issue for the firm that can be exceedingly difficult,
if not downright impossible, to fix retroactively.
“Working with a seeder is an extremely serious decision to make
because it is extremely hard to renegotiate,” Nissenbaum said.
Seed capital organizations typically have the strongest type of
minority owner protections. If not executed properly, a start-up
fund can end up in a situation where the entrepreneurial spirit, in
which it entered the hedge fund arena to foster, can be complete-
ly overwhelmed by the ceding of too much control, and profits,
to the seed firm.
Also, as competition for up-and-coming hedge funds inten-
sifies among seed capital firms, the traditional seeding model
is facing new competition. Start-up funds need to be exposed
to all of the rapidly multiplying seed models, and legal firms
that are structuring dozens of these deals each year are often
in the best position to provide counsel.
Another critical component of the legal language of funds -
also related to the race to gather assets in a saturated market
- is the balance between liquidity and creating a stable cash
flow for portfolio management. In some cases, a trading
strategy may be so liquid in its underlying securities that the
hedge fund has much greater flexibility in offering frequent
redemptions to institutional investors without hamstringing
its portfolio management. However, for many strategies that
deal in illiquid markets, the marketing impetus to offer
investors attractive liquidity terms can be at odds with what
is best for the fund’s cash flow, and ultimately for both the
fund and its investors in terms of performance. “I’ve seen
cases where hedge funds set lock-up terms with too much
flexibility because they thought they would not be able to
effectively market the fund otherwise, but it ended up dis-
rupting the management of the fund,” Nash said.
Mazin noted that this issue can take managers in the oppo-
site direction as well. Some managers are so paranoid about
a run on their fund and their business disappearing overnight
that they impose long lock-up periods. “This is one of most
difficult issues they wrestle with, trying to create permanence
for their fund but actually making that a more difficult task
due to these fears,” he added.
Three Questions
Ultimately, for all the complexities of setting up an invest-
ment fund and incorporating a business, the most important
conversation with a new hedge fund can be boiled down to
three questions: What type of strategy are you going to run?
Where are you going to have offices? And who are you going
to target as your clients? These questions are extremely
important because of the lack of specialized knowledge
among so many start-up funds coming out of a trading back-
ground. “Lots of managers mistakenly assume that one size
fits all, so they look at peer structures and think that will
work fine for them. There is often not a perfect answer, but
there is this simple set of questions to get the conversation
started,” Mazin said.
Lawyers say it is extremely important to have a detailed con-
versation about the nature of a fund’s trading strategy and
where the fund is to be domiciled because the tax implica-
tions will vary widely based on the fund’s approach and loca-
tion. It is very possible that selecting the wrong legal struc-
ture for a particular fund strategy could leave a manager with
an annual tax bill that eats up even sizable investment
returns. “Large investment management companies don’t let
a business start until the tax people have vetted it, but start-
up funds don’t have tax departments,” Mazin said.
What’s more, because hedge funds are involved in so many
complex security types and can incorporate in both domes-
tic and offshore markets, the tax ramifications have
increased. Lawyers described clients who began their career
in Hong Kong and now also have offices in London, New
York and India.
There is no easy answer as hedge fund shops expand around
the globe and trade in more complex securities. With the set
of issues related to the shift in mindset from employee to
business owner, the analysis is easier to outline for a general
audience. However, hedge fund lawyers say that, when it
gets down to the layer of specific tax treatment for various
security types and various onshore and offshore markets, the
situation can only be evaluated properly on a case-by-case
basis. Nonetheless, it is safe to assume that Mazin’s set of
questions will at least lead funds in the right direction and
help them to steer clear of the red-flagged areas from a tax
or legal perspective. i
From Left to Right: Jamie Nash, an associate with Kleinberg, Kaplan,
Wolff & Cohen, and Ron Geffner, a partner with Sadis & Goldberg

IN THE REAL ESTATE world, an old cliché
dictates that the preeminent success factor is
location. In the realm of technology and oper-
ations for start-up hedge fund managers, the
issue of chief importance is credibility. And in
the minds of prospective investors, nothing injects credibili-
ty like the comfort of knowing a manager has aligned with a
team of competent third-party service providers. Without a
qualified attorney, auditor, fund administrator and prime
broker squarely in place, a manager’s ability to raise capital
and achieve smooth execution is severely impaired.
“These services require outsourcing for one main reason:
there are more institutional investors interested in hedge
funds than ever before,” said Colin Bugler, managing direc-
tor and head of global prime brokerage at RBC Capital
Markets. “From an operational perspective, the minimum
standards institutional investors will accept are vastly higher
than what high-net-worth individuals and private clients
demand. So if a manager wants allocation from a pension
fund or other institutional player, they better raise the bar
and become more institutional in nature themselves.”
Long Arm of the Law
While each of the aforementioned third-party disciplines are
unequivocally vital to the start-up process, procedurally
speaking, the journey begins by procuring legal expertise.
After all, document creation must precede all else. Or as one
industry expert succinctly put it, “You’re nothing without an
offering memorandum.”
Manoj Nadkarni, a hedge fund manager with the
Washington-based ChipInvestor Group, relies on outside
council to articulate strategy and manage investor expecta-
tions in his offering documents, especially given that his sec-
tor-specific fund strays significantly from the typical
long/short model. “With regards to risk, the dynamics of sec-
tor funds are different,” Nadkarni said. “The more explicitly
you explain this from the onset, the better off you are with
regard to retaining investors in the future, particularly if
there are draw-down periods.”
Michael Tannenbaum, founding partner at the law firm of
Tannenbaum Helpern Syracuse & Hirschtritt, concurred
that clarity with disclosure documents is critical. But his
experience tells him that the lion’s share of the trouble most
start-up managers encounter has more to with daily infra-
structural difficulties than anything else.
“The operational risk associated with building infrastruc-
ture goes beyond the ability to trade properly and assess
the markets,” Tannenbaum said. “It has to do with the
day-to-day business operations: paying rent, paying the
lighting bill, making sure the technology is up to scratch.
These are the below-the-investment-line issues that make
or break a manager.”
Competent Service Providers
Are the Key to Credibility
When it comes to technology and operations, nascent managers
can quickly gain respect by outsourcing to qualified providers
From Left to Right: Michael Tannenbaum, founding partner at
Tannenbaum Helpern Syracuse & Hirschtritt, and Manoj Nadkarni,
fund manager at ChipInvestor Group

Tannenbaum’s best legal advice for start-ups: execute a one- to
two-month dry run before rolling out the fund. Although
doing so may delay a manager’s planned launch date, it’s bet-
ter to avoid humiliation by identifying and rectifying issues in
private, rather than doing so under the watchful eyes of
prospective investors.
It’s Primetime!
Beyond legal services, there are no hard and fast rules dictat-
ing the order for acquiring the remaining service providers.
Typically, however, securing the prime broker is the next
move, if only because such entities often have relationships
with fund administrators and auditors and can easily facilitate
those introductions.
In scope, the traditional prime brokerage role is vast. In addi-
tion to providing custody services like securities clearing,
prime brokers facilitate capital introduction by pairing man-
agers with investment clients, offer technology support by
handling execution and reporting and provide financing to
leverage client assets. Some prime brokers also lease office
space to hedge fund managers, providing them with a suite of
on-site services.
“The parameters of what we do are becoming broader and
broader as prime brokers try to differentiate themselves in a
bid to capture greater market share,” said Bugler, who shares
Tannenbaum’s observation that emerging managers’ most
common misstep is failure to effectively run the business.
This, he reasoned, is largely because many start-up managers
are stepping out on their own for the first time after stints
as proprietary traders for investment banks, where their for-
mer employers previously handled all
the logistics.
“If a hedge fund has problems in the
first few years of life, it’s not because of
failed investment decisions. It’s
because they don’t properly manage the
business side of their fund,” said
Bugler. He advises managers and prime
brokers to establish clean lines of com-
munication in order to function with
optimum operational efficiency.
“Investors are willing to listen to a
manager explain away poor perform-
ance due to poor market conditions or
bad timing, but they’re not so patient
with operational errors,” added
Bugler. “If you have to explain
accounting adjustments, correct
mark-to-market figures or re-state
your net asset value because of poor communication with the
prime broker, that doesn’t give investors a sense that you’re in
control of your business.”
A Perceived Conflict of Interest?
Some managers are dubious of prime brokers, many of whom
earn large chunks of their profits from fee-based commissions
and through spreads on clients’ long and short positions. For
some investors, this paradigm fosters an atmosphere of
favoritism, where prime brokers pay more attention to their
highly levered clients, leaving their long-only clients hanging
in the wind.
“Many times, what a prime broker is looking for differs from
what a fund manager is looking for,” Nadkarni said. “For me,
the important thing is what’s good for the fund and what’s
good for our limited partners. Prime brokers are mostly con-
cerned with landing that ideal candidate: one who’s leveraged
in the neighborhood of 150%, does a lot of shorting and
makes them a ton of money through margin trading. Prime
brokers are aggressive, and we changed ours when we realized
they were not acting in our best interest. I’m pleased with
that decision.”
For his part, Bugler conceded that prime brokers have indeed his-
torically made their bread and butter through providing securities
lending coverage to clients. But he noted that a large contingent
of brokers is evolving in an effort to become more accommodat-
ing to a wider spectrum of clients.
“As hedge funds have evolved, prime brokerages have aug-
mented their offerings in response,” Bugler said. “Initially,
they started off by introducing capital intro-
duction programs. This was followed by
enhanced technology offerings, risk plat-
forms, risk engines and performance analy-
sis. We recognize these things as needs in the
market, especially for small managers with
small wallets.”
Administering the Fund
For single manager funds, hedge fund
administration involves the dual tasks of
monthly accounting, including the calcula-
tion of performance fees, and investor
recordkeeping, which entails monitoring the
proportion of the fund that each limited
partner owns. It also entails collateral man-
agement and cash processing. While admin-
istrators perform the same functions for
funds of funds, they also act as custodians of
the investments, carrying out all the transac-
tion processing on those positions.
“If a hedge fund
has problems in
the first few years
of life, it’s not
because of failed
investment deci-
sions. It’s because
they don’t proper-
ly manage the
business side of
their fund.”
— Colin Bugler

“Investors, particularly institutional
investors, gain a great deal of comfort
from having both an independent
administrator and, on the fund of fund
side, a custodian holding all of the
investment assets,” said Elliott Brown,
global product manager at JPMorgan
Hedge Fund Services, which services
more the 240 funds with approximately
$85 billion in combined assets under
management.
“I’d say the biggest advantage to out-
sourcing is that it allows managers to
focus on their skill set, which is manag-
ing money, while the administrator stays
up to date with new technology and sys-
tems upgrades,” Brown added. “There’s
a huge cost for hedge funds to keep their
systems up to date, and by outsourcing
there’s a certain economy of scale.”
According to Brown, two-thirds of
JPMorgan’s clients are single manager
funds and one-third are funds of funds,
with new business evenly split between
the two.
As Sure As Death
With about 250 hedge fund clients,
Denver-based Spicer Jeffries provides
managers with audit and tax services,
including year-end financial statements, and K-1 prepara-
tions, which report capital gains, interest income and expens-
es the fund’s partners incur.
Spicer Jeffries manager Sean Tafaro’s best advice for hedge
fund managers is not unlike that dispensed by other service
providers: maintain constant communication with the audi-
tors, especially with respect to new product offerings and
new trading strategies.
“It’s important for the auditor to know about these changes
because different financial products are taxed differently, and
it’s crucial to have an understanding of this before you get to
year end,”Tafaro said. “Things can be done before year end to smooth
out the tax process. Plus, for marketing and SEC purposes, investors
feel more comfortable when this is prepared by professionals.”
Victor Chiang, chief operating officer of Boston-based BCM
Discovery Fund, said he explicitly monitors potential under-
lying managers to make sure they are aligned with reputable
third-party providers all around. If they’re not, he’ll elimi-
nate them from contention. Chiang’s chief worry is that care-
lessness and human error will cause mis-
takes, especially when people incorrectly
believe they have more cash on hand
than they actually do.
“It happens more than it should. People
make trading errors because they don’t
have an accurate picture of their portfo-
lio and position sizes. Trade reconcilia-
tion is everything,” said Chiang. “For
the most part, if you’re using one of the
major prime brokers, all of them will
offer you good technology, but technolo-
gy is only as good as the person who’s
using it. Are they checking the trade
blotter? Are they checking the daily
P&L? It’s important for fund managers
to know with certainty that they are.”
Moving Operations In-House
Once a fund takes root and substantially
grows in assets, some may wonder
whether it is sound practice to then hire
in-house talent to handle technology and
operations. “The answer is ‘yes’ and
‘no,’” declared one industry expert. “As
funds grow in assets, head count increas-
es with the addition of full-time employ-
ees, just as it happens with any company.
But they’ll never take the place of the
third-party providers.”
The expert conceded, however, that in-house legal, account-
ing and administrative staff may function well as liaisons to
the third-party providers. An in-house chief counsel, for
example, would interact with the outside law firm, just as a
chief operating officer would communicate with the third-
party administrator. “If you’re an investor you want non-
biased checks and balances in place,” the expert said. “That
never changes.”
However, some believe that certain situations are indeed con-
ducive to in-house operators taking lead roles. “There’s no
question that, when the assets under management rise, you
can get by with in-house staff in certain situations,” said one
proponent of such action. “The fund can hire in-house coun-
sel, even in-house computer programmers. The more money
you have, the easier it is to do it. But not all managers would
benefit. A manager who publicly trades securities that are
easily valued would have fewer problems with reporting than
a manager on the other end of the spectrum, who trades in
investments with little liquidity or distressed instruments
where clear valuation issues are more complex.”i
The Breakdown
What are the specific functions of the four
main service providers? The Hedge Fund
Start-Up Survival Guide breaks it down:
Attorney
• Fund structure
• Legal documents
• Regulatory requirements
• Registration
Prime Broker
• Clearance, settlement and custody
• Reporting
• Financing
• Capital introduction
• Technology
Accountant
• Annual audit
• Tax returns
• Schedule K-1
• Tax issues
• Compensation structures
Administrator
• Investor communications
• Marketing subscriptions/redemptions
• Books and records (onshore/offshore)
• Partner capital accounting
• Valuation
• Performance calculation
• Management fees

©2007 The Bear Stearns Companies Inc. All rights reserved. Bear Stearns®
and A Great Deal Depends on Working With The Right People®
are registered trademarks of The Bear Stearns Companies Inc. (BSCI). A culture of service.
A tradition of strength.SM
is a service mark of The Bear Stearns Companies Inc. Prime Brokerage Services is a business unit of the Global Equities division of Bear, Stearns & Co. Inc. (BS & Co.). Prime brokerage services are offered in
the United States by BS&Co. and outside of the United States by Bear, Stearns International Limited (BSIL). Clearing and custody services are provided by Bear, Stearns Securities Corp. (BSSC). BS&Co., a direct subsidiary of BSCI,
is a United States registered broker-dealer and a member of the NYSE, NASD and SIPC. BSSC, a guaranteed subsidiary of BS&Co., is a United States registered broker-dealer and a member of the NYSE, NASD and SIPC. BSIL, an
indirect subsidiary of BSCI, is authorized and regulated by the United Kingdom Financial Services Authority. Sources: (1) and (2) Lipper HedgeWorldService Provider Directory & Guide, 2006/2007 edition. Results are from a survey of
1700 Institutional investors and based on three primary factors, scores, respondent comments and number of responses. Respondents were asked to rate participants in the following areas, Client Service, Securities Lending, Financing,
Reporting, Technology, Operations and Capital introduction. (3) Global League Table 2007, Global Custodian Prime Brokerage Survey
It takes both to be a leader in Prime Brokerage.
#
1Prime Broker by Assets
of US Funds1
Lipper HedgeWorld, 2006/2007
#
2Prime Broker for all Funds2
Lipper HedgeWorld,
2006/2007
A culture of service.
A tradition of strength.SM
2007 GLOBAL CUSTODIAN PRIME BROKERAGE SURVEY
3
■ Funds over $1 billion
■
Multi-strategy Funds
■
Single strategy Funds
■ European Funds
■ Funds under $100 million
Top Ratings
■
Client Services
■
Operations
■
Consulting
■ Financing
■ Securities Lending
■
Reporting
■
Technology
Global Best in Class Awards
P R I M E B R O K E R A G E S E R V I C E S

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Your Language.
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