Hedge Fund Seeder & Capital Alternative
Although industry assets are at record levels, start-up and emerging hedge fund managers are finding it extremely difficult to raise capital. The overwhelming majority of asset inflows have gone to managers with assets in excess of $5 Billion despite empirical evidence that suggests that smaller/emerging mangers perform better. As a result, emerging managers are seeking capital sources active in the emerging manager space that can help grow their business. These capital sources range from traditional hedge fund seeding arrangements to acceleration capital (which is essentially a late stage seeding). One lesser known source of capital available to start-up and emerging managers that has been growing in popularity is so called “risk based managed accounts” or “first-loss” capital. This article will provide a general overview of how these programs are structured and explain the points that managers should consider when evaluating these programs.
Overview of First-Loss Type Programs
The capital provider that manages the program generally allocates to a separately managed account for the manager to trade. In order to receive the allocation the manager is required to contribute capital equal to a fixed percentage ranging from 10%-20% of the total managed account depending on the provider. The manager receives a higher than industry normal performance fee and for this higher payout the manager’s capital sits in a first position with respect to losses. What this means is that if there are losses in the account then they are absorbed first by the managers capital. However, it’s important to understand that in months following losses the manager receives 100% of all future profits until the manager is made whole, so it is effectively a “first-first” account whereby, losses are first absorbed by the manager’s capital account but first re-paid to the manager’s capital account upon future profits.
For example, if the capital provider allocates 10MM then the manager will be required to contribute approximately 1MM. If in the first month the account had a negative P&L of 100k, the manager’s capital account would equal 900k. If the following month the account had positive P&L of 200k the first 100k would go back to the manager and the remaining 100k would be split according to the performance fee payout.
Benefits for a Prospective Manager
The basic benefits to the managers include the following:
High performance payout – these firms pay a higher than industry normal performance payout
Increased capital base – these firms often allocate significant amounts of capital 25-100MM
Monthly payouts – the manager receives his split on the P&L on a monthly basis vs. having to wait till year end or post an audit
Cost effective and turnkey – the cost to the manager is minimal as these firms handle all of the set up and administration related costs
Establish a track record with a best ideas or second strategy – the track record is owned by the manager, and these firms allow managers to run portfolios that are different than the manager’s core fund.
Traditional allocations – there are certain first-loss groups that are affiliated with traditional allocation vehicles, fund of funds, etc. Such groups will use these managed account as form of active due diligence and allocate traditionally to managers who consistently perform
Fund Manager Considerations
As with any potential service provider, mangers who are considering running these accounts should perform due diligence on the program sponsors as there are differences between the various program sponsors. Important questions to ask when reviewing a sponsor include:
- Is it a reputable firm? Can they provide me with industry references, and current manager references? Who controls the firm?
- How long has the firm been running the program, and what experience does the sponsor have in the space?
- Who or whom is the capital behind the program? Is the capital committed for a long time period and/or has there been a longstanding relationship in place?
- Does the firm offer any additional opportunities for managers, such as the potential for traditional allocations? Are they actively making these allocations, and do they have recent live examples?
- What is the provider’s risk management policy & procedures?
- How is the first-loss capital provider compensated? Are they compensated strictly based on the manager’s performance or are they also paid a portion of the trading revenues?
- What are the details of the deal? Does the capital provider change the account level or your ability to use the capital at a certain level of losses thereby making it harder to make back previous losses? At what point is the account terminated?
- What are the fees and expenses including commissions, financing charges, or management fees?
As with any due diligence inquiry, there are a number of other questions and inquiries a manager should undertake when selecting a risk based managed account capital provider. Certainly, an onsite visit makes sense for any managers who are in the final stages of their due diligence.
There are multiple firms that sponsor these first-loss capital programs. Of the various providers, two in particular are most prominent in the space, Topwater Capital Partners and Prelude Capital. Topwater Capital has been existence since 2002 and is widely credited for creating the structure and is the clear leader in the space.
Fund Investor Legal and Regulatory Considerations
Mangers who ultimately decide to participate in a risk based managed account programs will need to discuss with their legal counsel the issue of disclosure. The discussion is likely to be cenetered around conflicts of interest, drawdown risks/ volatility, different terms for different investors (if in a fund structure) and/or discussion of investment through separate account structures. Additionally, if managers are registered with the state or SEC the manager may need to provide disclosures in the Form ADV Part 2. If a manager faces an examination by a securities division, it is likely that the structure will be scrutinized by examiners who may or may not understand the structure. Mangers who enter into these arrangements may also need to review compliance procedures and may need to receive certain reps and warranties from the program sponsor.
[Note: because of the bespoke nature of these arrangements, we cannot list all potential issues or considerations. Please also note we are not providing legal advice and please read our disclaimer.]
Risk Based Managed Accounts vs. Traditional Seed and Acceleration Capital
A risk based managed account program is often considered by managers when evaluating seed capital or acceleration capital. There are distinct advantages for managers pursuing a risk based managed account relationship as opposed to a seed or acceleration relationship. The most significant advantage of first-loss over seed/acceleration is ownership. Typical seed and acceleration deals involve the manager giving up an ownership stake or revenue share % to the seed/acceleration capital provider, which results in topline revenue shares for 5-10 years and in some cases, perpetuity. When managers are able to end the seed or acceleration partnership they are generally forced to buy back the stake in their company, which is valued by a number of different metrics depending on the deal. Additionally, seed/acceleration capital providers are generally granted a number of other benefits, including capacity rights, information rights, and preferred redemption rights. In many instances seeding or acceleration deals also put restrictions on the managers portfolio composition, risk management processes, and limit withdrawals by key employees.
The various restrictions placed on managers who enter seed or acceleration deals are one reason why many managers choose to manage risk based managed accounts instead. By choosing risked based managed accounts over seed or acceleration capital, managers maintain their autonomy and discretion as to how to run their business. Also, risk based managed accounts generally pay performance fees to managers on a monthly basis which can provide the cash-flow necessary to hire and retain key employees. Risk based managed account programs can also help increase the visibility of managers, which depending on the risk based managed account capital provider, can result in direct allocations into their fund.
There is a growing interest in first-loss programs for good reason. These structures allow for managers to grow their business, generate cash-flow, and receive higher than average performance fees, which are just a few of the reasons why managers choose to manage these accounts. The capital raising environment is tougher than ever and risk based managed accounts allow managers to grow their AUM without giving up a piece of their business to a seeder or accelerator. While these structures are growing in popularity, it is important that managers involved discuss their disclosure requirements with their counsel. Additionally, as mentioned earlier, managers subject to SEC examination might have to educate the examiners on the structure, which is why it is important that managers work with experienced attorneys, accountants, and first-loss capital providers.
Cole-Frieman & Mallon LLP is a hedge fund law firm and provides advice with respect to seeding arrangements, separately managed accounts and other structuring issues for fund managers. Bart Mallon can be reached directly at 415-868-5345. Karl Cole-Frieman can be reached at 415-352-2300.