Fee structures in the spotlight: What start-up hedge funds need to know

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Start-up hedge funds’ success or failure often hinges on how managers build fee structures and foster investor relationships during the perennially tricky launch process, which industry participants warn can be frustrating, expensive and time-consuming.

The opening session of day two of this year’s HedgeweekLIVE North America Emerging Manager summit focused on fee structures, with panellists discussing seed and anchor capital, developing networks in the remote working environment, and the shifting allocator sentiment towards the industry.

Kieran Cavanna, co-founder and CIO of fund of hedge fund Old Farm Partners, noted the challenges that have arisen as a result of Covid-19, but suggested things may now be starting to change.

“Demand for hedge funds has gone up because bond yields are so low,” Cavanna said. “There’s some negativity around hedge funds but generally people are increasing their allocations - whether it's private wealth, whether it's pensions. Yes, they're maybe not going to USD20 million dollar start-up hedge funds. But the pool’s growing a little bit at a time when some of those large multi-strats are hard-closed.”

He added: “It’s tough to do all these video calls, but maybe start departing from the pack and start getting out there on meetings. Take a little initiative and move your feet a little.” 

Greg Zaffiro, partner and head of IR and marketing at Electron Capital, a long/short equity hedge fund which runs USD2.3 billion, focusing on sector-specific utilities, infrastructure and renewables, touched on the balance between face-to-face and digital meetings, which he believes have brought scale to emerging managers.

“I like to say ‘face-to-face wins the race’ and that’s really the case when you're meeting people first - there's no substitute for that sort of interaction,” Zaffiro said. “But at the same time, Zoom has enabled us to get more access to more people than we ever had before.”

He noted: “At Electron we’ve changed our communication strategy completely. Since March 2020 we have done monthly investor calls. You might think it’s overkill, but it’s beneficial to the people we don't know in Singapore or Hong Kong or London, and for emerging managers that helps cut through the noise.”

Panellists also debated seeding and anchor investments within the start-up sphere, noting that seeding offers stability of capital.

“The toughest term in seeding in my opinion is not the deal going in - that's what everyone concentrates on - I concentrate on the deal going out,” said panel moderator Joel Press, founding member of Press Management.

“An anchor or founder looks to make a rate of return. But a seeder’s got to make a rate of return on an investment, and like private equity they’ve got to get out, sell it, liquidate and go to the next investment. When does that USD100 million leave? If it's exactly at the end of the three years that could destroy your firm. How they exit you is critical to your success.”

Zaffiro said: “The anchor tenant in a founder share class seems to be the most flexible. There is business risk to the exit on having a seeder assuming that seeder has to turn the capital. So my advice to emerging managers is to keep it simple. Having a founder share class first with friends and family, getting that anchor with USD50 million would be amazing, and USD100 million would be a home run.”

Meanwhile, Gary Berger, partner at CohnReznick, offered a note of realism. “We all know that these seeders are looking at 300 to 700 deals a year and they fund two or three. What are the odds of an emerging manager really getting capital from a seeder? Probably very small.”

He added: “Set yourself up right - look and feel institutional. Even if you’re small, get the right providers around you in terms of legal and auditors.”

Cavanna agreed on the need for realism among start-up firms. “I see people spend money on huge leases on Park Avenue with lots of marble, and I think that's a huge mistake - it sends the wrong message. It's okay to be a bootstrapper and have some grit.”

Reflecting on the difficulties of getting a new firm off the ground, Press said: “Once you get started, and you have the capital, stay with it. It takes time. Our industry is now about USD4.1 trillion. I remember predicting when it would be USD1 trillion, and people laughed at me. In the next five years we could easily go over USD6 trillion, which would be a tremendous growth.”