Incubator Hedge Funds: Your Questions Answered
We developed the concept of the incubator hedge fund and we continue to innovate, expanding the limits of what can be accomplished in an incubator fund structure.
Please read through the common questions and answers below relating to incubator funds. If you have further questions, or are ready to form an incubator fund, we invite you to contact us for a complimentary consultation.
What is an incubator fund?
An incubator fund is the ideal investment vehicle for entrepreneurial managers that are searching for a cost-effective stepping stone to launching a full-fledged hedge fund. Generally, a manager will contribute his or her own capital to the fund and manage the fund’s assets for 6 to 12 months in order to test investment strategies and create a track record of investment returns within the incubator fund vehicle. Once the incubator fund has established a track record, the manager can reach out to prospective investors and obtain indications of interest prior to incurring the expense of launching a full-fledged fund.
How is an incubator fund structured?
An incubator fund is typically structured by forming two separate entities: (1) a limited partnership (LP) or a limited liability company (LLC) which will serve as the fund; and (2) a limited liability company (LLC) which will serve as the investment manager / general partner of the fund (or managing member if the fund is an LLC). The individual who is actually managing capital would typically serve as the managing member of the investment manager. This structure grants you and your investors limited personal liability, as well as beneficial tax treatment. This structure also enables you to easily transition the incubator fund into a full-fledged fund once you are ready.
How long should I operate an incubator fund before marketing the fund to investors?
You can send out performance data to investors at anytime during incubation. It is our experience that managers typically incubate their funds for a period of 3 to 12 months prior to converting the fund to a full-fledged hedge fund. The longer the track record, the more attractive the investment will appear to prospective hedge fund investors.
Can I gather indications of interest from investors during the incubator phase?
Yes. Although you cannot market interests in the fund or accept capital from outside investors during the incubation period, you can begin gathering indications of interest through your personal network, friends and family (i.e., persons with whom you have a pre-existing relationship). Marketing the fund through general solicitation or advertising is generally prohibited, unless the fund manager is willing to observe various investor verification requirements. In addition, holding yourself out to the public as an investment adviser is also generally prohibited, depending on your state of residence.
How much does it cost to establish an incubator fund?
One of the primary catalysts for the growing popularity of the incubator fund is its cost effectiveness. Generally, an incubator hedge fund can be created for $2,500 – $3,500, plus state filing fees to establish the fund and the management company. If you’re ready to begin the process to start an incubator fund, or if you’d like to receive additional information regarding the timeline or costs to launch your fund, please schedule a complimentary consultation with our team.
Can I open a trading account for my incubator fund at any brokerage firm?
You can use any brokerage firm to launch your incubator fund. As soon as the fund has been established and you have received the organizational documentation and partnership agreement, you will be able to open a brokerage account and begin trading.
Can I add and withdraw capital from the incubator fund?
Yes. You may make additional contributions or withdrawals during the incubator period. The track record of the fund is measured as the percentage return of assets under management, regardless of the amount of capital contributed to or withdrawn from the fund. However, you should limit contributions and withdrawals to ease the calculation of the fund’s returns.
Do I need a fund administrator for my incubator fund?
No. Administrators assist in many of the ongoing operations of a full-fledged hedge fund, including processing subscription and redemption requests, providing net asset value calculations, preparing monthly reports, and calculating fees. Fees for a hedge fund administrator can range from $500 to $3,000+ per month. Establishing an incubator fund will allow you to develop a track record without incurring the costs of a third-party fund administrator.
Can I establish an offshore incubator fund?
Yes. If your prospective hedge fund investors will likely be non-U.S. persons or U.S. tax-exempt persons, establishing an offshore incubator fund may be desirable from a long-term perspective. The cost to establish an offshore incubator is typically higher than establishing a domestic incubator and the process can take a bit longer, but an offshore fund may be attractive in certain circumstances.
What are the tax consequences of establishing an incubator fund?
As a partnership, the fund is a pass-through entity for U.S. tax purposes, meaning that the fund’s realized income and gains are taxed at the investor level only (i.e., not at the partnership level). The various tax items that pass through to an investor’s tax return on a Form 1040, Schedule K-1 and comparable state tax forms retain their tax character for the investor.
Can outside investors or family members participate in an incubator fund?
In general, outside investors should not participate in the fund during the incubator stage. In certain circumstances you may be permitted to accept an immediate family member for no compensation; however, you should contact legal counsel to discuss the relevant legal issues involved prior to accepting such investments. If you’re ready to begin the process to start an incubator fund, or if you’d like to receive additional information regarding the timeline or costs to launch your fund, please schedule a complimentary consultation with our team.
Do I need to form a management company?
Not necessarily. During the incubator stage you can serve as the general partner to the fund in your individual capacity, if you prefer not to form a limited liability company to serve as the general partner. However, a limited liability company should be in place as the fund’s general partner for liability purposes prior to launching the fund to outside investors. Establishing the management company at the outset will better streamline the process to launch a full-fledged hedge fund.
Do I need any licenses or registrations to operate an incubator fund?
Generally, no, provided that the manager does not receive compensation in connection with its giving investment advice or hold itself out to the public as an investment adviser. However, each state has different registration requirements and exemptions. If a state does require a manager to be registered with its securities division as an investment adviser, the manager may need to take an exam and provide a detailed application. Many investment adviser exemptions also require the filing of a Form ADV.
How do I transition an incubator fund to a full-fledged hedge fund?
With the existing entities already in place and a marketable track record to show potential investors, transitioning your incubator fund to a full-fledged hedge fund is usually a straightforward process. Once you are ready to launch the hedge fund, you should consult legal counsel regarding the preparation of formal offering documents for the fund, which will include a private offering memorandum, partnership agreement, and subscription documents. You may also need to engage additional service providers, such as a third-party administrator, prior to launching a full-fledged hedge fund.
Can I operate more than one incubator fund?
Some managers will incubate multiple funds in order to develop track records for different strategies. You can efficiently manage multiple funds by having the same management company serve as the general partner and investment manager of each fund.
How much money do I need to seed the incubator fund?
There is no minimum investment requirement to seed an incubator fund (unless a minimum account value is imposed by your broker). However, you should consider your investment strategy and potential investor base when deciding your level of capital commitment.
Can I seed the incubator fund with my IRA?
Generally, yes. However, an investment by your IRA may, under certain circumstances, violate applicable prohibited transaction rules under ERISA. You should always consult legal counsel prior to directing assets from your IRA into your incubator fund.