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    The Hedge Fund Book: A Training Manual for Professionals and Capital-Raising Executives
    The Hedge Fund Book: A Training Manual for Professionals and Capital-Raising Executives
    The Hedge Fund Book: A Training Manual for Professionals and Capital-Raising Executives
    Ebook335 pages3 hours

    The Hedge Fund Book: A Training Manual for Professionals and Capital-Raising Executives

    By Richard C. Wilson

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    About this ebook

    An accessible guide to effectively operating in the hedge fund arena

    Hedge funds are now in the news more than a thousand times a day and yet it is hard to find clear, factual information about how they operate, raise capital, and invest. The Hedge Fund Book provides real-world case studies of various hedge fund managers providing a solid foundation in specialized hedge fund knowledge for both financial professionals and those aspiring to enter this field.

    It provides an analysis of funds within different phases of their life cycles and investment processes, and examines each cycle in ways that would be informational for marketers as well as investors, bankers, and financial professionals who would like to learn more about day-to-day hedge fund operations

    • Addresses everything you need to know about this popular segment of the financial industry within a case study format
    • Each chapter contains several types of investment and situational analyses, insights and best practices along with a review and "test your knowledge section"
    • Written by a successful hedge fund consultant and head of one of the largest hedge fund networking groups in the industry with more than 30,000 members
    • This book is required reading for participants within the hedge fund industry's leading designation program, the CHP Designation

    If you're looking to gain a better understanding of hedge funds, look no further than The Hedge Fund Book.

    LanguageEnglish
    PublisherWiley
    Release dateApr 12, 2011
    ISBN9781118107973
    The Hedge Fund Book: A Training Manual for Professionals and Capital-Raising Executives

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      Book preview

      The Hedge Fund Book - Richard C. Wilson

      Introduction

      What if you sat down with 30 hedge fund veterans and picked their brains? What if you spent over $80,000 hiring professionals with seven to 30 or more years of experience to provide you their insights on what is developing in the hedge fund industry, and what is important now?

      This is the premise on which I constructed The Hedge Fund Book: A Training Manual for Professionals and Capital-Raising Executives.

      This book is a discussion, a captured forum, not a dissertation, letter to Congress, or formal legal document. You will find less formality here than in most books, because that is how I am used to writing and transferring knowledge through speeches, e-mails, and blog posts. Some may appreciate this approach and form of communication; others will surely not.

      The Hedge Fund Book: A Training Manual for Professionals and Capital-Raising Executives will provide many benefits to those seeking to understand and work in this field. Our team at the Hedge Fund Group has raised millions of dollars of capital for hedge funds and personally worked with over 1,000 fund managers over the past several years. In the past we have freely shared our knowledge through our blogs, which you may still access today. They include:

      HedgeFundBlogger.com

      HedgeFundsCareer.com

      ThirdPartyMarketing.com

      FamilyOfficesGroup.com

      HedgeFundStartupGuru.com

      CommoditiesAndFuturesGuide.com

      PrimeBrokerageGuide.com

      PrivateEquityBlogger.com

      In addition to the more than 10,000 articles provided in these blogs, our free e-book has also been downloaded more than 100,000 times. These articles and resources were given away freely to develop relationships with those who found value in the resources.

      In an effort to now make this book worth more than the retail price, we include many diverse types of educational resources including case studies, examples, interviews, best practices, review questions, and video resources to help readers learn more about hedge funds. These interviews and videos were produced by hedge fund principals and consultants who normally either do not provide such advice or typically charge $200 to $475 per hour for their time. My hope is that the value of these additional resources alone will be worth more than what you paid to obtain this book. If you add up the 250-plus hours that went into putting this book together with all of the experienced professionals we interviewed, there is more than $80,500 worth of advice contained in this text. Here are some more details on the different resources included in this text and how they operate:

      Interviews. Over 20 interviews complete this training manual for the hedge fund industry, including many of the full transcripts in this text. The advice comes directly from numerous veterans in the industry, so individual readers do not need to interview all of them directly.

      Video resources. We have also created a series of over 40 video resources which act as a supplement to this training manual. Throughout this book there are references to specific video resources, and the complete list of videos available may be seen at http://HedgeFundTraining.com/Videos.

      Frequently asked questions. Our team at the Hedge Fund Group has received and sent over 800,000 e-mails since our firm was started in 2007. We have received thousands of e-mails on capital raising, starting a hedge fund, institutionalization, and hedge fund careers. I have used about 40 of the most frequent of these questions to create Chapter 9 of this book. Some professionals may find this resource more valuable than the rest of the chapter-by-chapter instruction and interview content.

      Why important. Each chapter begins with a short section on why the chapter is critical to the health and growth of the hedge fund as a business. This provision guides the reader as to which chapters will be most relevant to his particular career or business.

      Chapter review questions. Each chapter concludes with several review questions for those professors and trainers who have agreed to use this manual as part of their university course. These will also be helpful for those who are completing the hedge fund training and certification program referred to in this text as the Certified Hedge Fund Professional (CHP) Designation Program (www.HedgeFundCertification.com).

      I recently participated in a training session with Eben Pagan in Los Angeles at a marketing conference on how business is typically conducted. He told an interesting story. Eben spoke about how the streets in Boston are actually old cow paths that the city decided to just pave over to create the roads of the city. The result is a very complicated maze of one-way streets that really only make sense to the most veteran cab drivers. This is not the cows’ fault. They simply walked typically in the direction of least resistance. Nobody stepped back and looked at where the cows had wandered and asked if there was a better way to get the project done—they simply followed where cows had walked in the past.

      Eben's point in telling this story was that in every business, every form of marketing, and even in the hedge fund business, there are cow paths everywhere. The question is whether you and your business are wandering around on the cow paths of what others have done in the past, or building a super highway straight toward your goal.

      Areas to examine for hedge fund managers could include hiring, capital raising, employee management, performance reporting, transparency, governance, and investor relations. It helps to step back and look at competitors, other industries, and steps needed to complete the work we are trying to complete, to see if there is a more direct or efficient way of fully accomplishing it.

      BONUS VIDEO MODULE

      To watch a video on hedge fund cow paths, please type this URL into your Web browser: http://HedgeFundTraining.com/Cow

      Chapter 1

      Hedge Fund Fundamentals

      Training is everything. The peach was once a bitter almond; cauliflower is nothing but cabbage with a college education.

      —Mark Twain

      This chapter provides a brief 20,000-foot-view introduction to hedge funds and provides a context for the content of this book. In this chapter I briefly cover the history of hedge funds, important definitions, the hedge fund ecosystem, media portrayal of hedge funds, five industry trends, regulations, and the future of hedge funds.

      Why important: This chapter is the foundation for the rest of this book. If you have more than five years of industry experience, you may want to skim this chapter and skip to the chapter review questions to check your level of industry knowledge.

      What this chapter is not: This book is not a thorough review of hedge fund investment strategies or analytics; those topics are already covered in dozens of other texts, including two that are required in the Certified Hedge Fund Professional (CHP) Designation Program. See these required books and other recommendations at HedgeFundBookstore.com.

      What is a hedge fund? The one-sentence definition of a hedge fund is a private investment vehicle that charges its investors two types of fees: a management fee and a performance fee. Any more specific definition will lead to conflicts in the industry today, as it has grown in many directions. The management fee is a standard fee based on total assets under management and it typically runs between 1 and 2 percent. The second type of fee typically charged by hedge funds is a performance fee; typically this is 10 to 20 percent and is charged based on the performance achieved by the fund. If a hedge fund has 10 percent positive performance for a single year and its performance fee is 20 percent, the hedge fund's management would get to keep 2 percent of that 10 percent gain as part of their profits, a reward for achieving these positive returns for their investors.

      BONUS VIDEO MODULE

      Watch a video explaining what a hedge fund is and is not, here: HedgeFundTraining.com/What-is-a-Hedge-Fund?

      HEDGE FUND MECHANICS AND STATISTICS

      It is important to know that while these fee figures just mentioned are typical, the hedge fund industry has become competitive and diverse. There are now hedge funds operating that charge a 0 percent management fee while others charge 3 percent. Wide variations in performance fee levels may also be seen. One important aspect of this dual-level fee structure is the incentive it sets in place for hedge fund managers. While many hedge fund managers have already invested their own assets in the portfolio they are managing, remunerating the managers based on positive performance and not just total assets under management rewards those who can achieve consistent year-after-year gains. This in turn leads to rich compensation for those who can outperform the majority, and it attracts the best of talent to the industry. A portfolio manager can potentially earn two to three times as much working for a hedge fund as he could working for a similar size mutual fund or long-only optimization firm.

      Investments made in hedge funds are typically seen as medium to long term for several reasons. The main reason is liquidity. Most hedge funds have lock-up periods of one to two years, and many restrict redemptions for as long as three years after the initial investment is made. A lock-up period simply means that the investor may not redeem his invested funds until this period has expired. These lock-up periods are put into place so that the hedge fund may invest in various assets and will have more control and flexibility in the timing of its purchasing and selling of these assets over time. Without lock-up periods, a manager may make a long-term investment in a security, for example, and a new investor could come and request his assets back during a weak point in the markets, forcing the manager to sell the security at a loss to meet that redemption request. While lock-up periods help managers in running their funds, they are seen as a major concern and drawback by institutions and high net worth (HNW) investors. While this book does not cover hedge fund replication or publicly traded hedge funds, these are two areas worth additional research if this topic is of interest to the reader.

      There are between 100,000 and 150,000 professionals who work directly within the hedge fund industry and another 1,000,000-plus professionals who work with hedge funds in some way, indirectly or as part of a broader platform of services. There are between 10,000 and 25,000 hedge funds in existence today, depending on whose statistics and databases you trust most, and new funds are launched daily. The average hedge fund has just around $40 million in assets under management (AUM), while many start with just $500,000 to $5 million, and a larger group runs over $1 billion in assets.

      BONUS VIDEO MODULE

      To watch a video on hedge fund liquidity and lock-up periods, please type this URL into your Web browser: http://HedgeFundTraining.com/Liquidity

      Additional Common Hedge Fund Terms

      Hurdle rate: A hurdle rate is a set performance figure that must be achieved before any performance fees will be calculated or paid to the hedge fund manager. For example, a hedge fund may have its hurdle rate set at 3 percent so that any performance above 3 percent will be considered outperformance. Hurdle rates avoid having investors pay high fees for low-single-digit portfolio performance.

      BONUS VIDEO MODULE

      To watch a video on the definition of a hurdle rate, please type this URL into your Web browser: http://HedgeFundTraining.com/Hurdle

      High-water mark: A high-water mark is a tool by which hedge fund managers can assure investors that they will not be charged performance fees after portfolio losses until the fund has made up those past losses. In other words, if a hedge fund manager has a loss of 5 percent in one year, he may not be paid any performance fees in the following year until he has first regained that loss, restoring the fund to the high-water mark point. Again, the high-water mark protects investors from paying the performance fee until the manager has made up the ground he previously lost in the portfolio.

      BONUS VIDEO MODULE

      To watch a video on the definition of a high-water mark, please type this URL into your Web browser: http://HedgeFundTraining.com/High

      Gating clause: A gating clause allows a hedge fund manager, under certain circumstances, to restrict or completely cut off redemptions from the portfolio due to market illiquidity or specific sets of circumstances set forth in the contract. This term has been highly debated recently due to hundreds of funds closing the gate or enacting this clause in their agreements with investors.

      For more definitions, please see the Glossary at the back of this book.

      HISTORY OF HEDGE FUNDS

      Financial journalist, author, and sociologist Alfred W. Jones started the first hedge fund in 1949 while working for Fortune. The fund was started on the belief that the movements of individual securities were due to both the performance of that specific security and the performance of the broader markets. His strategy was to address this by investing in securities that seemed to be positioned to outperform the market, while shorting (see ) or selling those securities that seemed likely to underperform the market. The goal was to neutralize or cancel out market risk by allowing the portfolio to hedge against negative market movements. This is how the first hedge fund was created. This idea was unique in that it was designed to do well, or at least relatively well, during volatile or even bear market conditions.

      This new method of managing portfolios of equities started becoming popular in the 1960s, and by the 1970s there were over 150 hedge funds in existence managing close to $1 billion in assets. Some early hedge fund managers were Warren Buffett, Michael Steinhardt, and George Soros. Since then hedge funds have evolved to include commodities, bonds, real estate, and other types of assets.

      Over time, the term hedge fund took on the broader definition of a general private investment partnership, which typically includes management and performance fees as the only common denominator. Even this definition is now becoming dated as more hedge funds and firms that run hedge funds become publicly traded companies. Hedge funds are hard to understand as a whole because they are diverse and somewhat secretive. Hedge funds are secretive because of strict advertising and public offering rules as well as to keep their investment process, trading strategy, and positions from their competition. The hedge fund industry is very competitive and entrepreneurial.

      BONUS VIDEO MODULE

      To watch a video on the history of the hedge fund industry, please type this URL into your Web browser: http://HedgeFundTraining.com/History

      MEDIA PORTRAYAL OF HEDGE FUNDS

      Along the way there have been hedge fund blowups (that have had performance dives and made public headlines), fraud cases, insider trading, and misreporting. While the whole idea of what a hedge fund does has been growing, public knowledge of these vehicles is still relatively limited and misunderstood, and hedge funds are often in the bottom 1 percent of the industry in terms of ethics or performance that makes the headlines each day. Hedge funds are now mentioned in thousands of magazines and newspapers each month.

      There are often misconceptions formed about hedge funds, which are largely caused by reading mainstream news sources on the topic. Here are the top three misconceptions caused by the media:

      1. Hedge funds are large multibillion-dollar investment vehicles that can destroy companies. Reality: While the largest of hedge funds do control a large share of total assets under management, the industry is actually made up of mostly $1 million to $200 million size hedge fund managers.

      2. Hedge funds are not regulated. Reality: Many hedge funds are already regulated at the asset level based on what they are investing in.

      3. Hedge funds are always committing fraud and blowing up their funds. Reality: Less than 0.1 percent of the industry is ever accused of any fraud claims, and a 2006 study by Capco shows that over half of all hedge fund failures are actually due to operational business reasons and not performance-related issues.

      BONUS VIDEO MODULE

      To watch a video called Media Portrayal of Hedge Funds: Misconceptions and Myths, please type this URL into your Web browser: http://HedgeFundTraining.com/Media

      HEDGE FUND ECOSYSTEM

      Hedge fund managers do not work in a vacuum where they coordinate directly with investors and receive no assistance from outside parties. Most hedge fund managers work with at least three of the five types of service providers shown in Figure 1.1.

      Figure 1.1 Types of Service Providers Used by Hedge Funds

      ch06fig001.eps

      It is important to know the function of each of these parties to understand how hedge funds operate, and how they invest and control their assets. Here are definitions and explanations for each of these service provider types:

      1. Prime brokerage. Prime brokers provide a package of services typically within the largest business of an investment bank. The following services are sometimes offered by prime brokers: custody, securities lending, financing, customized technology, operational support, capital introduction, and other trading-related services.

      2. Fund administration. Fund administration firms provide support and operational services to hedge fund managers. These services may include accounting services, operational/finance services, settlement of daily trades, calculation and payment of distributions, and payment of fund expenses.

      3. Third Party marketing. Third party marketing firms are independent hedge fund marketing consultants who work to raise capital for two to five or more hedge funds at any one point in time for a single source of investors, or for multiple distribution channels. They typically require some sort of retainer along with sharing of 20 percent of both the management and performance fees while the funds raised stay invested.

      4. Legal and compliance. Legal and compliance firms become more important every year within the hedge fund industry. Hedge funds use law firms for complicated formation processes, ongoing business legal considerations, and ongoing compliance work as well.

      5. Auditing. Auditing firms are used by hedge funds on a quarterly and annual basis to verify their performance and accounting figures. Some hedge funds use auditing firms for monthly checks or to prepare for an annual audit as well.

      BONUS VIDEO MODULE

      To watch a video on the hedge fund ecosystem, please type this URL into your Web browser: http://HedgeFundTraining.com/Ecosystem

      Top Four Hedge Fund Industry Trends

      Understanding the hedge fund industry requires knowing what is going on now and also identifying current trends affecting how hedge funds operate, invest, form, and trade. Following are the top four hedge fund industry trends:

      1. Recent poor absolute hedge fund performance and fraud has led to increasing pressure from investors for additional transparency and levels of governance. This is being done to ensure that managers adhere to their investment mandates, only restrict investor liquidity when necessary, and ensure that internal controls, checks, and responsibilities are properly carried out. Independent administration firms and directors are now required by many investors and boards of advisers.

      2. The collapse of Lehman Brothers left some hedge funds in London without access to their assets, causing poor performance and in some cases fund failures. Since this event, hedge funds with over $30 million in assets have been investigating and implementing multi–prime brokerage models, rather than invite risk by working with one single prime broker. In the past, prime brokerage firms would conduct due diligence on the soundness of their potential hedge fund clients. Now the research is done in both directions, with hedge funds screening prime brokers and vice versa. Some newcomers to the industry are now gaining strong market share because they are seen as a safe place to do business.

      3. The use of outside capital-raising resources, investor databases, and third-party marketing firms is on the rise. The capital-raising environment is more competitive, and hedge fund managers are forced to evolve their investor relationship cultivation systems, capital introduction resources, and investor contacts in order to compete.

      4. Investors increasingly want to work with more institutional hedge fund managers. This typically means hedge funds with over $100 million to $250 million in assets under management. More specifically, it refers to the types of operational processes, technology, risk management, trading, and governance features that tend to be in place with funds that have $1 billion in assets under management. This has always been a challenge for emerging managers, who have limited access to high-pedigree (well respected and accomplished) team members, investors comfortable with small fund managers, and many times even the knowledge needed to create a more institutional-quality hedge fund operation.

      BONUS VIDEO

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