On 28 November 2012, Bloomberg ran the highly successful Hedge Fund Start-up Conference from its European Head Quarters in London. The objective was to provide new managers with a range of key insights from industry experts on what they need to think about during the start-up process. Various panels throughout the day discussed issues within fund administration, technology, prime brokerage, legal, regulatory compliance, and seed investing.
The seed investing panel discussion – Seeding: Securing Capital – The First Steps – featured three industry experts: Pierre-Emmanuel Crama, Signet Capital Management Ltd; Tushar Patel of Hedge Funds Investment Management, and Jeroen Tielman of IMQ Investment Management. This article highlights some of the key points that were raised during the discussion.
What seeders look for in a manager
For today’s start-up hedge fund manager, increased regulation and compliance have raised the barriers to entry considerably. Factor in the tough task of raising capital in an increasingly crowded marketplace and it’s understandable that new managers are having to look at potential seed investors as a way of building early momentum.
There are several things a manager must think about before approaching a seeder.
The days of launching with two Bloomberg terminals and a credit card are categorically over. Having quality service providers and a strong – ideally institutional-grade – operational infrastructure in place are vital.
Start-ups should therefore have a strong COO in the team. One who is able to provide a broad overview of how the fund works and demonstrate a strong commercial awareness to get the best terms and conditions possible.
A CIO/CRO should also be part of the team; someone who clearly understands the risks of the underlying instruments being trades and is willing to take an objective view and voice his concerns if the portfolio manager is in breach of the investment guidelines. Seed investors like to see a clearly defined organisational chart and evidence that key facets of the business are being properly managed.
Start-up managers can go to the AIMA website and go through their due diligence questionnaire (DDQ). This is a useful document that provides an insight into how to structure a business properly.
“Seed investors are very picky with who they want to team up with so you need to bring business acumen to the table. Running a hedge fund means running a business in addition to running money. You really have to have this in mind when launching as a new manager. If you’re not institutional-quality from day one, you’re not going to make it,” says Crama, in a telephone interview with Hedgeweek.
The more experienced the team, the better. Seeders tend to prefer teams with a track record, who have worked together in previous organisations for a number of years and who have been “stress-tested” in the marketplace.
A team’s pedigree is also vital. Aside from a strong academic background, seeders want to see evidence of a track record and proof that the portfolio manager(s) has delivered consistent results. They want to see evidence of entrepreneurial drive; a passion and commitment. Start-ups have to have significant “skin in the game” to prove that they are serious about running a business for the long-term. They have to be in a position to re-capitalise the business over at least three years for seed investors to take them seriously.
Finally, they need a competitive edge. A unique selling point. This is more important than ever given the size of the hedge fund industry. Managers have to stand out from the crowd and be able to clearly articulate their investment strategy: how are you different? How will you be providing low volatility risk-adjusted returns? Ultimately, start-ups must work harder than ever to present themselves in a new light and give seeders a reason not to cross them off their list.
Types of seeding model
The first and most common seed deal is the revenue share. In such an arrangement, the seeder is investing purely in the fund, with the objective of maximising their returns as the fund’s AUM grows. The manager agrees to pay a percentage of the fund’s revenues – which often ranges between 20 and 25 per cent – for an agreed period of time, or in perpetuity depending on the arrangement.
The second option is the equity stake where the seeder acquires a percentage of the GP; that is, the fund management company, not the fund. This is what the legendary hedge fund manager Julian Robertson has done when backing ‘Tiger Cub’ managers, and the model that Amsterdam-based seeder IMQuabator has traditionally used. Although free to run the investment strategy, equity stake seeders have a controlling influence over how the business is run. “They will have a say on any additional products that might get launched, play an active role in corporate actions etc,” says Crama.
The third model is the incubator model. This is suitable for managers who don’t feel ready to run a business from day one. Infrastructure support ranging from middle- and back-office functions, compliance, tax and marketing support, as well as the seed capital itself, allow the manager to minimise day one capital expenditure and run their investment strategy independently; as opposed, for example, to joining a hedge fund platform where the fund becomes a sub-strategy.
Another model gaining momentum is referred to as the “first-loss capital” program. Here, the seeder allocates capital into a separate managed account, in parallel with the manager, who will typically be required to allocate 10 to 20 per cent of the total managed account. Assuming the fund loses money in year one, the manager will be expected to take the first loss, after which the manager will recuperate 100 per cent of future profits until the losses are recovered. If the fund finishes the year in profit, the profits will be split between the manager and seeder depending on the performance fee arrangement.
According to the Hedge Fund Law Blog, Topwater Capital Partners and Prelude Capital sponsor such deals.
Before detailing a few alternative funding options, it’s worth pointing out here that seed deals between the US and Europe vary quite significantly. Whereas the typical seed ticket in Europe is around USD25million, in the US, where seeding is more common, it’s more likely to be in the USD75-150million range. That makes a huge difference to a start-up manager.
Says Crama: “If you get a seed ticket of USD100million that gives you a longer runway and means you’ll be less distracted at raising capital and more focused on the task at hand, which is building a track record.”
There are significant players in the US: Blackstone Group (recently invested USD100million in London-based Naya Capital), Foundation Capital, Goldman Sachs (invested USD650million in its seeding fund in 2011), Reservoir Capital. Any start-up manager able to get in front of a US seeder and present a compelling investment strategy is more likely to receive a higher capital injection than one based in Europe, currently.
One option is to capture the attention of a well-established hedge fund manager. Second generation managers spinning out to set up their own fund might work under the auspices of their former employer as a sub-adviser. Essentially, the established investment manager – many of whom are looking at ways to diversify – provides the seed capital to the start-up manager. They work under the investment manager, utilise their infrastructure, build their track record, and once they’ve reached critical mass (e..g. USDmillion-plus in AUM) they spin away independently as a fund in their own right.
Funding share class
Given the scarcity of seed deals each year, a start-up manager can attract day one investors – who, unlike seeders, do not take an ownership stake in the manager – by considering a funding share class. This involves offering discounted fees to day one investors for a limited time period, or until the fund reaches a pre-determined capacity. Rather than offer the usual 2/20 fee structure, investors are offered more attractive management fees of between 1 and 2 per cent and performance fees, which might range from 17.5 per cent down to 10 per cent. Once the fund reaches USD100million, for example, the funding share class is closed.
This is a good way for start-up managers who don’t need to rely on additional support services to entice early investors, particularly FoHF investors.
A similar option to the funding share class is the club deal. Here, the seed investor utilises their network to push the manager in front of a range of prospective investors: FoHFs, family offices. If the manager is able to successfully market themselves to, say, 10 family offices, each of which is willing to allocate USD5million, they could find themselves launching with a well-diversified pool of day one capital. This provides added stability as it’s unlikely that investors will all redeem at the same time.
“This is a good litmus test for a start-up manager to see whether their strategy has traction or not. If investors aren’t interested then maybe it’s a sign not to proceed,” comments Crama.
The Bloomberg Hedge Fund Start-up Conference was attended by more than 400 people. More events are planned for 2013.