HEDGE FUNDS
INCUBATOR FUNDS

An article by Robert A. Green, CPA & CEO of Green & Company CPAs, LLC (GreenTraderTax). A prior version of Green's article was published in the November 2005 issue of Active Trader Magazine.

Click here for the media version of the below article; which does not have any pricing information from GreenTrader.

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Many traders dream of having their own hedge fund business but only a small percentage of them actually take the plunge. Why do would-be fund managers hesitate? Probably the biggest reason is cost. In addition to paying between $10,000 and $50,000 to create the fund with a law firm, the new fund manager can plan on accounting and tax preparation for the first year of operation running anywhere from $16,000-26,000. Both the start-up and operating costs may seem quite high, especially for a trader who doesn’t yet have investors lined up.

Another common reason that traders do not go ahead with their dream of starting a hedge fund is that they do not have a useable track record. Although a trader may have lots of experience, it is quite likely that under federal securities laws he will not be able to use quantitative measures of his success to attract potential investors in his new fund.

Happily, for traders who would like to start their own fund but who are not ready to incur the associated expenses and / or do not yet have the performance history they need to attract investors, GreenTrader offers an incubator launch plan.

Starting your hedge fund business with an Incubator Fund can save you well over $20,000 during your first year of operations. It also allows you to create a stellar—and marketable—performance record that conforms to all industry and accounting standards. Only when you are confident that investors are ready to join do you engage your outside attorneys (GreenTrader is not a law firm) to prepare your investor offering documents and other legal paperwork. Legal fees are one of the biggest costs in launching a hedge fund and GreenTrader helps you select attorneys, monitor the process and costs.

Choosing the wrong attorney can be a nightmare. Some attorneys are overworked, others sell cookie cutter documents and some can be very difficult to deal with. Attorneys may be done with you when they complete the documents, but GreenTrader sticks with you for the life of your business in many areas of your operations. We have earned the trust of our clients since the founding of Green & Company CPAs in 1983.

Lower start-up costs with an Incubator Fund

Most law firms want to sell you the blue-prints and build the hedge fund all at once; they make more money that way. At GreenTrader, we place our clients first and customize a flexible plan that allows you to build your fund in two separate phases. By using our incubator fund strategy, you break down the startup process and related costs while avoiding redundancy: the two-step process usually costs no more than doing everything at once.

• Phase I: Incubator. Create your hedge fund and management company as legal entities, and you begin building the fund’s performance history by trading with your own funds. This phase usually costs around $3,500. These figures are for setting up onshore funds; the price for offshore entities is somewhat higher (and involves the use of offshore legal counsel).

For approximately $5,000 more, GreenTraderTax will prepare your fund investor-level accounting (using our GTT TradeDepot software) and annual income tax returns (for the fund and management company).

• Phase II: Completion. Using an outside law firm, prepare your offering documents, investor agreements, and other legal paperwork, and you begin accepting outside investors. We work closely with some outside law firms to provide Phase II services at excellent prices and customer service.

You can use the incubator strategy with any type of hedge fund. Whether you have a securities fund, commodities/futures fund, Forex (currency) fund, onshore, offshore, or master/feeder fund, our incubator strategy can save you lots of money in your startup period.

The cost advantage of our Incubator Fund strategy is tremendous. Of course, if you already have investors lined up, you’ll want to skip the incubator phase and have the complete fund set up all at once. However, if you would prefer to move ahead in two steps, the initial cost savings are significant.

Establish a marketable track record with an Incubator Fund

Unless you're well known as a successful trader in the financial services industry, with some pedigree (as institutional investors like to use the term), chances are you won't attract investors into your hedge fund until you can show them an excellent performance record. Of course, if you are thinking of starting a hedge fund, you probably have already had success trading your own accounts or trading professionally. Although prior experience in the markets is very valuable in many ways to a hedge fund manager, one thing it usually cannot provide are hard figures that can be presented to potential investors. Securities laws make it very difficult to use a manager’s prior performance figures to promote a new fund.

The problem with advertising prior performance is that the fund manager must show that it is truly representative of what an investor could reasonably expect from the fund. Quite simply, the problem is demonstrating that prior apples are equivalent to present oranges. This is not easy, since trading one's own personal account or trading as part of a team at a large hedge fund (just to give two examples) are significantly different from trading in a startup hedge fund.

Creating a prior performance record that can be used in your fund’s offering documents and shown to investors is not only difficult but also costly. Prior performance records not only must be audited for accuracy, in accordance with GAAP (Generally Accepted Accounting Principles), they must be verified according to the standards established by the Chartered Financial Analyst Institute (AIMR-PPS and GIPS)., The cost of hiring a specialized firm to perform verifications according to CFA Institute standards is quite high. An even greater obstacle, however, is that attorneys are very reluctant to allow the figures to be used in offering documents. Even if you pay accountants to verify that your figures conform to GAAP and AIMR-PPS / GIPS standards, most attorneys still will not include these prior performance records in offering documents because it exposes them to potential litigation from disgruntled investors.

If you have a great prior record and you plan to use the same trading program and environment in your new fund, it may well be worth the effort and cost to pursue this option. It will require that prior performance trading program “apples” be reconciled with future fund trading program “oranges.” You will have to document that your prior trading strategies and working environment are very similar to your future fund trading strategy and environment. In the majority of cases, however, prior performance simply is not representative. And when it is, it is still quite possible that the potential benefits of verifying prior performance do not justify the associated trouble, expense, and potential legal exposure.

Happily, the Incubator Fund is an attractive solution to the prior performance problem. Not only is our Incubator Fund economical, it generates a historical fund performance record that can be used to attract potential investors. Unlike prior performance—the manager’s investment success prior to starting the fund—historical fund performance does not require verification. It presents no problem of comparing apples to oranges: the historical performance record of the Incubator Fund is the record of the fund itself.

The bottom line is that the majority of those wishing to start a hedge fund are better off skipping prior performance and setting up an Incubator Fund. If you want to avoid dealing with the cost, uncertainty, and risk of crafting a prior performance record, you can use an Incubator Fund to generate the historical performance record that will appear in the fund’s offering documents. All that's needed is a regular annual financial audit in accordance with GAAP. And even if you change the fund's trading strategy in the future, which creates a problem of apples and oranges, there is no requirement for verification to CFA Institute standards.

Benefit from the flexibility of an Incubator Fund

Your life is easier during the Incubator process. Since you do not have investors in your Incubator phase, it's much easier to prepare your accounting and NAV reports. You do not need to deal with complex investor-level accounting issues. Annual tax preparation is also a snap; it's almost as easy as preparing tax returns for any trader entity. All this saves you money and reduces your work and time with our professionals. Since most complications arise when investors come into the fund, an Incubator Fund can save you many headaches while you are getting your fund’s business operations in order.

You have time to fine-tune your business plan with an Incubator Fund. When your incubator fund is successful and you are ready to meet with prospective investors, it's time to complete your hedge fund business plan and incorporate it all into your offering (disclosure) documents. With the time afforded you in the two-step process, you can benefit from hindsight and experience. Maybe you want to change brokers, take soft dollars (or skip them); change other operations like management team, systems and more. Since you can tweak your hedge fund business plan before preparing your offering documents, those documents will be more representative of your revised operations than if you created them on day one (without an incubator). Since these offering documents are the way you fulfill your disclosure obligations, from a legal and compliance point of view, the incubator approach provides added protection.

The Incubator can be valuable even if you decide not to complete the hedge fund. If the Incubator Fund is successful and can attract outside investors, you will probably decide to move forward with a hedge fund and management company. If, however, you decide not go ahead and complete the fund, you can still take advantage of the entities created in the Incubator phase, since they are designed to accommodate business trading as well as hedge fund trading. You can use one or both of these entities to gain important tax benefits, such as retirement and health insurance deductions. Business traders often need an entity to create “earned income” in order to deduct contributions to retirement and health insurance plans. Learn more about GreenTraderTax business entity tax strategies here and retirement plan strategies here. This built-in contingency plan helps ensure that you get the maximum value for every dollar spent with us.

The Incubator Fund allows you to start big or small. Many traders ask about the amount of money they should start with in their Incubator Fund. The answer is that there is no minimum investment, though you probably will want to start with at least $25,000, which is the minimum required to establish a pattern day trader account at a direct-access broker. To attract serious outside investors, you will want to consider trading $100,000 to $1,000,000 or more.

Some restrictions with an Incubator Fund

Under federal and state laws you are not allowed to accept compensation (in any form or kind) from investors, including yourself, during the incubation period. Nor can you accept funds from outside investors, except (in limited cases) from family and close friends. Since you are subject to fiduciary duty rules even with non-paying investors (which means that you can be sued for losing their money), you should consult with an attorney before accepting other people's money into your Incubator Fund.

The Bottom line
Starting your own hedge fund business can be your ticket to financial and business freedom. However, it is a reality that most new businesses, including hedge funds, fail in their first year of operations. So as you start your fund, plan wisely. If you decide on a low-cost, low-risk vehicle for getting your fund off to a solid start, talk to us about an Incubator Fund.

Ready for help?

If you have any questions or would like to get started, please email hedgefunds@greencompany.com and/or call us.

Consider starting with a 60-minute consultation with our GreenTraderFunds professionals to discuss incubator fund strategies. In this consultation, you will speak with a senior attorney on registration, development and entity structure issues, plua a CPA on accounting, tax and audit issues.

After this initial consultation, you can upgrade to our full execution services and we will give you price quotes too. Formation services come from our affiliated law firm and the accounting, tax and audit services (to choose what you need) come from GreenTraderFunds.

Incubator (start-up) fund services from GreenTraderFunds:

A GreenTraderFunds incubator fund is the least expensive and most flexible hedge fund business plan around! You can form your incubator fund with GreenTraderFunds and our outside law firm for around $4,000.

Then begin generating an attractive performance record now and complete the setup of a hedge fund (Phase II) that can be offered to others when the fund is already a proven success. GreenTraderFunds can handle the preparation of your fund level accounting and annual income tax return filings with Schedule K-1s for a very reasonable additional cost.

Although audits are a "self-imposed" requirement for incubator funds in Phase I, they are useful for attracting institutional investors in Phase II. Note that many domestic incubators can forgo audits to a later date, whereas offshore incubator funds usually are required to have audits from the start. In most cases, GreenTraderFunds can handle your audit too. Click here to learn more about our audit services.

You don't need any other service providers, as GreenTraderFunds handles all your needs under one roof. We also offer specially priced packages including everything you need.

Soft dollars or hard trouble, look before you leap?

Are you a candidate for “soft dollars”? Larger brokerage firms generate excellent revenue streams catering to the many needs of hedge fund managers; some are labeled “prime brokers.” In addition to executing trades for commissions, some firms provide leverage (lend money) and package derivatives, and offer administration. Brokers are keen on hedge fund customers and many are willing to entice new hedge fund managers with “soft dollars,” a form of commission rebates on large volumes of trades by the fund. But don't count on being offered soft dollar deals unless you have a pedigree. Soft dollars are intended to cover research costs but some brokers stretch the concept (at regulatory risk) to include startup legal services, maintenance costs, equipment charges, and office space.

The SEC has stated that it intends to narrow the definition of soft dollars to its intended original domain of research only and to unbundled soft dollars from commissions (for more transparency with investors). Some brokers offer cookie cutter hedge fund legal documents to new managers, which can be dangerous. It's wiser to have an outside law firm with the necessary experience in hedge funds prepare your offering documents.

Consider that every “conflict of interest” needs to be disclosed in your offering documents. Understand that your management company may have a conflict of interest with your hedge fund (investors) and your brokers for “best execution.”

Your investors should come first under the fiduciary care rules which apply to hedge funds. But do investors come first if your broker pays most of your startup and operations costs (enriching your management company directly – that's you personally) at the expense of higher commission charges to your fund (investors)?

Investors pay for commissions and managers get commission rebates (soft dollars) directly (not back into the fund). Is it (legally) wise to have your prime broker prepare your offering document disclosures? Learn more about Best Execution rules in our Operations and Compliance section.

Many traders simply don't have the necessary pedigree required for the above-described special startup support deals. Lacking pedigree is all the more reason to get your performance record in order first with an incubator plan. How can you be successful without one?

We had a conference call on soft dollars on August 17, 2006.

New SEC rules on “soft dollars” (effective 1/24/07).

Hedge fund advisers use soft dollars (brokerage commissions paid in excess of the lowest rate, which is termed best execution) to buy goods and services. There is a statutory safe harbor in Section 28(e) for “research” – which the new rules define much more narrowly. You may need to revisit your documentation on brokerage fees.

It is hard to imagine getting investors for a fund if the fund manager has no track record to advertise. Unless you're well known as a successful trader in the financial services industry, with some pedigree (as institutional investors like to use the term), chances are you won't attract investors into your hedge fund until you can show them an excellent performance record. This places the would-be fund manager in a Catch-22 situation.

The Problem of Prior Performance

The problem with advertising prior performance is that the fund manager must show that it is truly representative of what an investor could reasonably expect from the fund. Quite simply, the problem is demonstrating that the “apples” he produced in his prior experience are equivalent to the “oranges” he will produce with the new fund. This is not easy, since trading one's own personal account or trading as part of a team at a large hedge fund (just to give two examples) are significantly different from trading in a startup hedge fund. The environments are different enough that a disgruntled investor (and the litigator he hires) could argue in court that the record the hedge fund manager touted was not a fair representation of the fund’s potential performance.

Creating a prior performance record that can be used in your fund’s offering documents and shown to investors is both difficult and costly. Prior performance records not only must be audited for accuracy, in accordance with GAAP (Generally Accepted Accounting Principles), they must also be verified according to the standards established by the Chartered Financial Analyst Institute. These Global Investment Performance Standards (GIPS) are designed to ensure that investors are able to make “apples-to-apples” comparisons between investment options. The cost of hiring a specialized firm to perform verifications according to CFA Institute standards is quite high. An even greater obstacle, however, is that hedge fund attorneys are very reluctant to allow the figures to be used in offering documents. Even if you pay accountants to verify that your figures conform to GAAP and AIMR-PPS / GIPS standards, most attorneys still will not include these prior performance records in offering documents. The reason is simple: they do not want the exposure to lawsuits from disgruntled investors.

If you have a great prior record and you plan to use the same trading program and environment in your new fund, it may well be worth the effort and cost to pursue this option. It will require that prior performance trading program “oranges” be reconciled with future fund trading program “apples.” You will have to document that your prior trading strategies and working environment are very similar to your future fund trading strategy and environment. In the majority of cases, however, prior performance simply is not representative. And when it is, it is still quite possible that the potential benefits of verifying prior performance do not justify the associated trouble, expense, and potential legal exposure.

The problem of prior performance puts the would-be hedge fund manager in a Catch-22: to be a hedge fund manager he needs a track record—but to get that track record he already needs to be managing his fund.

One Solution: Forget Prior Performance and Create Historical Performance

Understandably, a trader who wants to launch a hedge fund may find it hard to stomach the idea that he cannot take full advantage of his well-earned record of success in the markets. It may be easier, however, if he is aware of another way of translating his trading skill and experience into a track record that is fully marketable to potential investors. The solution is, quite simply, to get the fund started—in a preliminary way—so that the trader can start generating historical performance.

The distinction between prior performance—the manager’s investment success prior to starting the fund—and historical fund performance can be crucial for the trader trying to make the transition to hedge fund manager. Unlike prior performance, historical fund performance does not require verification to GIPS. It presents no problem of comparing apples to oranges: the historical performance record of the preliminary fund—what I call an “incubator fund”—is the record of the fund itself.

The majority of those wishing to start a hedge fund are better off skipping the complex and costly process of verifying prior performance and instead setting up an “incubator fund” that allows them to start generating the same historical performance record that will later be presented to investors in the fund’s offering documents. And it is worth keeping in mind that historical performance is probably more valuable to potential investors than is the manager’s prior record: what the manager did before coming to the fund pales in comparison to what he has in fact done since starting the fund.

What I am suggesting amounts to a two-step approach to starting a hedge fund. In the first step, the legal entity is created, but investors are not yet accepted. The manager trades with his own money, perhaps as little as $25,000. This is what I am calling the “incubator fund.” When the manager is ready for investors, the legal documents for accepting investors are drawn up and the hedge fund is fully formed.

This two-step process has a number of advantages. In addition to eliminating the prior performance problem, it makes getting started much less expensive. What makes the fund expensive to start and to run are investors. Because there are fewer documents to draw up and fewer accounting chores, an “incubator” hedge fund costs a fraction what a full-fledged fund costs. The two-step approach also gives the manager an opportunity to fine-tune his business plan and investment strategies before preparing his offering documents.

The obvious limitation with this strategy is that the fund is not able to accept outside investors. It may be possible for family members and close friends of the manager to invest, but the manager is not allowed to accept compensation of any kind. These restrictions might make the two-step solution seem like no solution at all. After all, what kind of hedge fund doesn’t have investors, and what hedge fund manager doesn’t receive compensation for his services? But if one takes the long view and remembers that starting any business involves hardship and sacrifice, the “incubator” may be just the place for a newly-hatched dream.

Ready for help?

If you have any questions, feel free to call us and/or hedgefunds@greencompany.com.

We suggest that you start with a consultation to discuss whether or not an incubator fund is a smart strategy for you.