Who among us would not like to launch a hedge fund? However, the obstacles and challenges are legion.
For example, one must develop an investment strategy or strategies, determine the structure under which to the fund will operate, secure the necessary registrations and licenses (state and federal) with applicable regulators, forge service partner relationships, craft governance and offering documentation, develop marketing communications materials, establish a marketing strategy, open bank and brokerage accounts, approach prospective investors and implement, through live trading, the fund’s strategy.
Oh, yes…will you choose to be a domestic or offshore fund? By the way, we have yet to touch on the implementation costs!
Starting an incubator hedge fund is the sensible alternative. It is the equivalent of putting a toe in the water versus cannonballing into the pool. In short, it is a cost effective stepping stone to launching a full-fledged hedge fund.
How Does It Work?
Typically, the founder will contribute his own capital to the fund, managing it for 6 months to one-year, which provides ample opportunity for testing investment strategies and establishing a track record. Upon establishing a successful track record, it is possible to reach out to prospective investors to see what levels of interest exist prior to incurring the costs of a full fund launch.
What Are the Principal Advantages of an Incubator Fund?
First and foremost—costs! Some experts estimate that as little as $3500, plus state filing fees is a sufficient sum to establish the fund and the management company.
Simplicity of structure—an incubator fund consists of 2 entities, a limited partnership (LP) to serve as the fund and a limited liability company (LLC) to serve as the investment manager/general partner. This gets you limited personal liability, favorable tax treatment and a seamless transition into a full-fledged fund.
No administrator required—unlike a full-fledged hedge fund, incubator funds are not burdened with redemption requests, providing net asset valuations (NAV), preparing monthly reports and calculating fees. This fact alone will save up to $3000 per month in costs.
No licenses or registrations needed—as long as the manager receives no remuneration for investment advice and does not advertise himself as an investment advisor. State laws do vary, however, so the safe play is to seek legal advice in your state. If it turns out that the manager is required to register with the state’s securities division as an investment advisor, the manager will need to complete the Series 65 Exam. This would be required to transition to a full-fledged hedge fund anyway, so it is not a big deal.
Because existing entities are already in place and a track record of performance has been established, the transition to a full-fledged fund is fairly straightforward. When you are ready to launch, consult with legal counsel to arrange formal offering documents, such as the private offering memorandum, partnership agreement, and subscription documents. You may also need to employ third-party service providers, such as the aforementioned administrator.
The takeaway is that by starting with an incubator fund, you have developed a firm foundation and a high level of confidence that is difficult to achieve by jumping headlong into a full-fledged hedge fund startup.