'Early bird' founders’ share classes in decline amid shifting investor incentives

Early bird gets the worm

Founders’ share classes – which offer special terms to early bird investors in hedge funds – appear to be in decline, as investors become more selective in their allocations and managers potentially opt for more bespoke offerings, a new industry study has suggested.

Law firm Seward & Kissel’s annual New Hedge Fund Study has found that fewer than half of new hedge fund launches now offer founders’ share classes, continuing a sustained downward trend which reflects a rapidly shifting dynamic between hedge fund managers and early investors.

The study - which examines new US hedge fund launches’ strategies, structures, fees and incentives - found the number of new strategies offering founders’ classes dipped to 44 per cent last year, down from 57 per cent in 2018, and 68 per cent in 2017.

Meanwhile, those funds that did offer founders’ classes did so with smaller percentages offered on discounts on management fees and incentive allocation rates, the report found.

Specifically, some 47 per cent of funds running equity strategies, and 38 per cent of funds with non-equity strategies, offered lower management fees or incentive allocation in founders’ classes - down from 63% and 45%, respectively, in 2018.

Steve Nadel, partner in Seward & Kissel’s Investment Management Group and lead author of the study, said the fall in founders’ classes is surprising.

“Factors at play here could include more side letters and bespoke products, as well as a rise in high-demand launches,” Nadel said. “As institutional seed investors placed larger bets on a more selective basis, they increasingly competed to back premier managers. The dynamic suggests the continued emergence of a bit of a star system.”

Management fees charged in the standard non-founders’ classes has held steady at 1.43 per cent on average for equity strategies, and 1.68 per cent for non-equity strategies.

The annual report – which analyses investment strategies, incentive allocations, management fees, liquidity, structures, founder classes and seed capital – also detected a shift in seed investments in new hedge funds.

According to the study, the number of seed deals fell moderately in 2019 - but the size of those deals trended higher. The higher end of seed deals fell in the USD100-200 million range, and typically included a two- to three-year lock-up.

On seed deals, the report noted more activity from institutional seeders than from opportunistic, one-off seeders - such as high net worth individuals and family offices – just entering the space.

“This represents a bit of a change from prior years where we observed more balanced participation. That being said, a number of smaller seed deals were generated from consortiums of family offices who are planning to make multiple seed investments albeit at a lower check size than the traditional institutional seeders,” the report observed.

Elsewhere, the percentage of funds launched running equity-related strategies rose from 63 per cent in 2018 to 70 per cent in 2019, reflecting the continued dominance of long/short equity strategies in the global hedge fund industry.

Commenting on the report’s findings, Nadel added: “The stability of management fees and incentive allocation rates in 2019 suggests, among other things, that fund pricing is reaching its floor.”