The Fundamentals of Hedge Fund Management

The Fundamentals of Hedge Fund Management

Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers professional and personal knowledge and understanding. The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more. For a list of available titles, visit our Web site at www.wileyfinance.com.

The Fundamentals of Hedge Fund Management Second Edition DANIEL A. STRACHMAN John Wiley & Sons, Inc.

Copyright C 2012 by Daniel A. Strachman. All rights reserved. Appendix A: Hedge Fund Litigation, copyright C 2012 by Scott M. Berman. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. Excerpt on page 3 reprinted from the March 1949 issue of Fortune by special permission. C 1949 Time Inc. All rights reserved. The first edition of this book titled, The Fundamentals of Hedge Fund Management, was published in 2007 by John Wiley & Sons, Inc., Hoboken, New Jersey. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: Strachman, Daniel A. The fundamentals of hedge fund management / Daniel A. Strachman. 2nd ed. p. cm. (Wiley finance series) Includes bibliographical references and index. ISBN 978-1-118-15139-6 (cloth); ISBN 978-1-118-22593-6 (ebk.); ISBN 978-1-118-23923-0 (ebk.); ISBN 978-1-118-26391-4 1. Hedge funds. I. Title. HG4530.S8368 2012 332.64 524 dc23 2012004092 10 9 8 7 6 5 4 3 2 1

To Felice

To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks. Benjamin Graham * * * The day is short; the task is great. Ethics of the Fathers, Chapter II Verse 20

Contents Preface Acknowledgments xi xiii CHAPTER 1 The Hedge Fund Industry 1 CHAPTER 2 The Service Providers 23 CHAPTER 3 Hedge Fund Structures 41 CHAPTER 4 Hedge Fund Accounting 59 CHAPTER 5 ERISA, UBTI, and Offshore Funds 77 CHAPTER 6 Marketing and Capital Raising 91 CHAPTER 7 Why the Back Office Matters 113 CHAPTER 8 The Launch 127 CHAPTER 9 Perception versus Reality 141 APPENDIX A Hedge Fund Litigation 153 ix

x CONTENTS APPENDIX B Examples of Hedge Fund Structures 189 Resource Guide 199 Notes 205 Glossary 209 Bibliography 213 About the Author 217 Index 219

Preface Over the past five years since the first edition of this book came out, the hedge fund industry has grown enormously. Hedge funds, which were once thought of as a tool of the rich and privileged, are commonplace in investment portfolios around the world. No matter what you read, see, or hear in the popular press, the hedge fund industry is here to stay. Even in the wake of the collapse of many large funds, the industry is stronger than ever and has become a force to be reckoned with here and abroad. Now is a wonderful time to be entering the hedge fund industry, for three reasons. First, the industry is primed for growth; second, the markets are volatile; and third, hedge funds have come into their own, nearly on someone else s nickel. This means a lot of the work you previously would have had to do to build your business has been done for you, and the road to hedge fund riches is going to be smoother than it was, say, three years ago. However, that being said, building a successful business is going to take a lot of hard work, there are going to be disappointing times, and it is going to be frustrating more often than not. Therefore, my advice is as follows: Be prepared for the worst, expect the best, and be satisfied on some level with your success. I believe that the industry is primed for growth, and with this growth will be many questions. The intention of this book is to answer some, if not all, of the questions you or your colleagues may have and provide you with a foundation for your business and tools to enable you to find the answers. Over the past 12 years, I have had the unique experience of working around the world with people who are creating, building, developing, and marketing hedge funds. Some are starting out and have less than $1 million in assets under management; some are well-heeled firms with billions in assets under management. Others fall somewhere in between. Though their situations are different and in some sense unique to them, they all have the same questions, they all need basically the same answers, and they don t have a place to turn to for advice. My job is to give them that advice, whether they want to hear it or not. My job is to tell it like it is and to help them get to where they need to be with their business. During this time, I have worked with clients around the globe; it has been quite a wild ride. The key for me xi

xii PREFACE has been to solve problems for those in the hedge business who fly without a net because they aren t part of some investment management behemoth. This book provides you with some of what you need to be successful. It provides you with the tools you need to make good decisions, the tools you need to create good plans, the tools you need to set out a marketing strategy to help you raise assets, and the tools you need to create an infrastructure that will allow you to support your business. Your goal in reading this book is to learn as much as you can about how to operate the business side of a hedge fund. This book is not about money management strategies. This book is not about buying low and selling high. It is about the infrastructure, the business side, of the hedge fund industry, and as you read the following pages, you will learn the fundamentals you need to run a successful business. This book will not solve all problems or provide you with everything you need to succeed; instead, it will give you the fundamentals. One thing you should look for as you go out on your own is a mentor. To succeed, you need good, solid advice givers, and you need to be willing to take advice and look for it. Don t be embarrassed or too proud to ask for help. It is okay to have questions; the key is finding answers. This book should be viewed as a great resource tool. It should be something you use repeatedly to help you understand, deal with, and operate your business more efficiently and successfully. I hope you will get as much joy from reading and rereading it as I have had from writing it. As I say more than once throughout these pages, if you have any questions about anything that you read in this book, or if you have issues you want to discuss, you can always send me an e-mail at das@hedgeanswers.com. Thanks for purchasing this book. I hope you enjoy it.

Acknowledgments The idea for the second edition of this book came about through a series of e-mails between my editor and me during the early part of 2011. Since that time, I have spent an enormous amount of time trying to update the original pages to provide you with new and informative information to help you launch and grow a fund. In the pages that follow, I have provided you with a road map that will allow you to avoid failure and to succeed. Your interest in hedge funds has made this book possible. I thank you very much for your interest in this fascinating subject. I wrote the second edition of Getting Started in Hedge Funds because these unique investment products are here to stay. They are no longer considered an alternative investment vehicle but rather an important part of a diversified portfolio. Though hedge funds have not yet become traditional, in the months and years ahead, the characteristics that separate traditional investments and hedge funds are going to become smaller and smaller. Hedge funds aren t going to disappear because people understand the value of creating a portfolio that is hedged against market volatility. Hedge funds are for investors of all shapes and sizes and play an important role in the future of the financial markets. As in the past, to write this book I have called on many of the usual suspects who have helped me over the years look good in print. It has become more evident to me that there is nothing more important than to have good people at your side. These people are better than good, and without them I would not get my work done. They are, of course, Viki Goldman, the greatest librarian and researcher I have ever met, and Sam Graff, the only true newspaper man left in the tri-state area. Thank you for your hard work and for always making my work better. I appreciate everything you do for me. Special thanks to Christine Enners, who came through with the logistical support to make this book a reality. The people at John Wiley & Sons have once again provided me a platform for my work. To all of them, I say thank you. I hope the book is all you intended it to be when you gave me the go-ahead to write it. I want to thank all my family members for their support and guidance over the years. It is through your efforts that this book is possible. xiii