Hedge Funds / Private Equity, Litigation Finance, Money

What Does It Take To Start A Hedge Fund Or Litigation Finance Fund?

Starting a fund is very difficult and most funds fail, especially today.

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Who doesn’t want to run an investment fund? In my role as a consultant to fund companies, I’m asked this question all the time. The financial press around fund managers like Jim Simon, Steve Cohen, and Ray Dalio often leads many aspiring fund managers to believe that all it takes to become fabulously wealthy is getting a successful investment fund off the ground. For attorneys, this is often a particularly tantalizing prospect as many work with hedge funds, private equity funds, VC funds, and litigation finance funds. The reality is less sanguine.

The reality is starting a fund is very difficult and most funds fail, especially today. In a recent conversation with a fund manager running a $1B fund that he first started in 1992, I asked him if he thought he could successfully start his fund if he were beginning today for the first time. His answer was a clear no. It’s not often that a successful person admits he couldn’t do it again if forced to start over.

In fact, there are over 8,000 investment funds out there, and the majority have less than $100M in assets – widely considered the benchmark number to run a profitable investment fund with a real office and staff. And, as the investing world moves towards passive management, the challenge of starting a fund is getting harder.

So what does it take to start a successful investment fund of any variety? Most people would say hard work, perseverance, perhaps a set of deep-pocketed friends. And all those factors help without a doubt. But it’s not enough.

No matter how many wealthy friends one has, it’s still incredibly difficult to raise $100M or more for a fund. The alternative is to start with less money and try to make a name for oneself. Indeed, even with $100M, generally fund managers are fighting tooth and nail against other funds trying to establish a reputation. Many funds try to start with $5M or so, and then try to build a reputation that will attract institutional investors.

Building off a small fund is much easier in newer arenas. Litigation finance and high-frequency trading, for instance, both present more opportunities for neophyte fund managers than the crowded hedge fund and private equity spaces. For instance, many of the well-known litigation finance funds today, from Lake Whillans and Parabellum to TownCenter Partners and Longford, did not exist a decade ago. Just as in any business, it pays to be a first mover, or at least a fast follower in the fund world.

In addition to success in raising at least a few million in a promising investment area, fund managers also need a well-defined strategy with clear historical back testing, and hopefully a promising track record of similar investments in their prior career. Even wunderkinder like Eddie Lampert, who started ESL when he was 26 years old, tend to come from backgrounds where they could demonstrate their expertise (in Lampert’s case, Goldman Sachs).

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To get beyond the stage of being a trader living in a basement and investing $1M or so, many would-be fund managers turn to placement agents. Groups like First Avenue Capital Placement help investors to identify promising emerging funds. The problem is that there are many funds competing for the attention of a limited number of investors, so it is imperative that start-up funds have a strong team in place, an excellent set of documents and materials explaining their strategy (something lawyers frequently help with), and an articulate person to pitch the fund via a roadshow. All of this takes capital upfront.

Ultimately, just like most small businesses of any stripe, most new funds won’t make it — not because of bad returns or a bad strategy necessarily, but because the founders of the fund don’t have the resources in place to make a real go of it. More than anything else, startup capital to be used in setting up the business and advertising it, not just capital for investment, is critical to success. A well-capitalized fund company has access to resources and personnel that most firms don’t. Would-be fund managers, in any area from litigation finance to hedge funds, should remember this truism regarding capital and be careful not to launch prematurely lest they lose credibility with the market and investors.

Michael McDonald is an assistant professor of finance at Fairfield University in Connecticut. He holds a PhD in finance. Michael consults extensively through Morning Investments Consulting and writes for Litigation Finance Journal. Michael has served as an expert witness in legal disputes, and is an arbitrator with the Financial Industry National Regulatory Authority (FINRA). Michael can be reached at M.McDonald@MorningInvestmentsCT.com.

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