Proprietary desk traders who start their own hedge funds, forced to leave banks by January 1, 2013, when the Volcker Rule goes into effect, are suddenly being thrust into managing a business and its operations as they come face-to-face with Dodd-Frank Act regulations.
“What’s happening now mirrors what happened with star traders with winning strategies ten to 15 years ago when money, ego and opportunity motivated them to leave to start hedge funds,” says Matt Simon, senior analyst at the TABB Group. “Only now they’re being thrown out of larger banks, continuing on as stand-alone hedge funds.”
The industry has changed since then, when the old saw had it that all that was needed to start a fund was two guys and a Bloomberg terminal.
Today there are more regulations to comply with and operating requirements to meet, yet former prop traders will no longer be able to depend on the requisite tools and services they had available at their former employers.
“It’s easy to underestimate all the facets that the bank had taken into account and now they need to recreate,” says Bob Guilbert, managing director at Eze Castle Integration in Boston, which provides IT systems to about 600 hedge funds worldwide. “It’s a shocker; it’s cold water in the face.”
For starters, former prop desk traders will need to register with the Securities and Exchange Commission (SEC) when they have at least $150 million in assets under management. Ten years ago they could start a fund with just a strategy, but today Dodd-Frank makes regulatory compliance one of the top priorities.
Then there are the sophisticated operating systems, including voice and data networks and a recovery site, that hedge funds need to compete in today’s wired world. The systems must be resilient and redundant to minimize downtime, and this costs money. So does the security that goes with all of that.
In addition, hedge funds today must have institutional-quality auditors, administrators, execution partners, attorneys and insurance brokers, plus two or three prime brokers, whereas lower-level service providers and a single broker would do before.
“We know that for the real money, funds have to dress themselves up,” explains Jason Gerlach, California Hedge Fund Association (CHFA) president-elect and COO at Sunrise Capital Partners in San Diego. “Any hedge fund today has to have a real office — you can’t garage or home office it. Investors are going to come and look at your back office. They want to touch it; they want to see the people who work at your firm. They want to see how you execute a trade, how you back up your data.”
The cost of all that is at least $5,000 a month, five times what it cost 10 years ago, says Chris Ainsworth, president of the CHFA and chief operating officer of Maerisland Capital in Newport Beach, California.
Case in point: It took two years of preparation to launch Hunting Hill Global Capital in New York, says chief investment officer and co-founder Adam Guren, because of the need to search for the right providers of information technology and a prime broker capable of working with a fund like Hunting Hill, which invests in multiasset classes, including exotic as well as plain-vanilla swaps, foreign exchange and options.
“We needed a prime that could handle all those things,” says Guren. “We saw that small primes weren’t able to, so we determined that we needed to look at the majors and that included European banks as well. We needed execution and coverage when considering their services.”
The decision came down to Citi and Deutsche Bank, with Hunting Hill chosing Deutsche in the end.
Guren says operational experience will help traders in the new environment. He learned how to run a prop desk at First New York Securities, a privately held shop. Guren considered leaving the prop desk back in 2009, but after taking a look at what starting his own fund would entail, he decided to first return to school to learn how to manage a business, getting an MBA from the Wharton School of Business at the University of Pennsylvania.
But even that didn’t prepare him for everything he would need to run a hedge fund, so Guren made sure that his team included an experienced chief financial officer. Still, he estimates that it took six months to a year to make sure the fund was run properly.
Now Guren expects to have enough assets under management — $150 million — to register with the SEC by first quarter of next year.
Hunting Hill is far from alone, says Ainsworth, whose Maerisland Capital opened just this past March. “I feel sorry for any fund that’s launching today,” he says. “If you are not a big-name prop trader from a big-name bank, you are going to find it extremely difficult.”
He notes that he partners with Mark Beder, founder, CEO and CIO, who has 18 years of investment experience — all but six of those in hedge funds — and that the partnership was a leg-up. Ainsworth worked in operations for Bank of America and several private equity firms. “Having operational experience is very helpful,” he says.
Maerisland uses multiple primes for custody, credit and lending. “Lots of funds turn to third-party systems providers to build redundancy, making sure information is secure.”
He attributes the change in environment to the financial crisis.
“Pre-'08, you didn’t need to think about knowing how to run a business,” Ainsworth says. “The equity markets were booming, hedge funds as a category were very hot — anyone with a pulse and a decent strategy was raking in money.” But post-'08? “You’ve got to demonstrate the business behind the fund — you’ve got to have robust compliance and risk management and you’ve got to prove it,” he says. “It’s a lower-margin business, although the best managers still make 2-and-20.”
Others say the difficulties of starting a fund today primarily reflect performance. Although acknowledging that “it’s a very tough environment in terms of asset-raising and operations,” Sun Capital’s Gerlach adds: “Let’s be fair — there have been very disappointing results and so the general negativity towards this category is warranted. Funds haven’t been performing well. The market environment of constrained volatility has hurt funds.
On top of that, Gerlach continues, there’s intense competition. “It won’t mean that you won’t see good performance again; it just means we’re in a tough stretch now.” Sunrise Capital is a quant trading shop — “a systematic trading firm” with about $660 million in assets under management.
As often is the case, the largest fund will be those most likely to survive. True, Gerlach says all funds face “more operational due diligence for trading and the back office needed today than 10 years ago, or even five years ago, when the amount of transparency we’re facing today wasn’t required.” But Guren notes: “It’s an extra burden on small funds.”