Lets make a hedge fund!

The Escape Artist does not recommend investing in hedge funds but has noticed that managing one can be remarkably remunerative…so today we are going to learn how to start a hedge fund.

Baked…

Lets make a hedge fund!

OK, boys and girls!  It’s a lovely day here at prep school and its been a while since the last global financial crisis so we’ve all forgotten about all that unpleasantness.

So today, children, we’re going to start our own hedge fund!

Ingredients – you will need:

• 1 American ex head of global derivatives trading from a large investment bank in his 50s with slicked back grey hair and a Viagra habit
• 3 US Ivy League school MBAs in their mid to late 20s – ideally with mild social autism
• 4 Eastern European guys with PhDs whose CVs say they worked on the Russian nuclear weapons programme (but didn’t)
• 2 surgically enhanced “executive assistants”
• 1 Short term lease in a prime street in Mayfair complete with meeting rooms with Stubbs style oil paintings, walnut desks and green shade bankers lamps (can be rented)
• A Bloomberg terminal connected to an empty black box
• Some powerpoint slides with lots of graphs
• 20-30 Insurance companies from the mid West or continental Europe
• 100- 200 gullible high net worth clients

What’s that I hear? Treasury yields too low to keep your parents racehorses in the style to which they’ve been accustomed? Is your local life assurance company worried that equities may go down as well as up?

No problem!   See, this is why I’m The Escape Artist and you’re not even out of middle school. I have 3 words for you: Sustainable Alpha Generation. That’s all you need to know.

Now go and raise $20m seed capital from your Mum and Dad and their pals at the Country Club…. I’ll wait.

Got it? Great.

So, lets go. Like all forward thinking chancers, 5 years ago we incubated 10 different fund strategies each with a minimal amount of capital  No matter how incompetent we are, at least 1 or 2 of them will have done OK right?

Lets take a closer look, children. Great! so one of the strategies beat the S&P 500 over that time period!  Let’s ditch the other 9 and never mention them again, OK?  It’ll be our secret.

Now let’s create a bunch of graphs plotting the performance against various benchmarks. Use lots of bright colours, children! But hey, no need to show the timeframes or the benchmarks where we we under-performed right?  Let’s not be negative!

Talking of not being negative, a big chunk of the fund is obviously going to be invested in “non-liquid strategies” so we we can value those positions at whatever value we want.  That’s going to come in handy if the fund hits a sticky patch and we need to be able to use our “discretion”.

On the subject of discretion, let’s show all those performance stats before fees.  Well, its a bit vulgar to talk about money but, since you raise the subject, its very important that we are highly incentivised and our interests are fully aligned (keep face straight here) with our investors. So lets call it 2% of annual assets under management and 20% of all profits over 8% per annum, shall we?

OK, so now we are ready to take our powerpoint slides with graphs on a fundraising roadshow to all the new potential investors into the Fund.  Let’s fly first class to New York, Singapore and Dubai!

Well, that was easy!  They lapped it up. We now have $2bn.

So lets start gambling investing the investors money. If we lose (and, let’s face it, over the long term we usually do) then that’s their problem and we still get the management fees.  If we win, then we get 20% of the profits. What’s not to like?

Our 2% of $2billion means we get annual management fees of $40m.  Nice. That’s before performance fees and any other fees we can dream up. We need $5m to spend on property costs, $1m on pharmaceuticals (who says the drugs don’t work??) and $4m on the back office costs we outsourced which leaves $30m to split between the staff.

But wait!  There are 10 staff!  How the hell is everyone going to live on a pitiful average of just $3m each?  Well that’s easy, the American guy with the slicked back hair has decided to pay himself $25m (because he’s worth it!) and share the $5m between the rest.

But lets not just play with $2bn of small change. We are also going to borrow a lot of money from a major commercial bank, children.   They are rigorous in their assessments so we are going to have to wear a tie and talk about football when we go and pitch to them. Sincerity is important, so lets all practice our smiley faces!

We are going to need some clever sounding phrases, children. So our English assignment for this afternoon is to re-arrange the following words into some drivel to put into the investor reports:

–          Event driven

–          Global macro

–          Enhanced credit strategies

–          Long / short

–          Arbitrage

–          Special situations

But what about a competitive edge?  All the other kids say they’ve got one. So lets say we’ve got an algorithm based, proprietary trading system that allows us to achieve superior market execution in dark pools of liquidity.

No, of course I don’t know what that actually means.  But let’s get a big black box, run a connecting wire to a Bloomberg terminal and put it in sight of the meeting room so that the clients can see it…lets tell them that it uses artificial intelligence to read incoming trading instructions from large investment banks and the power of magic leprechauns…lets face it, these people will believe almost anything.

Does anyone remember Blakes 7?

On the side of the black box, lets all use our colouring crayons to draw on some impressive fund return statistics.　Investors may ask us how those return stats are generated but, at that point, lets just smile and say that it’s all very complicated and confidential and that they should not worry their pretty little heads about that stuff.

You might imagine children, that 5 years after the greatest financial crisis ever investors would have learned not to take marketing bullshit at face value and would insist on good disclosure and financial reporting.  Actually, no!  So, lets not actually tell the investors anything about what the fund is invested in…that way, it’ll take em longer to notice when things go pear shaped and we’ll charge that $40m p.a. a bit longer. Yay!

Finally, lets have a slot at the the top of the black box into which muppets retail investors can post their £10,000 subscriptions.  We’ll call that a “feeder fund”.  In a couple of years, there may be some completely unforeseeable problems in the high yield bond / Japanese equity warrants market and the investors will ask where the black box with the money has gone. Good luck with that.