Seed Capital Options and Considerations for New and Emerging Hedge Fund Managers

The success of the hedge fund industry relies not only on its ability to perform, but also on its ability to remain diversified, innovative and competitive. New launches and the establishment of new managers are crucial to ensuring the same and driving a high-performance culture within the market.

Yet, despite the benefits offered by new and emerging managers, investor concentration levels have increased significantly in recent years, with investors increasingly displaying a preference for managers with a longer track record and a ‘brand name’ that inspires confidence from a risk management and governance perspective. Additionally, the rise and success of ‘multi-managers’ continues to attract assets away from start-up managers, whilst increased regulatory scrutiny and cost barriers to entry have further accelerated the trend towards a concentration of assets.

This reduction in the availability of more typical seed capital has led to an increase in what might be referred to as ‘alternative’ seed arrangements. We consider certain of these arrangements below:

Managed account seeding

A higher rate environment and a desire to invest on a capital efficient basis, coupled with an increasingly sophisticated investor base seeking to leverage off the successful multi-manager model, has driven significant growth in the use of managed accounts as an alternative to investing in a fund. This model has enabled investors to increase the amount of capital they are able to put to work with multiple managers through the investment of capital in a number of strategies on a non-segregated basis, allowing for the netting off of margin and collateral required to be posted with trading counterparties.

The obvious drawback to this arrangement is that often a revenue or equity share is relinquished for ‘seed’ capital that does not anchor a comingled product, leaving the manager to seek alternative capital to launch a fund (utilising the track record of the account).

Managers agreeing to accept managed account seeding should seek to ensure that the capital being made available is not subject to investment restrictions that unduly prevent the manager from pursuing its ‘flagship’ strategy that it will need to market to raise additional capital. Further, the revenue share should fall away (or at least reduce) if the seeder fails to maintain a certain level of exposure with the manager (and concepts like a ‘lock-up period’ should be replicated).

Third-party fund platforms

‎The structure and offering of third-party platforms has increased and varied significantly in recent years. The term ‘platform’ can be used simply to refer to multi-manager platforms where the portfolio manager joins an existing investment management business as a partner or employee to run a portfolio of assets or a fund. However, it can also be used to describe a third-party operation offering one or more of the following:

• a fund vehicle, either a standalone fund or, more typically, a sub-fund of an umbrella fund structure or the right to manage a portfolio of assets within a fund ‘housing’ multiple managers;
• initial seed capital;
• business support, through shared resources and personnel, and perhaps office space;
• marketing and distribution services for a fund; and/or
• regulatory cover such that the manager does not need to obtain its own regulatory authorisation.

The key advantage of third-party platforms is that they reduce cost in the short term and allow the manager to maintain a small operation in its formative years. Further, the use of a platform allows the manager to build a track record that, if successful, may enable the manager to spin-off the platform and go it alone in the future (in which case, it is important that managers seek appropriate rights over the track record at the outset).

The downsides of launching on a platform include a lack of control (the manager will be an appointed service provider and will not have a direct contractual relationship with the fund/portfolio of assets of which it is manager and will be unlikely to have any representation on the platform’s board), the manager may have limited choice in terms of service providers, and problems may arise if the manager wishes to move to its own fund structure or the platform itself goes out of business (for example, where moving the fund/portfolio of assets to another vehicle, there is a risk that any investment gain enjoyed by an investor will be crystallised for tax purposes).

First-loss capital

The first-loss capital model is an interesting source of capital for new or emerging managers. The capital provider will generally provide access to a managed account for the manager to trade and in order to receive an allocation, the manager will be required to contribute capital equal to a fixed percentage of the total size of the account. The manager’s capital absorbs losses prior to the capital provider, but the manager generally receives all of the account’s future profits until the manager’s loss is made whole. Any profits remaining will be shared between the capital provider and the manager on a pre-agreed basis.

One key benefit of the first-loss model to new managers is that it allows them to build a track record (assuming that a reputable provider is engaged). In addition, the model is usually cost effective for the manager as the capital provider will set up the account and engage service providers and trading counterparties over multiple accounts (thereby benefiting from economies of scale).

However, it is important that managers fully understand the terms and risks of any first-loss deal. In particular, managers should understand the consequences of incurring a loss in the account. Most first-time capital providers may require the manager to contribute further capital to meet the loss. Alternatively, the capital provider might reduce its exposure to the account, making it harder for the manager to make back its loss.

Conclusion

While the trend towards investor concentration and preference for established managers poses challenges for new and emerging managers, alternative seeding models offer the necessary capital and support to launch and scale businesses and therefore contribute to a dynamic and successful hedge fund industry. That said, it is imperative for managers to carefully evaluate the terms and potential risks associated with these arrangements to ensure long-term sustainability and growth.

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Craig Borthwick is a Partner at Dechert in London

Freddie Newman is an Associate at Dechert in London

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The views expressed in this article are those of the author and do not necessarily reflect the views of AlphaWeek or its publisher, The Sortino Group