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Hedge Fund "First-Loss" Capital Programs

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.

Capital Providers

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.

Conclusion

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.

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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.

Hedge Fund Incubating and Seeding

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Syndicated Post on Hedge Fund Seeding

As I mentioned in a previous article about hedge fund compensation, I have recently come across a very good blog called Ten Seconds Into the Future by Bryan Goh of First Avenue Partners, a hedge fund seeder. Bryan’s posts are very insightful and I recommend all managers take a look at his writings.

The post below discusses hedge fund incubating and seeding platforms which offer managers a turn-key solution to getting a fund up and running. As I point out in this blog from time to time, many managers neglect to really create a detailed business plan which addresses many of the business aspects of running a fund. In this respect incubation and seeding programs are often good places for a manager who is looking to just focus on the trading. The article below discusses some of the aspects of these programs and includes considerations for managers contemplating such an arrangement.

Please feel free to comment below or contact me if you have any questions or would like more information on starting a hedge fund. The original post can be found here (ephasis and bolding in the original).

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Hedge Fund Incubation and Seeding. A perspective for 2009.

by Bryan Goh

In the interest of full disclosure, First Avenue Partners of which I am a partner, runs a hedge fund seeding and incubation business. I generally don’t talk my own book and I don’t intend to start now, but I will speak generally about the industry without specific reference to what we do. So please read this with a skeptical eye, and if seeding sounds like it makes sense, there are a range of seeders besides FAP out there. Talk to as many of them as you can, and please feel free to tell me if I am out of my mind. With that out of the way, let’s begin:

In 2006 if someone suggested that it was a good idea to be seeding and incubating hedge funds, I would have been highly skeptical. Managers who were any good were raising large amounts of capital on their own on day one, mediocre managers were able to start with credible amounts of day one capital and even managers who while talented had no idea how to run an investment management business could get into business. The hedge fund seeder faced insurmountable adverse selection problems.

Hedge fund managers willing to give away either a share in their management company or a share of their fees tended to be of lower quality. You didn’t want to be seeding them.

Hedge fund managers of good quality but who understood the business development support role of a seeder and were happy to work with one were labelled as poorer quality and found it difficult to raise capital, so also were from a business perspective, less attractive to a seeder.

Seeding was simply a negative signal to the market all around.

In fact, seeders play an important part in the hedge fund industry. They provide all kinds of support that the fledgling hedge fund manager simply doesn’t want to bother with such as infrastructure, business development and marketing, a stable base of capital, corporate governance, risk management and a host of intangibles such as a sounding board for trade or business ideas.

Of course until the adverse selection problem was resolved, none of this really mattered. And well it should be. The adverse selection up until the middle of 2007 was severe.

2008/2009. What’s changed? Investors risk appetite has been drastically reduced. The number of new funds starting up is down drastically, the number of fund closures is up drastically. The size of the hedge fund industry has halved in size by assets under management according to several of the usual industry sources such as HFR, Eurekahedge and surveys conducted by the major prime brokers. Hedge funds which were previously closed to new investment with multiples of billions of assets under management are reopening their funds (after losing big chunks in losses and redemptions) and finding it hard to raise new capital. This it should be said, in an industry which managed to lose 20% in 2008 while the long only world lost double, and only in the second half of the year when regulated banks failed and regulators decided it was a good idea to ban short selling.

Investors are more discerning. Quality of the hedge fund manager matters. Quality of the strategy, idea generation, execution and trading, mid and back office, systems, counterparty management, liability management, corporate governance, investor management, all matter and matter more than they ever did 2 years ago when investors were happy to fund a business plan with two phone lines and a credit line.

That’s a lot of considerations for a hedge fund manager striking out on his own. What is my strategy? Will it sell? How do I represent it? Who should my counterparties be? Ditto service providers. Who should be on the board of the fund? My best mate’s uncle or an industry professional? Who are my potential investors beyond my partners and I, our best mates’ uncles and aunts? Should there be lock ups, gates, side pockets, NAV suspension rights, what are the right terms? And how do we divide the spoils?

A seeder can help. There are different seeding models to suit different manager objectives and immediate needs. Do I give up fees? Do I give up equity? What control does the seeder have? What services beyond capital can the seeder provide? Often the advice and structuring are worth as much as the capital. And if I brought all this in-house, what would be the cost of it all? Would it be cheaper than a seeder?

The raison d’etre of a seeder has never before been clearer; the value that the seeder brings never been greater.

2009 and beyond: For the prospective investor in a seeding fund, what is the opportunity?

First of all, the investor must want to invest in hedge funds. No amount of incubation economics can make up for a bad investment. Over the last 10 years, hedge funds have done better than long only equities (MSCI World), bonds (Barcap Global Bonds, the old Lehman bond index), commodities (CRB), and real estate (UK IPD all sectors) for example. In 2008, hedge funds lost less money than real estate, equities and commodities. In fixed income, depending on credit quality, you would have lost as much in credit (high yield) as in equities, or lost low single digits if you were in guvvies.

Second of all, smaller, newer funds tend to do better than the big funds. Its not always true but there are various academic studies that seem to indicate that this might be the case over a large sample of managers across the gamut of strategies. The truth is that in some strategies size is an advantage. Nothing like an 800 pound gorilla of an activist or distressed debt manager. For trading and liquidity constrained strategies, beyond a certain size the fund begins to behave like a beached whale. The real advantage with smaller funds is that they haven’t yet accumulated the arrogance that comes with multi billion dollar success to deny the hapless investor transparency, clarity or airtime. Beyond the transparency necessary for the proper monitoring and risk management of a fund investment, being in constant touch with the manager and being involved with their business and playing a part in their success is a highly rewarding activity. It is certainly why I love it.

If one is to invest in start up and new managers, there are of course additional risks. With less money to manage there is also less money to spend on systems and people. Shorter track records also make an econometric assessment harder to do. Risk of failure is higher than for a large fund, but surpringly lower than for a mid sized fund. Anecdotal and some albeit stale studies have found that while the big multi billion funds may have very low mortality rates, medium sized funds’ mortality rates can be substantially higher than that of small funds. Why is this? Big funds are well resourced and have the financial viability to maintain their resources. Also, big funds often have defined succession planning. The founding portfolio manager rarely abdicates but does take on a Presidential role rather than as lead General of the Campaign. Small funds may be thinner on resources but are likely fuller on resourcefulness and the drive to succeed. Medium sized funds exhibit high mortality probably because of lack of succession planning so that even a great track record may not survive beyond the management of the founder. Whatever it is, investing in small funds needs to be compensated over and above the returns they generate. Some seeders take a stake of equity in the investment management company, some take a share of the fees charged by the fund manager, and some take some combination of both. Some seeders provide only investment capital, some provide working capital as well, and still others provide infrastructure, risk management, marketing or other business advice.

Seeding and incubation, like so many things, is a highly cyclical business. A couple of years ago, the managers entertaining seed deals were mostly those who could not raise day one capital on their own. The number of hedge fund managers cognisant of the complexities of running a hedge fund business and saw the logic of partnering up with a seeder were few and far between. Today the landscape has changed. The pipeline of managers is supplied by both types of managers. Seeders are spoilt for choice. Where once capital went in search of talent which was relatively scarce, the world is relatively well supplied with talent. It is capital which is scarce.

Of course the competitive landscape for seeders has changed as well. The number of seeders has diminished significantly, as has the capital available for seeding. Why? It was a highly cyclical business and it was victim not of the bust but of the boom of the last 5 years. Too much money was chasing too few deals. Manager quality times deal terms equals a constant. In the good times, that constant was rather low. But the pendulum has swung the other way. Many of the deals struck in good times broke and incubation as well as incubated funds performed poorly, not always for lack of talent. More often than not, talent was abundant but non-investment support was not forthcoming or deals were structurally unsound and failed to align interests. As the tide of risk and capital ebbs, it leaves many stranded, but as it flows once more the opportunities in seeding appear brighter than ever.

In that context hedge fund seeding and incubation is a recovery play, one that if structured well, keeps paying for years to come.

How to grow your hedge fund

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There are several effective ways to grow your hedge fund. Many of those methods will be discussed and evaluated here. Obviously superior performance among investors with comparable risk is a great way to grow your fund. This section will delve into how investment teams can derive the superior performance that all funds strive for.

Character of the Management Team

There are certain key characteristics of successful investors that generally indicate whether the management team will be successful. A concentration on the business processes of the fund and consistent learning rather than daily results will generally lead to a knowledgeable management team. Most successful money managers understand that markets tend to be fickle and daily results are not always a good barometer of achievement. Hubris has the potential to plague intelligent investors; however, humility tends to lead to personal improvement and less risky investment strategies.

Investment managers should focus on their love for their work. Investors like to invest with people they can trust and those that exude a love for their work. A common trait amongst successful investors is a deep understanding of how investing induces the progress of our society. If investors have a sense that they are actually doing good for society, they tend to be more enthusiastic about their work which encourages investment. Investors should focus on the value that they provide to society. Many sophisticated investors want to believe in positive effects of their investments in addition to creation of wealth.

In addition, managers should focus on their skills rather than attempting to predict general macroeconomic trends. Successful managers know that there are always excellent opportunities in the markets to exploit. There are many trading strategies that successful investors can employ but the management team should focus on their abilities. Good management teams are patient. They fully understand their methodology. They rarely look for shortcuts or the easy way out.

Consistency

Investment professionals aspiring to become masters will strive for understanding and be consistent in their philosophy. Novices tend to look for an easy way to succeed. New investors will extrapolate previously successful investment models in books and project future gains. Inexperience leads investors to search for immediate profits rather than the consistent model of return that successful long term managers achieve. Thus, patience and consistency is a virtue.

Understanding and Application of Economics

A superior understanding of market forces can lead to growth of a fund. Investors that align their investment strategies with the overall economic and liquidity environment tend to be more successful and are able to maximize profit in nearly all environments. An intrinsic understanding of the drivers of market prices and examples of investment success guides successful funds. In addition, staying dynamic and perceptive of changing market trends is vital to maintaining the edge that superior economic knowledge grants.

Being able to time the liquidity cycle of the market should be a determinant in how a fund allocates capital. It has been found that 97% of equities fall in a period of tightening while 90% of equities rise in a steep yield curve environment. In addition, liquidity cycles can be utilized to determine the attractiveness of foreign markets that actively trade stocks and bonds. In an increasingly flat economic environment understanding global liquidity and economic indicators is essential to most funds.

Asset Allocation

Large cash positions provide low returns but good investors should be patient within their preferred asset class. Thus, investors looking to grow their funds should seek out other asset classes in which to allocate capital. While investors should find asset classes that best match their portfolio, it has been found that allocating 10 to 25 percent of assets to actively managed futures can increase long term returns and decrease long term risk. Many studies have found that adding actively managed futures to a portfolio of stocks/bonds can decrease volatility and increase gains.

In addition, investors should understand the almost universally recognized truth that joining several risky investments into one portfolio decreases risk and raises return. Mixing together uncorrelated assets should smooth out long term performance and increase fund size as the investments will react to different market forces.

Effective Marketing

In today’s increasingly competitive market for the capital of sophisticated investors, hedge fund managers need to market their fund properly in order to encourage large infusions of capital. A hedge fund manager may not solicit investment into the fund through any “general solicitation” or “general advertisement” per SEC regulations and thus funds rely upon advisory services to raise capital. Hedge funds used to rely on networks of advisors and their high net worth clientele; however, with the increasingly flat investment world, hedge fund consultants can be easily contact via the internet. Hedge fund advisors utilizing the internet are subject to the same SEC regulations as traditional advisors. Operational websites must adhere to the following regulations: the site is password protected, there are no references to a specific fund on the home page, the internal contents of the website are only available to qualified clients, and prospective investors are required to wait thirty days before investing.

In addition, a hedge fund administrator may be helpful in marketing and managing the fund. A hedge fund administrator provides valuable third party resources that: reduce expenses of the fund, validate performance results to investors, increase the managers’ time available to focus on investing, and provide access to accounting and finance professionals.

Hedge funds can benefit from using banks as a prime broker as it provides many resources and most importantly a centralized clearing house for transactions. Prime brokerages also provide value-added services of: capital introduction, risk management advisory services, and consulting services. Outsourcing non-investment activities to another firm decreases distractions, allowing the managers to focus on investing.

Transparency and Simplicity

Hedge funds trying to grow should encourage capital infusion by being somewhat transparent and simple. Typically hedge funds want to be relatively opaque; however, increasing investors are requesting more information and a minimum level of transparency for effective due diligence in now usually required. A level of transparency can be accomplished with an operational website that complies with all regulations. Many investors may not seriously consider investment in a fund without a website. In addition, managers should list performance on hedge fund databases. Acknowledgment of outperforming associated risk benchmarks on a hedge fund database will typically induce some investors to choose your fund over another.

Hedge Fund Seeder to Go Public

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Two hedge fund groups, Tuckerbrook Alternative Investments and HARDT Group Advisors, are joining forces to create HT Capital Corporation, a hedge fund seeder/incubator which will seek to go public with a $300 million offering of it securities. The IPO will be underwritten by Jeffries and Company, will be listed on the NYSE, and go by the symbol “HTG.”

HT Capital Corporation plans to use approximately $200 million to seed/incubate an initial stable of 8 promising hedge fund managers. The company will then seed an additional 10 managers within the 12 months after the IPO with proceeds from the IPO as well as a credit facility. HT Capital Corp. will invest in emerging managers through senior loans to the management company and participating interest (equity) investments in the hedge fund management company. These two types of investments are expected to produce four different revenue streams:

1. an 8.5% quarterly cash interest payment on the senior loan

2. a share of the management company’s management fees (expected to grow as AUM grow)

3. a share of the management company’s performance allocation (with the potential for such performance allocation to increase as AUM grow)

4. a stake in any sale of the hedge fund management company

The company will invest in emerging hedge fund management companies; the below statement comes from their N-2 filing with the SEC:

We plan to diversify across the following three distinct stages of emerging management companies:

“Incubation-stage” management companies, which will generally have few or no assets under management at the time of our investment, but may have, for example, an investment manager who recently came from the trading desk of a larger firm or established an investment track record in another firm’s name. We generally expect to provide incubation-stage management companies with between $5 million and $10 million of senior loans and a participating interests investment of typically about $1 million.

“Early-stage” management companies, which will generally have an investment track record of between 6 months and 24 months and between $5 million and $25 million of assets under management at the time of our investment. We generally expect to provide early-stage management companies with between $10 million and $25 million of senior loans and a participating interests investment of typically between $1 million and $2 million.

Acceleration-stage” management companies, which will generally have an investment track record of between two and three years and between $25 million and $100 million of assets under management at the time of our investment. We generally expect to provide acceleration-stage management companies with between $25 million and $50 million of senior loans and a participating interests investment of typically between $1 million and $2 million.

Hedge fund incubation platforms are becoming more and more popular as reports indicate that small and emerging managers present larger investors with the greatest opportunity for the most attractive returns. By participating in an incubation program as well, the investor will have the opportunity to allocate more assets to the manager in the future – a potentially valuable future right.

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Tag Archives: hedge fund seeder

Hedge Fund "First-Loss" Capital Programs

Hedge Fund Incubating and Seeding

How to grow your hedge fund

Hedge Fund Seeder to Go Public