The Purpose of an Incubator Fund

For a manager without previous fund management experience or ready access to initial investor capital, an incubator fund provides a cost effective way to begin building a marketable performance record using the manager’s personal funds.  An incubator fund allows a manager to fine-tune the trading strategy while creating a marketable track record.

Although there is not a maximum time allowed for an incubator fund to be active before converting to a full offering, typically six-to-twelve months is common. Contemporaneously, the manager can prepare for any applicable Financial Industry Regulatory Authority (FINRA) examinations that may  be required to file for regulatory registrations for the full offering. Additionally, they can engage services for marketing development and design for the fund’s marketing marketing materials, working alongside their legal counsel to review the prepared marketing materials for compliance with marketing and advertising regulations.

Once ready to continue the document preparation and regulatory filings process in order to start accepting outside investors, the manager will work with legal counsel to convert the incubator fund to the hedge fund. 

• Track Record

Trading in a start-up hedge fund involves a different strategy from trading with part of an organization.  Securities laws make it challenging for you, the manager, to use prior personal performance figures to promote a new fund.  The concept of “cherry picking” discourages you from disclosing certain personal performance while omitting others.  The incubator fund allows you to show performance in the same entity structure that will eventually be used for the fund using actual performance.

• Self-Funded

With very few exceptions, the incubator fund will not accept outside investors.  Even investments from close friends and family can run afoul of state and federal securities law. Likewise, you should not borrow capital from individuals with the intent to deem this “internal capital”, as this can be seen as a clear attempt to bypass securities laws in order to accept outside investor capital during the incubation period. You should consult legal counsel prior to accepting any outside funds from any source.

• Minimal Regulatory Requirements

Given the fact that an incubator fund does not have outside investors, it is generally not subject to many of the regulatory and filing requirements required by federal and state law, such as investment adviser registration, Commodity Pool Operator, Commodity Trading Adviser registration, or other similar registrations, and Form D filings.  However, you should check with legal counsel prior to concluding which regulatory requirements, if any, must be satisfied.

• Structure

An incubator fund is an investment fund structure, commonly consisting of a limited partnership as the fund entity, an LLC as the management company entity, and an LLC as the general partner.  The same entities will eventually be used for the hedge fund.  Unlike a full hedge fund, an incubator fund does not include the securities offering documents and regulatory filings necessary to sell to outside investors, which is why only internal manager capital is allowed during the incubation period.

• Cost-Effective

An incubator fund significantly reduces start-up capital risk while the strategy is tested.  The cost to form an incubator fund is considerably lower than the cost to form a hedge fund.  The incubator fund can be converted to a full hedge fund once you have established a sufficient performance record.  Since an incubator fund formation involves some of the work that will be performed in forming the hedge fund, Capital Fund Law Group offsets the cost of the incubator fund against the subsequent preparation of the full hedge fund formation documents.

• How is an Incubator Fund Taxed?

An incubator fund is generally set up using a pass-through fund entity (typically a Delaware limited partnership). The fund’s realized income and gains are only taxed at the individual level for federal income tax purposes. Taxation at the state level will vary depending on state. Tax gains and losses pass through to your personal tax return.  Items of income gains, losses, and expenses allocated to the fund managers will retain their tax character. It is recommended to engage a tax professional to assist you with any required tax preparation services. 

• Process to Convert to a Fully-Formed Fund

To convert to a full hedge fund, we will assist you in the preparation of formal offering documents for the fund, which will include a private offering memorandum, partnership agreement, and subscription documents, as well as the necessary regulatory filings and applicable registrations. Additionally, once you have prepared your marketing deck, our attorneys will review the deck for legal compliance, including necessary disclosures. Unless requested during the incubator phase, review of marketing materials is not included in the incubator fund formation services.