Hedge funds allow portfolio managers to pool investors’ money. But unlike traditional businesses, hedge fund managers are allowed to use riskier investment strategies that are not allowed for mutual funds, including short selling, increasing leverage, derivatives, distressed assets and high yield bonds. Hedge funds also charge somewhat high management fees, the most common being known as “2 and 20”. Under this structure, managers charge 2% of capital as a commission and earn 20% of all annual returns.
Key points to remember
- Canada is home to a growing number of hedge funds, but setting one up in Canada is a bit trickier than in the US
- Hedge funds in Canada are more regulated and transparent, overseen by the Canadian Securities Administrators (CSA).
- Hedge fund founders must meet strict regulatory requirements, file necessary documents and be in continuous compliance
Start a hedge fund in Canada
Financial experts looking to start a hedge fund have good reason to do so these days. In 2015, hedge fund compensation skyrocketed as the industry’s assets under management hit a new record high of $2.97 trillion, according to Glocap’s 2016 Hedge Fund Compensation Report. But starting a fund in Canada is a more complex process than forming a private equity fund or a traditional LLC. The country’s regulatory requirements make it very difficult for retail investors to access hedge fund strategies, as they are generally limited to high net worth individuals and institutional investors.
Starting a hedge fund in Canada usually takes about a month and the cost of professional fees is probably between 25,000 and 35,000 CAD. It also requires a solid background in finance and investment. Hedge fund managers have likely worked at a large retail or institutional bank and earned certifications such as Chartered Investment Manager (CIM) or Chartered Financial Analyst (CFA). Although no standard certification or training is required, managers without advanced finance training will find it difficult to secure clients and build their assets under management.
Meet regulatory requirements
To get started, hedge fund managers must first register their fund in the specific province where it will operate. In Canada, there are 10 provinces and three territories. However, Canada is unusual in its regulatory oversight in that it does not have a single national level regulator like the Securities and Exchange Commission (SEC) in the United States. Each province’s rules are distinct, but almost all except Quebec follow a standard set of rules. Together, the country’s provincial and territorial regulators are known as the Canadian Securities Administrators (CSA).
Ontario remains the most important jurisdiction for hedge fund registration and manager oversight in Canada. Its authority is called the Ontario Securities Commission.
If a fund provides investment advice, managers must register as a financial adviser. If the portfolio manager sells securities in a hedge fund, they must also register as a broker. Advisors generally only need to register in a specific province, while dealers need to register in all provinces and territories where the fund will be sold. However, there does not appear to be a minimum education requirement when filing to start a hedge fund, and it is possible to obtain a waiver.
Ongoing reports
After registration, a hedge fund manager will be bound by ongoing reporting requirements to provincial regulators. In addition, the Manager is bound by regional laws which regulate insider trading, conflicts of interest and proxy voting, among other factors. The hedge fund is also bound by federal and provincial laws that focus on crimes like financial terrorism, money laundering and privacy.
According to KPMG, the hedge fund must also provide annual audited financial statements to investors and regulators within 90 days of the end of the year. In addition, funds must provide semi-annual unaudited financial statements to investors and regulators within 60 days of the end of the interim period. Finally, the financial statements must be prepared in accordance with Canadian generally accepted accounting principles (GAAP) and the rules of NI 81-106.
Capital raising
Finally, a hedge fund requires capital. Fundraising requires a manager who can sell the fund and the investment strategy to people who have money. However, there is a minimum requirement in each province or territory to be registered as a hedge fund. In Ontario, for example, the minimum capital requirements are:
- CAD 25,000 for a portfolio manager,
- CAD 50,000 for an exempt market dealer, and
- CAD 100,000 for an investment fund manager.
When hedge funds are formed, there are two options when marketing the fund. Either the company sells itself with a prospectus or it does not. The prospectus describes the investment strategy, risks, structure and other key elements of the business. When a fund does not use a prospectus, a manager has much more flexibility in how they sell the fund. However, without a prospectus, it is limited to specific investors.
Investors include:
- Qualified investors are allowed to invest. These include government agencies, institutions and high net worth individuals, investors who have at least $1 million in net worth or earn $250,000 in income each year.
- Investors who respect a minimum investment. These investors must invest at least $150,000 in a fund.
- Investors from British Columbia, New Brunswick, Newfoundland and Labrador and Nova Scotia can also sign a form acknowledging the risk they are taking with their capital. Each investor has two days to withdraw from positions. In Ontario, an offering memorandum exemption is not an option.
The essential
The process for starting a hedge fund in Canada is very similar to that followed by portfolio managers in the United States. A few key factors differentiate the Canadian hedge fund industry from that of the United States, including costs and the lack of a single central authority to oversee the industry. Each province and territory has its own regulatory body. Prospective hedge fund managers should visit the Alternative Investment Management Association (AIMA Canada) for additional insight into each step of the process.