What are the major legal requirements of owning and managing a capital management firm?

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by aint_no_lie

1) There’s 2 key types of money managers. First is where you manage money for individual clients meaning you make investment decisions for a specific individual with their capital. You do not mix their capital with other clients. The 2nd key type is where you pool investor money and manage it as a fund. There’s 2 main sub types here. Mutual funds and hedge funds. Mutual funds are allowed to advertise and are allowed to take money from anyone, but are incredibly restrictive in how they invest. Hedge funds are not allowed to advertise and are only allowed to take money from accredited investors (this isn’t strictly true, but for simplicity it’s safer to say that). Hedge funds have substantially more flexibility in how they invest. If you’re good at picking stocks and want to pool money, then it sounds like you want a hedge fund.

2) There’s a lot of regulations. When you take in investment money, there are a number of disclosures and questionnaires that have to be provided and documented. There is a process and if you don’t follow it, miss something, or even include something you shouldn’t, you could get sued or have regulatory agencies up your ass.

3) You do not gain the tax advantages you think you’ll gain by forming a business to trade. In fact, you’ll get charged professional market data fees, be subject to professional maker-taker fees (depending on your registration and exchange membership) and lose customer priority in some markets (ie US equity options).

4) A hedge fund is typically set up as 2 separate entities. A limited partnership (LP) and a general manager (LLC). When someone invests, they become a partner to this LP. The LLC has an agreement with the LP to manage the LP’s money on their behalf and receive compensation for managing that money.

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5) You must not mix LP money with LLC money. Costs to operate the fund come from the LLC. Investment money comes from the LP. These are not the same. You want to subscribe to some indicator service, have a monthly accounting audit, hire a lawyer, all of that comes out of the LLC. Effectively any costs required to manage the money comes from the LLC. The money that actually purchases the asset comes from the LP. DO NOT CROSS STREAMS! So how does the LLC get money? Well that’s through the fee structure you set up. Historically it was common for this to be 2% off the top and 20% of profits above a bench mark with a high water mark.

6) If you want to actually start a hedge fund, it’s my estimate that to do it on the cheap would be in the $30 – $50k for the first year. This is to cover your minimum fees regarding legal, accounting, and administrative fees (assuming you’re using 3rd parties and not hiring someone full time obviously).

7) You may think the legal is optional. It is in theory, but in practice you’ll need to do presentations for people and you need someone who is very familiar with the various regulations to ensure that you don’t put anything in that presentation that is not allowed and that you include everything that is required. Anything that could even remotely be construed as advertising needs to be approved by someone who knows this stuff. Sure you could research it on your own, but even after doing hundreds of hours of research, I’d not trust myself on this stuff. Too much risk.

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8) If you’re not going to get at least $2M in initial investments (a better minimum in my opinion would be $10M because $2M is awfully lean and most new funds fail due to under capitalization), it’s not worth even considering doing a hedge fund. Until then, set up an account to trade with in the same style you would if you were running a hedge fund to build up a track record that you can eventually use to get investors in the future. Some will suggest even higher minimums, but I’m assuming you won’t be paid from the fund for the first couple of years and that you’ll be the only person working for it (aside from contracted professional services as needed) which substantially cuts down the costs.

9) If your goal is to get the best tax advantages, you should consider moving to Puerto Rico and not bothering with a corporation.

My comments are based on the extensive research I’ve done on starting a fund and law firms I’ve consulted with regarding this. I had a group I was going to start a fund with, but they ultimately couldn’t close the deals they thought they could and I felt it was too risky to operate without sufficient capital. So I’ve not actually started operation, but I did go through a lot of the work to start it up. Having said that, nothing I’ve said should be considered fact. Do your own research and I strongly recommend hiring a legal professional.

Good luck.


Disclaimer: This content does not necessarily represent the views of IWB.


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