Incubator Fund Formation

Incubator Fund Formation Services

Our client-tailored flat fee incubator fund service includes the preparation of all needed formation documents and governing agreements to operate an incubator fund. An incubator fund provides a cost-effective solution for an emerging manager to develop a marketable trading record and test performance before launching a fully operative fund. For detailed information regarding incubator funds, please read our article here.

A key area of potential liability (of particular importance to hedge fund managers) is the disclosure of pre-launch trading performance or “track record.” Most emerging hedge fund managers look to provide potential investors with some level of performance data to gain confidence in the manager’s skill in executing the fund’s trading strategy. Often managers have proven the strategy through prior trading with a former fund, as an advisor to separately managed accounts, or through personal trading. Other times, the strategy has not been fully proven and is still in a conceptual-type phase that requires investments to prove its worth. In both cases, the fund manager must remain vigilant to not oversell the track record or strategy and must be accompanied both with proper disclosures.

Performance Record Disclosure Concerns

Managers must exercise extreme caution when providing performance data outside of properly audited, live-trading of a pooled investment vehicle by the management company performed by the same managers. Past trading conducted through former funds, former advisory firms, and personal accounts, even when pursuing a substantially identical trading strategy, must be disclosed with extreme care, if at all. Such performance disclosure can quickly cross the threshold of being deemed misleading and is subject to “cherry-picking” concerns.
Forming an Incubator Fund

Accordingly, emerging hedge fund managers needing to establish a bona fide, audited trading record will often start with an incubator fund structure, using entities that will eventually be converted to a full fund to accept outside capital.

Properly prepared incubator fund documents should include management-level and fund-level formation documents and governing documents, as well as an investment management agreement between the management company and the fund entity to attribute the performance track record to the management company. Legal counsel should be especially careful to provide fund-level governing document terms that closely follow the allocation, distribution, and tax provisions of the eventual fund documents.

Fund managers will use the incubator fund documents to open a fund brokerage account with an introducing prime broker and have trading audited at the fund level. This allows emerging hedge fund managers to begin pre-launch live trading with the fund manager’s own capital with an appropriate fund structure, allowing the fund to convert to a full fund when it is ready to accept outside capital. Closed-end funds, including real estate funds, venture capital, and private equity funds rarely use an incubator fund to build performance records, given that a closed-end fund cannot accept ongoing investments and requires several years to obtain performance returns.

Transitioning to a Hedge Fund

During the incubator fund formation, we advise our clients on important aspects of transitioning to a fully operative domestic or offshore hedge fund to help them make key decisions. Capital Fund Law Group advises hedge funds of all investment strategies and asset classes, including long/short equity, fixed-income, arbitrage, global macro, managed futures, event-driven, multi-strategy, quantitative, and sector funds (including healthcare, technology, energy, and others).

Forming & Operating a Hedge Fund |By John S. Lore, Esq.

Written by John S. Lore, Esq., managing partner and shareholder of Capital Fund Law Group, Forming & Operating a Hedge Fund is a brief guide for emerging fund managers. Click the button below to view and download the eBook on a mobile or desktop device.

This book provides a concise guide through the process of structuring, launching and raising capital for domestic and offshore hedge funds and other private investment funds. Throughout this book, we highlight pitfalls that fund sponsors should watch for and suggest best practices to safely and effectively navigate the process of forming and operating a fund.

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Sample PPM Document Excerpt | An Example Document

This is a brief excerpt of a sample hedge fund Private Placement Memorandum (PPM) with footnoted explanations of the PPM provisions.

The PPM is based on a fictitious master-feeder hedge fund using a global fixed-income arbitrage strategy. The accompanying explanations discuss the reasons behind certain disclosure language as well as more detailed examination of certain fund topics and how they apply to the disclosure document.

The excerpt also provides drafting tips, best practices recommendations, potential pitfalls and common mistakes in hedge fund PPMs. The fictitious feeder fund XYZ, LP is a domestic feeder fund to a Cayman Island master fund. Although the XYZ Feeder Fund, LP specifically uses a fixed-income arbitrage strategy, the explanations provide information that should be helpful to fund managers using any strategy.

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Hedge Fund Investment Terms | a White Paper

This white paper describes some of the most common hedge fund terms and how they apply to various hedge fund strategies.

One of the most important aspects of forming a hedge fund is setting the terms of the investment. When properly structured, hedge fund offering documents contain terms that adequately protect the fund sponsor and are attractive to investors. Hedge fund terms are driven by the fund’s strategy, the market trends within the fund’s asset class and the particular needs and objectives of the fund. It is crucial that the investment fund legal counsel has an in-depth understanding of current investment market trends and how those trends affect the strategy the fund will employ.

Incubator Funds