Not even close, most hedge fund managers actually struggle, particularly in the first few years. This is in large part due to the absolutely insane amounts of rules and regulations a small firm has to comply with. I’ll rant a little about how this came about, then provide some figures for you.
It is no big secret that big firms on Wall Street (primarily JP Morgan and Goldman) had a big hand in drafting Dodd Frank and updating the SEC (and various state) regulations. There were comments made that this was specifically done to eliminate small hedge funds that were providing the bigger firms with quite a bit of competition. It’s government collusion at its best and a great example of corporations using the government to hurt others. Multi-billion dollar firms can stomach an increase in compliance cost – small businesses cannot.
And let’s not pretend that the regulatory changes protected customers any more than the TSA changing the regulations on liquid bottles from 4 oz to 3.6 oz protects passengers. There were already rules and laws on the books to prevent both the Madoff issue and the mortgage collapse (which was almost 100% caused by a combination of government laws, the FED, and agreements with the large banks…but that’s another topic).
I run a small firm. I get audited regularly because I do businesses in a number of states. An audit normally takes multiple days (once it took 12 days) and multiple auditors (not infrequent to have 3–6 government employees in the office). They check things like making sure my files are in alphabetical order, that my security license is hung the right number of inches off the floor, that my bills going to my clients are written in an approved font, that my signature block on my email messages contained the government approved statements, and the like. I’ve been chastised for having sent bills on letters with too small of margins.
Do you know how many times a government auditor has taken my bank account statements, my brokerage statements, my client statements, and reconciled them to make sure everything was calculated? Once. It happened for the first time this year. When I’ve asked why they don’t check things to ensure that firms aren’t actually stealing client money I get told the auditors really don’t have the education to do that (which is why we also have a requirement to have an independent auditor review everything).
The number of rules and regulations I have to comply with is well North of 100,000 pages.
Ok Rant Over — now for actual numbers.
Here is a rough estimation of the cost to start a fund on a SHOESTRING budget:
- Create offering documents (private placement memorandum, subscription agreement, fund overview, Form ADV disclosure document, and any others) – $30,000. (And that’s cheap);
- Assume you only do business in one state – state blue sky filings and notice filings – $1,000
- PCOAB annual audit – there are VERY few PCOAB auditors that will audit a small fund (I’ve probably talked to them all). If you have a VERY simple fund this will costs $12,000/yr. If you have a more complicated fund with some sort of onshore/offshore mechanism or complex trading instruments, this is going to go north of $20,000 quickly;
- Annual tax filings – $8,000 (what I paid last year for my fund for federal and state filings); and
- Business formation cost (LLC to act as a GP and a limited partnership for the fund itself) – $1,250 (if you file it all yourself).
This assumes you are running things out of a home office, spend zero dollars on marketing and promotion, and do everything yourself (e.g. no payroll expenses), you use a computer you already had, found a free website hosting location (and know the rules on online advertising and don’t have to pay a compliance firm), do all of your client correspondence electronically (no postage – and illegal in some states such as South Dakota where you have to mail things even if everyone agrees to electronic service), you spend nothing on digital security (probably also illegal), have a free trading platform (actually possible), and no other expenses (internet, power, water, phone, fax, etc.) — which is just impossible. But we’ll assume all of those costs are $0 for this example.
The above totals to $52,250.
Assume the average fund charges a two percent management fee and takes twenty percent of the profits (these fees are actually higher than average as fees have gotten compressed over the last decade).
Doing the math, if a small fund manages to raise $5 million from friends, families, and knocking on doors, that seems like a ton of money. You might have gotten $100,000 from 50 different people to get there. (I’ve done this, it’s not easy raising money as a small firm).
Take out the above expenses and your left with $47,750.
If you have a more reasonable cost — namely you actually rent an office somewhere to meet clients, cost go up quickly. Even if you go to a share space, where you share the cost of a receptionist, copy machine, internet, phones, etc., you’re still going to be spending at least $1,000/month.
I run a VERY tight ship and cut every cost I can. We have no frills, perks, or anything, and our annual budget on raw expenses is just over $80,000.00. At a 2% fee, that means I need a $4 million fund to just break even, before making one penny — and have no unexpected costs.
Note that DOES NOT INCLUDE payments to myself. That’s the cost of the business. I have also represented small funds as an attorney — very well run ones. I’m the only one I’ve ever encountered that can run the company for under $150,000 (before owner salaries). But let’s stick with the $80,000 number.
What’s a reasonable before tax salary in Dallas, Texas? (Remember, your self employed, so your taxes are higher than a normal persons, as you have to pay social security and medicare twice). $100,000 before taxes? That would leave you with a take home of roughly $70,000.
So now we are at $180,000 — which requires a $9 million fund. That’s just to have a basic lifestyle met.
Most funds out there, particularly startup ones, don’t ever survive. The cost of running it are just too high. The above also doesn’t include the cost of having to pay an attorney and accountant to sit through that week long audit either. I’m lucky in that I can do that myself. If you can’t, or don’t have the knowledge, you just lost another $30,000. Are you not an attorney and don’t know how to keep up with compliance? A good compliance firm will run you $12,000 – $30,000 per year.
You get the idea.
HOWEVER — if you are good at what you can go, and can generate alpha, and can get through several lean years, things improve. Most funds are scalable (if yours is not, start over).
So I only have $5m my first year and actually lose money. But I keep banging on doors the next year and we get up to $10m. Whew, I finally don’t have to rely on the wife’s paycheck to pay the bills. My partner and I only make a few thousand dollars each this year, but at least we’re making money. Keep the head down, keep banging on doors, network, and your fund keeps doing well. Year 4, $50 million.
Wow, I now can pay for an assistant and don’t have to stay up to 2am doing paper work and filing 6 days a week. My partner and I actually make a real paycheck (something close to $100k per year). It’s not a GREAT living, but it actually feels like a real job at this point.
And now people are starting to call ME, asking how they can invest with us. Weird. About this time you learn about institutional introductions. Wait…you mean there are companies that just write $10m checks or introduce you to people/businesses that do? Amazing. Maybe we can get to a $100m fund in the next 3–4 years and $250m within 10.
And, once you get to that size, if you haven’t jumped off a cliff, and if your fund keeps performing…..THEN you get your $1 million/year salary.
Hedge funds aren’t any different than any other business. You have to have a good product. You have to market it. You have to keep your customers happy. If you do, and grow well, you can make a million dollars per year.
But you know what? I’ve seen people do that in pipeline sales, pool cleaning services, lawn care service, construction, advertising….it doesn’t matter. If your business can be scaled, and you are GOOD at what you do, and know how not to get bloated as you grow, almost any business can be grown to making that type of salary.