Prop Traders Face Headwinds in Starting Hedge Funds

March 21, 2011

As the Volcker rule forces many banks to wind down their proprietary trading desks, more and more in-house traders are viewing this as an opportunity to start their own hedge funds.

Not so fast, reports Reuters. Traders may be inspired by the success of Goldman Sachs stars such as Pierre-Henri Flamand and Morgan Sze, who have raised billions of dollars to launch their own funds. But other proprietary traders may face more daunting challenges.

First, since they’ve been investing their banks’ own money behind the scenes, these would-be hedge fund managers may have little or no track record that they can share with prospective investors.

“It is not a complete slam-dunk for us (to invest in a spin-out),” Patric de Gentile-Williams at FRM Capital, told Reuters.  “The transition from prop trader to hedge fund manager is not totally obvious.” His firm has not yet backed any of these new start-up funds.

A survey by Credit Suisse revealed that only 52 percent of investors would be prepared to invest in a prop-trader spin-out, and only if it had a 3-year track record.

Without the necessary track record, new fund managers would need to compensate heavily by gathering great references, according to Peter Rigg, global head of the alternative investments group at HSBC Alternative Investments Limited. Rigg’s firm is one of the backers of Pierre-Henri Flamand, whose event-driven Edoma fund has raised roughly $1.6 billion to date.

In addition, these smaller start-ups are unlikely to have the same internal controls and compliance structures that major institutional investors require today. Another hurdle to overcome.

Nevertheless, with more cash flowing into the hedge fund industry, and more banks deciding what to do with their proprietary trading desks, the lure of launching your own fund will continue. JPMorgan reportedly plans to move its prop trading desk to its asset management division and seed the group with $2 billion. Morgan Stanley is set to spin off its Process Driven Trading unit by the end of 2012.  We are still only at the very beginning of this process, says de Gentile-Williams.

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