Launching A Hedge Fund
January 21st marked Tidefall’s one year anniversary.
I’ve had a lot of people on FinTwit contact me about this experience as they are interested in doing something similar.
So I figured I’d write down some notes, especially since there’s a number of things on the operations and capital raising side that I would have done differently.
First off, if you think you might launch a fund in the future, make sure you keep all of your fund statements. Outside of family and friends, any initial investor will want to see an audited track record of at least five years before joining. Also, although it isn’t a requirement, having completed the CFA was a big help with the regulators in my jurisdiction since it meant we were exempt from many of their required exams.
The Decision To Launch
I’ve been interested in stocks since an early age. I was fascinated by the idea that anybody could own a part of a company. The first stock I ever bought was Petro Canada when I was 13. “That gas you bought for your car? You’re paying me.” I loved knowing that. It didn’t matter that I owned an incredibly small percent of the company, I just liked the concept.
After graduating from University I wanted to work abroad and I offered to intern at a small global equities manager in Australia. I was soon hired full time and ended up spending the better part of a decade with the firm.
In the second half of my time there, my head of research would occasionally ask where I saw myself in ten years. I thought that he might be criticizing my work but he was actually trying to help. He could see that I had gotten comfortable in my job and my career progression had plateaued.
Subconsciously I knew that I should leave and start a fund but I constantly came up with reasons not to do it.
Plus by this stage I was working remotely for half the year and backpacking the world. I was making dollars and spending pesos. It was a really good lifestyle, but deep down I knew I wasn’t challenging myself.
Fate would force my decision here. After years of outperforming, the fund I was working for had gone through a difficult period and AUM was declining. The owner eventually decided to wind it up.
I had to either join another firm or try it on my own.
I spent a number of weeks thinking it over but this Jeff Bezos clip about regret minimization made the decision clear.
I was in the position to start a fund and if I didn’t, I’d likely regret it for the rest of my life.
I was in!
Choosing your service providers is a time consuming and extremely important process. The biggest lesson I learned was to simply ask the people you respect most in the industry for their recommendations. Price is not the most important factor; trust, communication and execution are what you need to focus on.
I figured that after I got a lawyer, banker and broker sorted out I could finally get back to researching stocks.
Now I needed to hire a fund administrator and accountant. Yet more meetings!
By this stage I was getting a bit frustrated. As much as I wanted to start a fund, the actual administration was starting to add up. Had I made a mistake in trying to launch this?
Jason is a longtime friend that I had first met back in grade 9. He also went on to pursue a career in finance but in a more traditional big bank setting at fund management companies in Toronto.
In the middle of getting Tidefall registered Jason came over after work and told me he was thinking about quitting his job. I realized that if I could get Jason to join, I could then focus exclusively on investing while he handled the compliance and operations of the business. I pitched him on it: A fund that was unconstrained by sector or style and just put our clients’ capital into our best ideas.
He was in!
Now we needed to decide on a fee structure.
Hedge funds are well known for their 2 and 20 fee structure. This means that they take a 2% annual fee as well as 20% of the annual profits. It’s a highly lucrative business model and would guarantee us a profit in the first year.
This should have been a no brainer decision, why rock the boat?
I didn’t view it as fair to clients. As a business owner, it was a case of heads I win, tails I win even more.
In fact, Warren Buffett had spent years complaining about the 2 and 20 fee structure calling it obscene. He went so far as to make a highly publicized bet in 2008 against a hedge fund on the premise that their high fees would cause them to underperform a basic S&P 500 index fund over the next decade. Unsurprisingly, Buffett easily won and by a massive 490 basis points!
Ok, so no 2 and 20 fee model. What were our other options?
Many high net worth asset managers charge a simple flat fee of 1-1.5% (mutual funds charge about 2%). A flat fee would provide a stable revenue stream for the business but had the disadvantage that we would get paid the exact same amount regardless of how our clients’ investments performed. I couldn’t imagine that conversation at the end of a down year. ‘So, your portfolio declined 35% this year and now we are going to take another 1.5% for our services; you’re welcome!’
There was one fee method left that I wanted to consider and unsurprisingly it was called the Buffett model.
Before Warren Buffett took control of Berkshire Hathaway he ran his own partnership that employed a 0/6/25 fee structure.
He took the unconventional approach of charging no annual fee but 25% of the profits above a 6% hurdle rate.
For example, if the fund returned 10% in the year, Buffett would receive a 1% fee. (10% minus the 6% hurdle equals 4%. One quarter of 4% is the 1% fee).
If the fund returned 14% for the year, then the fee would be 2% (14% minus 6% equals 8%. One quarter of 8% is 2%).
And if the fund returned 6% or less, then Buffett would receive no fees at all.
The Buffett model also aligned me as a business owner. If I wanted a higher fee, I would have to make our clients more money. There was the obvious risk that if my stock picks were poor we wouldn’t get paid but that was the whole point of launching an actively managed fund!
Traditionally before launching you get commitments from a group of investors that is locked up for a number of years. However, I generally felt awkward approaching potential investors, I had no experience with it. I figured that everyone would soon find out about it when I posted on social media.
Don’t do this! I incorrectly assumed anybody that was ‘interested’ would likely invest but out of my 10 external prospects, only 1 external investor (who I am forever grateful for) came on board. I should have met with more potential investors before launching. We ending up raising dramatically less than we expected.
Thankfully, word had gotten around to a journalist that I knew, who asked if I wanted the launch of Tidefall to be featured in The Globe and Mail? Yes! I was thrilled.
But this wasn’t any year, it was 2020.
Covid had arrived.
By late February I heard back from the journalist who explained that the article would be postponed for the foreseeable future. Understandably, the pandemic was the only thing that people wanted to read about.
It became increasingly clear that the best way to build up Tidefall was just putting up strong returns. However, an issue with the stock market is its unpredictability. Even great investors can go through years of severe underperformance. Charlie Munger once had a year where his partners lost 32% and then another 32% the next year! Anything can happen.
Fortunately, I had followed Covid somewhat closely and had bought put options of Royal Caribbean as a hedge. Cruise ship passengers skewed older and the tight communal living conditions were a perfect viral breeding ground. If Covid were to spread, I was confident that cruise demand would collapse and when combined with their levered balance sheets their stocks would get crushed, making our put options worth multiples of what I paid for them.
I got this one right as well as a number of other investments during the market panic. By May, Tidefall was up materially, and in a down market. Even better, by June Covid was starting to get (temporarily) under control and the Globe wanted to run the story.
The article was finally released. The Buffett fee structure resonated as strongly as I’d hoped. New clients were ready to join and checks were finally starting to arrive. We were on our way.
And that covers Tidefall until today.
Ultimately, the biggest risk wasn’t failing, it was not trying.
I’ve learned so much over the years from FinTwit that hopefully others can take something from my experience. If I can help out in any way more directly please feel free to DM me.
See More: This Week In Intelligent Investing has two great podcasts on the subject.