Passing on the message from one of our teammates, who has raised from large institutional fund investors and also dealt with regulatory audits:
This is not legal advice but personal experience. This is mostly from a US setting.
No, as unintuitive as it sounds, you do
not require audited financials or returns as others have said. And there's no regulatory requirement, to my understanding, that expects that you use a certain type of report, so long as you are clear in your promotional materials about the potential risks and any material factors for the type of performance report you've provided.
Say you're raising from institutional QPs/QEPs, or accredited investors who are familiar with alternative investments, the most "peddled" source of your track record is typically your third party fund administrator's performance reports and they're the closest to the true fund net returns after fees. There's many of these; we liked NAV Consulting (for disclosure, Databento doesn't have a business relationship with them, so this is purely an anecdotal recommendation), but there's also others like Maples, MUFG, SS&C who are popular with quant trading firms, and large players like State Street and Citco.
The TPA works for you, so their performance reports are technically no different from your own inhouse controller, CFO or accountant claiming the numbers to be true - and indeed at some large firms they prepare these reports themselves. TPAs are often just preparing numbers based on brokerage statements and other valuations that you supply them, so there's a lot of good faith going on that typical investors and LPs exercise.
There's various reasons why this is the conventional practice.
- As weird as this sounds, for better or worse, the US and most parts of Europe clamp down harder on white collar financial fraud than murder. And just as you don't suspect everyone is a closeted murderer, as long as you have a reasonable social presence, work history and educational background, no one makes a prime facie assumption that your returns are fake.
- Large TPAs have just as much of a reputation to maintain for their business as the large accounting firms and have no reason to go down taking one for a small fledgling fund.
- It's not as if an auditor is foolproof either. (That's why Arthur Andersen went down.) Your TPA needs to exercise as much if not more scrutiny than an auditor to do their job. Auditors typically run a few samples and do a couple of short phone calls, and arguably take less time to do their job than your TPA or inhouse controller.
- It's impractical to audit your returns each time for a due diligence meeting. It takes time and costs a lot, and those costs are typically amortized and borne upon the investor, not the manager.
That said, past a trivial number of investors and AUM, you'll fall under some kind of regulatory regime that requires you to submit annually-audited financial reports, so there's generally a side expectation that your unaudited performance reports will eventually be harmonized with your year-end audited financials.
All this is nice to know, but I doubt it's immediately helpful, because it creates a chicken-and-egg problem: if you don't have capital raised, it's unlikely that you're paying for a TPA, much less an auditor.
To get around this chicken-and-egg problem, we've mainly just seen 4 groups of approaches:
- Most people rely on prior reputation and pedigree to get investor commitments even before they trade.
- We've seen small trading groups that were just starting out with 1-2 guys looking for seed capital and they'd often just send out an Excel spreadsheet and brokerage statements. These have typically spun out from a top prop firm or hedge fund, just that their principals don't have as much street cred as the first group. Technically, one could present these brokerage statements with a similar, onerous level of disclosures as backtested returns - the latter of which is acceptable. But there's some legal grey area with this approach that I haven't seen tested in practice: despite obvious disclosures on the principals' parts, we're pretty sure the regulators will still find some fault with this if they really wanted to go after any of these guys.
- Some rely on some kind of seed or incubator program, which usually takes a big haircut, expects you to trade out of a joint account or SMA, and require you to put up your own capital to absorb much if not all of the downside. In turn, these guys give you all of the administrative pieces that will start you on your journey of raising capital.
- Some just have wealthy friends and family or deep pockets themselves, which you'd often expect of someone who has had success trading.
1-3 years is unnecessary. There are many industry surveys that have debunked this myth that length of track record is the primary determinant for an allocator. Most sophisticated investors we know understand that it depends a lot on the Sharpe ratio of your strategy and turnover frequency. Also many investors want to take on the risk to get in early, because chances are that if you have 3 years of good track record, it's already too late for the investor to get capacity allocation on favorable terms.
