Starting a fund / raising capital

[moneyguy]

Thanks for the feedback folks.

A few things:

1. I appreciate and understand what you are saying about the financial ramifications of a small fund. I make pretty good money now with my existing business, and a fund would be operated alongside it, as a potential source of additional income. That was probably obvious at the outset, but I point this out because I think my situation is a bit different than most, who might be trying to launch such a fund as their sole business. At $5mil, I feel like the annual costs comprising 1% of the fund assets is reasonable. And if I am making an extra 100k or so off of the fund while it is in its infancy, I would be fine with that. I am still relatively young, and open to the extra work. Then again, having not run a fund before, I don't know the extent of the BS that you have to deal with.

2. Epic, if I read you correctly, are you saying that aside from the fund minimum concern, one would start this in an LP with one's own funds, and then convert it at a later date once enough OPM is committed?

3. Prior to the last few posts, I hadn't considered my current business to be a liability to this endeavor. What important regulatory exemptions would I lose? I expect to have to register in my home state, where my current RIA is registered, and wasn't too concerned about that. But at this point, there are many things I don't know.

Thanks for the help folks. Glad to have found this forum.

 

[doublet83]

Quote from Epic:

Just one thing to add to Heech's comments on personal account performance. If you use ANY proprietary (or hypothetical) performance capsules you must include ALL proprietary accounts within the last 5 years. So if a manager was trading 5 different accounts and choosing to present only the good one, it should be very evident in the disclosure document.

Forming the entity and trading the entity account is the only real way to generate a stand alone performance capsule. That said, any good due diligence team is going to uncover the fact that it really is just a prop account under an entity title. But that will only be relevant during the early stages when coincidentally clients are really just investing in the manager anyway. The benefit is that nobody will care once you've got >$3-5MM in client AUM, and even though the early entity account was really just a prop account, it will still count toward that 3 year hurdle that many offices seem to have.

{edit} What I was really trying to say was that it is all in how you present yourself. Everyone you meet with is expecting you to be emphasizing the good and skirting the bad. As a start-up manager you must come to grips with one thing. They already know they are taking a big risk with you. You don't need to make them feel like there is no risk. Be straight up with them and make them realize that the risks are well known and accounted for. This will result in most of them taking a smaller position to start, but they will still be taking a position. Then you are set to exceed expectation, after which they will increase their investment.

Thanks for the comments. What you and Heech are saying make a lot of sense.

All in all, I feel that I do need to give the fund set up more consideration. However, as Epic noted, my first institutional investor is taking a large risk anyway. For an institution to invest in a one man shop working from his apartment - he is investing in the manager to some large extent. I doubt whether I have made my money under a fund or my personal account makes much difference in this case.

In the immediate future, I am happy to start building my business, as I have done, by managing some friends' money for free. I feel like this could grow nicely if my performance continues to be good and I avoid many of the legal issues by doing it for free (I think?)

 

[Epic]

Quote from moneyguy:

Thanks for the feedback folks.

A few things:

1. I appreciate and understand what you are saying about the financial ramifications of a small fund. I make pretty good money now with my existing business, and a fund would be operated alongside it, as a potential source of additional income. That was probably obvious at the outset, but I point this out because I think my situation is a bit different than most, who might be trying to launch such a fund as their sole business. At $5mil, I feel like the annual costs comprising 1% of the fund assets is reasonable. And if I am making an extra 100k or so off of the fund while it is in its infancy, I would be fine with that. I am still relatively young, and open to the extra work. Then again, having not run a fund before, I don't know the extent of the BS that you have to deal with.

2. Epic, if I read you correctly, are you saying that aside from the fund minimum concern, one would start this in an LP with one's own funds, and then convert it at a later date once enough OPM is committed?

3. Prior to the last few posts, I hadn't considered my current business to be a liability to this endeavor. What important regulatory exemptions would I lose? I expect to have to register in my home state, where my current RIA is registered, and wasn't too concerned about that. But at this point, there are many things I don't know.

Thanks for the help folks. Glad to have found this forum.

Re: #2... What I'm saying is that there really doesn't need to be a "conversion" at any time. If you setup the two additional entities now, then you are all set. Here's what it really comes down to.

When you start to solicit clients for the pool, you'll need performance history. If you include any proprietary history, then you must include 5 years worth of history for every prop account. This is a big pain because there are typically prop accounts that are used for other purposes, like testing trading ideas. Some of these accounts likely have poor performance and make it more difficult to raise capital.

To avoid this hassle, it's better to simply not include any prop history. But you cannot simply setup a CTA and trade your personal account and call it discretionary history. The regulating bodies will still call it prop because it is your personal account.

To get around that technicality, you setup the Advisor (usually an LLC) and the fund (either an LP or an LLC). Now, technically speaking, the fund account is not your personal account and you could use the performance history without defaulting to the 5 year prop requirement. This is the concept behind "incubator" funds. In reality there is no such thing. It is just an imaginary product that accounting and legal firms are using to make more money. They are charging you a few thousand to setup the two entities and get your registrations in place. Because there is no solicitation or outside clients, you don't need a PPM, acknowledgment of receipt, notional trading agreement, audits, admin, etc. and these things are the expensive parts of fund formation/operation.

Personally, I don't agree with the idea behind incubator funds. The point of the 5 year disclosure requirement is that trading your own capital is very different in practice than trading for clients. An incubator fund works on a technicality and attempts to ignore the spirit of the law while still following the letter of the law. If I was running due diligence for a family office and I found out that the performance history was simply personal capital, I would demand 5 years worth of prop account records.

Anyway, when you feel like you want to start soliciting clients, you get the necessary paperwork together and start making phone calls. There is no official conversion from incubator to full fund, it's just that before this point you cannot get in trouble for not having a PPM if you are not accepting outside capital. You don't have to provide yourself with a disclosure document or advisory agreement.

BTW, there is a downside to the incubator fund. If it fails due to poor performance and you try to start another one, you have to disclose this performance as discretionary because it is not a prop account.

 

[sf631]

Also note that an LP structure (most common for proper HFs) requires at least two partners (ie you can't have an LP with only one partner. You can have your entity become the second partner (so you as an individual are one partner, your LLC is another partner).

 

[Epic]

Quote from sf631:

Also note that an LP structure (most common for proper HFs) requires at least two partners (ie you can't have an LP with only one partner. You can have your entity become the second partner (so you as an individual are one partner, your LLC is another partner).

Personally, nobody has ever convinced me on a good reason to do an LP instead of an LLC anyway. It used to be that all funds were LPs and now many are LLCs.

 

[heech]

Quote from Epic:

Personally, nobody has ever convinced me on a good reason to do an LP instead of an LLC anyway. It used to be that all funds were LPs and now many are LLCs.

I'm not a lawyer, but I question whether that's really true. Is it more complicated splitting between "rights" for part-owners in a LLC, versus the more obvious division between general partners and limited partners in a LP?

 

[Epic]

Quote from heech:

I'm not a lawyer, but I question whether that's really true. Is it more complicated splitting between "rights" for part-owners in a LLC, versus the more obvious division between general partners and limited partners in a LP?

I'm not a lawyer either. You might be right that the LP definition is simpler in certain aspects. But the LLC rights should be well defined. I know that LLCs are becoming increasingly popular vehicles for funds outside of TX, FL, and CA where LLCs don't qualify for 'passive income' tax loopholes.

As a general statement, an LLC is typically more flexible in terms of defining relationships, compensation, management, etc. For example, if a limited partner in an LP ever acts in a managerial capacity, he loses his limited liability status as he becomes a GP which doesn't enjoy limited liability. It seems that most disadvantages of the LLC are easily overcome by definitions in the operating agreement whereas certain disadvantages of the LP cannot really be avoided.

 

[et2011et]

Quote from Epic:
BTW, there is a downside to the incubator fund. If it fails due to poor performance and you try to start another one, you have to disclose this performance as discretionary because it is not a prop account. [/B]

Are you talking about CPO pool or equity hedge fund or both?

 

[heech]

Quote from et2011et:

Are you talking about CPO pool or equity hedge fund or both?

Good point. Epic is talking about a NFA rule, applying strictly to non-exempt pools and CTAs. So, should not apply to managers trading non-futures.

And even if you trade futures, there are exemptions. I believe you claim the QEP exemption (essentially only raising from extremely wealth / experienced individuals.... >$2mm in futures account is one standard, I think?), you lose a lot of the need for this type of disclosure. Indeed, the NFA never sees/reviews/approves your offering document.

 

[Epic]

Quote from et2011et:

Are you talking about CPO pool or equity hedge fund or both?

Both. With both the NFA and the SEC it is not required to disclose proprietary trading results. That is the entire point of the incubator fund. It supposedly allows you to classify a prop account as a discretionary account, which would then allow you to use it for performance history without having to abide by the 5 year prop disclosure rule.

Both of them have a rule stating that performance disclosure for prop accounts is not required, BUT if the manager elects to disclose ANY prop history, he must disclose ALL of it for the past 5 years. This is to prevent cherry picking of only the accounts with good performance.

What I'm suggesting is that the incubator can be a bad thing too. If you have a couple years of bad performance, you cannot simply start another one and act like the first one didn't exist. You also cannot start 5 of them and then run with the one that had good performance. This is because they are all considered discretionary accounts now, and by rule, you are required to disclose the performance of ALL discretionary accounts during the last 5 years that were managed by any of the fund's principals. Disclosure for these accounts is no longer optional.

The only way to get around this is if the offered fund itself has at least a 3 year history and at least 75% of the capital in the fund was people not affiliated with fund's principals. But if that is the case, then it is disqualified from being an incubator anyway.

I was also suggesting before that I think the whole "incubator" loophole is not gonna last very long. Examine the definition of proprietary results.

Any pool or account in which 50% or more of the beneficial interest is OWNED OR CONTROLLED BY;

1) the Advisor or any principal
2) an affiliate or family member of the Advisor.
3) any person providing services to the account.

It's just my opinion, but I think that those definitions clearly place the incubator account well within the realms of prop trading. The regulating bodies have been cracking down on fraudulent solicitation lately. They are being pressured to revise their regs to comply with the JOBS ACT, but the argument is that if they are going to allow everyone to advertise publicly, they must be more strict on adherence to the rules.