Seed Capital Arrangements for Hedge Fund Managers
We receive numerous inquiries from new managers seeking capital sources in today’s challenging financial climate. Recent regulatory changes have increased legal and compliance costs associated with launching a hedge fund and many smaller investors are wary to invest with first time managers, despite their potential to generate alpha. One way emerging managers can secure the much needed capital is via a “seed deal” whereby a seed capital provider (the “Seeder”) makes a significant capital investment (the “Investment’) in the manager’s fund (the “Fund”) in exchange for a share of the management fees and/or incentive fees. In addition to providing the manager with start-up operating and investment capital, the manager gets additional credibility with prospective investors. This article will summarize some of the basic terms involved in seed deals, as well as a number of issues a manager should consider. Please note that each seed deal is unique and a manager should work with experienced counsel to negotiate the appropriate terms.
Seed Deal Basics
The amount of Investment can range greatly, the initial funding can be as much as $150 million
or as little as $1 million depending on a variety of factors.
Depending on the size of the Investment and other negotiated terms, the Seeder will generally commit keep the Investment in the Fund for a period 2 to 4 years, subject to certain early withdrawal rights, including but not limited to:
- Violation of proscribed investment guidelines;
- Decline of Investment by a certain percentage;
- Misconduct by the manager or its principals;
- Key man provisions or change of control; and
- Reaching a certain AUM threshold.
Share of Revenues.
In exchange for the Investment, the Seeder receives a percentage of the manager’s revenues (including management fees and/or incentive fees) lasting in perpetuity or for a specified term. This arrangement is usually accomplished in one of two ways:
1. Equity Interest: The Seeder receives a direct equity interest in the management entity and typically receives revenues “net” of expenses. In this type of deal, the Seeder will generally require limitations or consent for expenses.
2. Fee Sharing Agreement: The Seeder enters into a profit/fee sharing agreement with the manager whereby the Seeder will be entitled to a portion of the management and/or incentive fees received by the manager. Fee sharing agreements have been more common as they offer greater freedom for the manager to operate its business. In this type of arrangement, the fees will generally be calculated on a gross basis. The actual sharing percentage varies depending on the amount of the Investment; however, amounts from 15 to 30% are common.
Seeder Rights and Obligations
Depending on the size of the Investment, the Seeder may obtain certain special rights, including but not limited to:
- Access to Fund records and accounts, including “side letters” with other investors;
- Portfolio transparency;
- Most Favored Nation treatment;
- Capacity rights
- Right of first refusal on launch of subsequent funds, service providers or corporate events;
- Management and oversight rights, including budget approval, fund terms, investment guidelines and restrictions;
- Special liquidity terms;
- Notification of significant matters and periodic meetings with principals of the manager.
The Seeder may agree to serve on an advisory committee for the manager, assist in the marketing of the Fund, and/or provide office space or other specified services to the manager.
Fund Manager Obligations
Depending on the size of the Investment, the manager may agree to additional obligations, including but not limited to:
Principals of the manager agree to make and maintain a certain investment in the Fund, and may be required to re-invest a portion of received inventive allocation.
Revenue Share of All Fees
The fee sharing agreement will include all fees the manager receives from its investment management related activities (including other funds or managed accounts managed by the manager).
Principals of the manager will be prohibited from forming other management companies or funds for a period of time and may agree to a specific time commitment. In addition, the principals will agree to not solicit other employees of the manger or the Seeder for a period of time after they leave.
Representations, Warranties and Covenants
The manager will be required to make certain representations, warranties and covenants relating to regulatory and compliance issues.
The Seeder will usually be fully indemnified by the manager against losses arising out of the seed agreement or the investment in the Fund or any Fund document.
When contemplating entering into a seed deal arrangement, the manager should also consider the following:
The manager may request the right to buyout (in whole or in part) the Seeder’s interest in the Fund, after a specified number of years or upon receiving a certain amount of fees. The buyout price can be determined ahead of time and is generally determined by a formula based on Investor receiving a certain amount of fees or a certain rate of return on the Investment.
Similar to the above, the Seeder may also request the right to sell its interest back to the manager.
Tag Along Rights
In the event of a sale of the manager, the Seeder may request a provision that would require the purchaser to also buy out the Seeder’s interest in the manger on a pro rata basis.