Seed Capital for Hedge Funds

Contributed article from Ka Ng, CAIA and AVP at Merrill Lynch

Time and again, studies on hedge fund performance indicate that smaller, emerging funds outperform their larger brethren because they are more nimble, being able to get in and out of positions without moving prices; and have the ability to build focused portfolios.  Even with this evidence, emerging managers are finding it difficult to raise money.   The situation has been exacerbated by Dodd-Frank legislation, causing proprietary traders at banks to spin-off into hedge funds and prohibiting banks from investing in funds.  More funds are chasing less investment capital.  Also, the HFRI Fund Weighted Composite Index returned negative 4.8% in 2011.  Investors want access to the higher returns of emerging managers. These pressures are causing managers and investors to turn to an alternative:  seed capital. 

According to a research report from Larch Lane Advisors LLC, seed capital is a multi-year commitment in emerging hedge funds.  Larch Lane has been a provider of seed capital since its inception in 1999.  It has seeded twenty-five hedge funds.  Seeders (either from an investor or a hedge fund seeding vehicle) give small funds a stable asset base that will not be withdrawn at the first sign of a drawdown.  This helps attract other investors.  Fund managers may receive assistance in operations, risk management, marketing and business development.  Seeders can receive a share in the fund’s management and performance fees, full transparency, risk control and ability to monetize their investment.

The three main seeding arrangements are equity ownership, revenue sharing and hedge fund platform.  In equity ownership, the investor actively helps manage the hedge fund from a business point of view only.  Investment decisions are still made by the manager.  Seeders can profit by being bought out by the manager or another investor or the manager may grow large enough to be brought to the public markets.  The Tiger Cubs are the most prominent funds in this category.  They were seeded by the famous investor Julian Robertson of Tiger Management.  He invested $25 million for a 25% equity stake.   The Dutch firm IMQubator is another investor using this type of transaction.  In January, they announced a joint venture with Synergy Asset Management to source emerging managers in Asia.

In revenue sharing, the arrangements are variable but they all have one goal – to enhance returns.  A seeder’s investment is improved by the fund’s revenues.  As the fund attracts more assets under management, the seeder’s returns increase.  Additionally, the manager pays a percentage of the revenues (usually around 20-25%) to offset the “2 and 20” fees paid by a regular investor.  Below is an example of how the return on investment increases as the assets grow.

Source:  “Hedge Fund Seeding:  A Compelling Alternative.”  Larch Lane Advisors LLC, 2011.

Terms of the agreement between seeder and hedge fund may include a limit on the amount of fees shared with the investor or the investor may pull out its capital after the seeding arrangement is completed and still retain the revenue flows.  FRM Capital Advisors has used revenue sharing agreements in seeding funds such as WestSpring Advisors and Beechbrook Capital according to an article in the hedgefund journal.  FRM Capital Advisors’ parent is Financial Risk Management, a fund of funds with more than twenty years of experience. 

Hedge fund platforms are offered by large hedge funds and financial institutions.  They provide a platform with marketing and operational expertise.  The investor has control over the manager’s business and investment process.

A hedge fund seeding vehicle specializes in investing in emerging funds.  According to one source, the number of seeders has dropped from 100 to 20-30 in third quarter 2011.  They close two to four deals annually and the average size of an investment is $10-30 million.  In addition to the advantages of direct investing (share in fund growth, higher return potential, transparency and risk controls), a vehicle gives investors manager diversification, access to co-investment opportunities and returns equivalent to private equity but with better liquidity.  The 800 pound gorilla is the Blackstone Group.  It raised $2.4 billion for the Strategic Alliance Fund (SAF) II in 2011 according to HFMWeek.  Other large firms include Reservoir Capital ($1 billion), Protégé Partners ($750 million) and Goldman Sachs Asset Management ($500 million).

Current investing conditions are favorable to the growth of seeding arrangements.  They allow investors to participate in the fee structure of managers and the on-going growth of the hedge fund sector.  A seeded fund attracts other investors and allows the seeder to benefit greatly by the increase in assets under management.   In addition, investors gain exposure to the higher returns of emerging managers.   Anyone with a longer time horizon will find this an attractive investment as three years is the standard lockup period.

The Hedge Fund Registration Act Ensnares Non-US Funds

Up to now overseas-based investment advisors to offshore hedge funds did not have to register with the SEC. It used to be that the American system of fund regulation was based on regulating the products that were sold, rather than the firms carrying out the business. The old form of regulation was about mitigating mis-selling of products to individual investors. So a form of investment that did not allow unqualified investors in a fund regulated in another country (offshore hedge funds) was not covered by domestic US regulation. John Doe of Main Street was not allowed into hedge funds, and the funds were not allowed to be marketed to retail investors in the United States. So there was no need for protection of the little man.

Today, offshore hedge funds are still not allowed to be marketed to retail investors in the United States, and unqualified investors still may not buy hedge funds. However, first there was the enforced registration of all (domestic) hedge fund advisory firms, and now the the US legislators have gone a step further by seeking to regulate non-US entities with hedge fund clients in the United States.

In the first week of this month the US Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Bill"), which contains The Private Fund Investment Advisers Registration Act of 2010 (the "Act"). The Act requires all private fund investment advisors to register with the SEC, whether they are US-based or overseas-based.

It is a curiosity, at the least, that the SEC has this role. Speaking to a House Financial Services subcommittee this week, SEC Chairman Mary Schapiro said “it’s really not clear” what (systemic) risk, if any, the hedge fund industry presents. Even if she is not clear, I am: it is quite feasible, given the scale and activity scope of hedge funds that in combination hedge funds can have systemic impacts. In the UK this addressed through the FSA monitoring exposures of the largest hedge fund groups operating in its jurisdiction. The hedge fund industry assets are not managed by many groups, so this focus on the bigger groups is very sensible and practically readily achievable. The SEC should follow suit and limit the number of hedge fund groups it (or another regulator if it doesn't want or see the need for such a responsibility) tracks. However that is not enacted by the new US hedge fund legislation, and the scope is broad, too broad.

That written, there is, I should point out, a Foreign Private Adviser Exemption, but the criteria are set at a level that all non-US hedge fund groups would have a business aspiration to exceed. The Act provides a limited exemption from registration for a "foreign private adviser", which is defined as an investment adviser that: (i) has no place of business in the U.S.; (ii) has in total fewer than 15 clients in the U.S. and investors in the U.S. in private funds that it advises; (iii) has less than $25 million (or such higher amount to be determined by the SEC) in assets under management attributable to clients in the U.S. and investors in the U.S. in private funds that it advises; and (iv) does not hold itself out to the public in the U.S. as an investment adviser, or advise an investment company registered under the Investment Company Act of 1940, as amended (the "Investment Company Act") or a business development company. 

It might take a few marketing trips to bring in 15 US clients to a European or Asian hedge fund, but it is certainly do-able for a Billion Dollar Club member (or a fund with a track record of more than two years) to have that number already. And $25m of US-sourced capital as a threshold will exclude few commercially-sized hedge funds

And what is a "business development company"? Does this include an offshore marketing company that an overseas hedge fund group might have in place to mitigate tax payments within the hedge fund management company?

Also, who is this regulation for, who is it protecting? The likes of CalPERS and other giant state pension plans, sophisticated family offices like the Rockerfeller Foundation, the Endowments of Harvard and Yale, all invest in hedge funds, but given they are qualified investors and large in their own right shouldn't they operate under a "buyer beware" philosophy?  To repeat, the man in the street in the United States cannot buy a domestic hedge fund, still less an offshore hedge fund. 

A few consequences of the implementation of this Advisers Registration Act are: that the costs of being in the hedge fund business have gone up again, reinforcing the tendency for the industry to concentrate; non-US funds will find it more difficult to obtain seed capital from US-based incubators and early stage backers; the Gucci tasseled loafers/Bass Weejun penny loafers division within the hedge fund industry will be reinforced. Across the Atlantic we are being forced apart from our American cousins in hedge funds, by the EU Commission and the US Congress.



Addition of 22nd July: a comment from Andrew Shrimpton, Member at Kinetic Partners: “The expanded authority of the SEC will have a far reaching effect on the alternative investment industry, both in the US and in Europe. Not only will asset managers who handle significant assets in the US now be required to register, they will also be faced with more onerous compliance and monitoring obligations. Therefore, managers in the UK and Europe need to consider whether they are obliged to register with the SEC and respond appropriately to the heightened scrutiny and new demands.”

According to Kinetic Partners SEC registration will have the following bring with it the following requirements of managers: 

•  comply with applicable SEC filings such as the Form ADV I, Part II and accompanying Schedule F;

• develop a compliance manual, code of ethics, employee investment policy (personal account dealing policy) and a compliance monitoring programme that meet with SEC requirements and industry best practices;

• undertake an annual review and testing of the compliance programme; and

• undertake annual compliance training.

Where applicable, firms should also consider their global group structure and how the Bill may affect non US managers within their group. For example, many managers operating in the UK also have an offshore, non US, manager which delegates to the UK. 

This posting used information made publicly available by law firm Seward & Kissel LLP and a press release from Kinetic Partners.

The Shrinkage of Hedge Fund Seeding Capital

I have written in the past (http://simonkerrhfblog.blogspot.com/2009/11/gathering-assets-still-difficult-for.html , http://simonkerrhfblog.blogspot.com/2010/01/excess-supply-of-emerging-managers-to.html ) that my expectation is that emerging manager hedge funds will find raising capital difficult. Part of the reason for this view is the shrinkage of seeding capital providers. Infovest21 is the source for this overviewing of the status quo in hedge fund seeding:



The size of assets committed in the overall seeding industry dropped in 2008/2009 as has the number of seeders actively providing seeding capital.


Seeding is very resource-intensive. It requires sourcing a wide range of proposals, having the skills and resources to analyze diverse strategies, having negotiating skills and helping put businesses together. This cuts down on the number of firms that can do it, says Patric de Gentile- Williams of FRM’s Capital Advisors. “People are getting out of seeding business because it is a very hard business - you need to find the talent, be a risk manager of the talent and have a disciplined marketing plan for the business,” adds Anthony Scaramucci of Skybridge Capital.

In 2007, there were 50-90 seeders. Today, there are just a handful of active seeders. Many of the active seeders don’t expect the seeding activity to get back to 2007 levels. Many key personnel at some of the larger seeders have left. Many are virtually out of the business but not publicly admitting to that, says one seeder.

The vast majority of seeders were a part of larger businesses. Those businesses became stressed by events in 2008 and had to refocus on their core business at the expense of their peripheral business. “Where seeding was a peripheral activity, it had to be sacrificed even though this is the one of the best times for seeding. In addition, some seeders were within investment banks and were using capital from the bank’s balance sheet. When 2008 arose, much of that capital was withdrawn,” adds Gentile-Williams.

It may be tough for some of the fund of funds’ seeders to come back. Scaramucci says, “If they don’t have the right resources in their organization, then they think they’re in the funds of funds business as a seeder. They’re not in the funds of funds business: they’re in the private equity/intellectual capital management business…When a fund of funds goes into the seeder business, they approach it the way funds of funds would. They don’t get deal terms right. They’re not partnering as tightly with the manager.”


In terms of seeing new candidates to be seeded, seeders say they haven’t seen a better environment. There are large numbers of talented people who want to be entrepreneurs who have been displaced by either the collapse of the firms they were with, whether hedge funds or investment banks, or are in an existing platform where they can’t supply enough capital.


Outlook



Gentile-Williams observes that the first quarter of 2010 has been more active than last year. “The pipeline is very strong; eight or nine managers are in [our] pipeline which could lead to a transaction in the next few months.”

Asset raising at the seed level i.e. raising a new fund is still challenging, say a number of seeders.As general interest for hedge funds picks up, emerging managers will benefit. The challenging piece is that some of the established largest managers, who had been closed, opened up to new investment following the financial crisis. Some of the largest allocators are currently going directly to the larger funds.

If the hedge fund situation improves and liquidity returns to the market, former seeders could return but they will probably do one-off deals rather than a dedicated fund. It could be done as a side letter not as a cookie cutter fund, says a former seeder.

There will be more capital committed and new players. There will be a small number of large players. Some family offices and some institutions are seeding. On the family office side, seeding is often viewed opportunistically. For example, The Koffler Group seeds only one manager or so a year. It seeded EchoBridge with $20 million in 2008. Another example is Parly Company which has seeded about 25 funds in the past.

Some larger pensions are also entering the seeding arena. CalPERS is considering providing start-up money to hedge funds similar to what it has done with private equity. The UK pension fund Railpen is expected to start a hedge fund seeding operations in order to gain greater control of alternative assets. Details haven’t been publicly disclosed yet but sources expect the model will follow the CalPERS and Hermes’ models.

In 2010, New York State Common Retirement Fund seeded London-based Finisterre’s emerging market hedge fund with $250 million.

Excess Supply of Emerging Managers to Come?

One of the consequences of the growth of institutionalisation of the hedge fund business is that it has become a lot harder for small and start-up hedge fund managers to get commercial traction. In the late Nineties it seemed that a manager only had to turn up with a credible background and they could launch with $30 to 50m. In the early Noughties it was still fairly easy to set up and it was quite common for a large wealth management company or fund of hedge funds to put a manager they believed in into business. From 2003 onwards the bar was raised for start-ups – managers had to come to potential backers with much more of a complete package, including a preference for two portfolio managers and an analyst or two. "We expect start-ups to have a headcount of five or six," was a typical quotation at the time. It was not impossible to get going on either a bigger or smaller scale, but if it was smaller it was odds-against.

In the period 2005-2007 asset flows into the hedge fund industry became the dominant driver. The consequences included a break-away pack of winners amongst allocators of capital to hedge funds. The flows of new capital were dominated by institutional assets such that institutional imperatives dominated the processes and mind-sets of funds of funds businesses. Ticket sizes became bigger generally. And this was a problem to new and smaller funds – as investors in hedge funds commonly have prudence rules that limit the percentage of assets of a fund they can represent. In this era the second generation manager was the most successful route to hedge fund launches. This was a very safe route for the middle men of the business – as many more of the boxes could be ticked at launch, particularly if the second generation manager stayed under the same roof. The same can be said where additional strategies were launched by the management company for a successful large hedge fund.

Times since the middle of 2008 have been tougher for newly launched funds. There were far fewer of them, but redemptions across the industry made things very difficult. The outflows of capital across all funds left capacity at great and very good managers. Logically the first flows into the industry went to the best managers with available capacity, which was all of them.

New Supply

Late into 2009 the word was that the reining back of capital at investment banks, but across the sell-side generally, was going to compel an outflow of talent into the hedge fund world. Investment management consultancy Laven Partners have said that they are seeing a trend for traders from banks to launch new businesses, partly reflecting concerns about remuneration levels within banks. They say that many traders working as the number 2 or 3 portfolio manager in a fund feel that now is the time to strike out on their own. In particular this is true in funds that are well below their high water mark. Other service providers confirm the trend - prime brokerage departments were said to be running longer lists of newly formed funds coming to market. For example Morgan Stanley reported a 10% increase in prime brokerage clients in the 4th quarter. So 2010 is expected to build on the recovery in launches of the second half of 2009.

Anecdotal evidence suggests that for Europe at least, the first half of 2010 will be a busier again for new launches. Three quarters of Europe's hedge funds are in the U.K., and in the U.K. the management companies of the investment advisor have to be approved by the F.S.A. Start-up consultancies say that they have a good pipeline of new and completely independent managers, and the workload at the FSA confirms this. In early 2008 I was involved in a fund launch, and the authorisation part of the process took around 4 weeks with the F.S.A. Whilst it is true that the FSA is subjecting applications to greater scrutiny, that firms are being told by the FSA that applications are piling up, and that the average processing time is approaching 12 weeks, reflecting an increasing number of fund management company and fund launches. Rob Mirsky of Laven Partners told me that the FSA is certainly still backed up - even getting a case officer at the FSA at the moment is a struggle, he says.

Demand

So what kind of demand environment are these management companies and new hedge funds going to launch into? Alternative investment data specialist Preqin surveyed investors in hedge funds in the last couple of months to find out about their attitudes to emerging managers. The Preqin survey suggests that only 29% of investors would consider investing in a hedge fund with less than $100m in AUM. Further, they suggest that, in the main, funds of funds are the only investor type to get involved. So a principal difficulty faced by emerging managers is that they are mostly trying to attract capital from a type of investor that remains under commercial pressure itself because of its own investment returns and capital flows. 

Flows at the industry level, having turned positive in April/May of last year, have reversed in the short term. After seven straight eight up months up to November last year, flows turned negative in December 2009, according to HFN. In October investors committed $16bn of new capital to hedge funds, and in November investors subscribed a further $26bn. However, in December investors redeemed $4bn from hedge funds, according to analysis of the HFN database. Given the emerging bear phase in equity markets, it is not expected that capital flows into hedge funds will resume with force until later in 2010.

Industry level flows can be very important to new funds. Funds of funds went through a lot of fire-fighting in the second half of 2008 and the first half of 2009. The senior staff that have the ability to make seeding decisions or can decide to back an early-stage manager were completely occupied with existing investments (and keeping their firms afloat) during that twelve month period, and only emerged with some degrees of freedom in their management choices very recently. When industry flows are consistently positive again funds of funds will be able to get on the front foot in decision-making. In the aggregate, funds of funds have barely had any positive flows yet, even when single managers were gathering assets again in the second half of 2009. So the major source of capital for small and new hedge funds has been, and will continue to be, constrained for capital and senior management time in the first half of 2010, with a few small exceptions.

The small exceptions are funds and funds of funds that seed and invest in new managers on a dedicated basis. Seeders have been making capital commitments, and are well invested - many are looking to raise additional capital before they can back any more new funds. There are some new entrants: United Investment Managers and Aptima Capital Management have both recently announced plans to launch fund of hedge fund vehicles focused on emerging manager hedge funds. They should both have plenty of choice, at least in Europe.


Addendum I: according to magazine AR, the assets garnered by new funds declined 36% to $14.89 billion in 2009 —the worst showing in years. In total, new funds in 2009 that were managing a minimum of $50 million in assets by year-end amassed a mere $14.89 billion, the lowest on record, according to the biannual survey by AR, which has been tracking the biggest new fund launches since 2004. That is 36% less than $23.17 billion in 2008—a figure that was helped by two mega launches from Goldman Sachs that raised a combined $7 billion—and 63% less than in 2004, when assets garnered by the biggest new funds peaked at $40 billion.

While the number of new fund launches in 2009—53 funds met AR's criteria for inclusion—came close to those in 2008, the average assets are lower, and the number of funds managing more than $1 billion has collapsed. Only two funds were able to end 2009 with $1 billion in assets or more, as compared with 2008, which boasted five funds managing that amount. 


Addendum II: Edgar Senior, head of capital services at Credit Suisse in London, commented in February 2010: "It is harder to launch new funds than in the past, so existing hedge funds that have capital to deploy and have built out the institutional infrastructure have the luxury of choice." (source: Financial News)

Gathering Assets Still Difficult for Hedge Funds (New and Old)

I spoke to the CEO of a London-based hedge fund group today. He said that his experience was that money was coming back into his hedge funds slowly. His funds outperformed two-thirds of the industry last year and this. "The whole process (of investing) takes a lot longer than it used to," he said.

It is natural, given Madoff (and maybe K1) that due diligence prior to commitment of any capital will take longer than it did previously. The due diligence will be more diligent, and there may be second checks, and references are much more likely to be taken up now.

The situation for hedge fund managers looking for seed capital is much more difficult than it was. There remains a shortage of entrepreneurial spirit in combination with ready capital from seeders. A survey by Acceleration Capital Group* estimates that from the stated intentions of seeding groups there is 44% less seed capital available in the second half of 2009 than there was in the first half of the year. The survey also shows that there are less seeders around by number than there were. As in the first half of the year, the strategy preferred by most seeders is distressed investing.

*available at http://www.scribd.com/doc/22022800/Hedge-Fund-Seed-Capital-Report-For-Q3-Q4-2009