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Incubator platforms provide start-ups with a solid foundation

The attraction of incubator platforms has increased noticeably in recent years. New hedge funds face a Sisyphus-like task getting up and running as global regulation and compliance pushes costs up, whilst investors simultaneously expect to see institutional quality operations in place from day one.   

Of notable benefit are the cost saving benefits and the avoidance of building out large operations teams that incubator platforms offer. This is critical in the early stages of running a fund as it helps managers to avoid the risk of burning through their operating capital too quickly.  Rather, managers can “plug and play” into an established operational framework, thereby circumventing the stress and complexity of creating a nexus of service providers. 

This is particularly important in today’s climate where prime brokers are becoming increasingly more hardnosed in determining which clients to work with to optimize their balance sheet. In short, the cost of bringing on new clients has risen tremendously post-2008. 

According to Clayton Heijman, Managing Director at Privium Fund Management and CEO of the Darwin Financial Platform, by joining a platform, each new manager benefits from running on the same operational network and legal infrastructure. This in turn makes life a lot easier for the prime broker. Privium has offices in London, Amsterdam, Luxemburg, Cayman Islands and Hong Kong.

“If a prime broker begins a trading relationship with one client, then 85 per cent of the work is done for the next client; we have a template in place whereby all they need to do is discuss the portfolio management arrangement and fees with each subsequent new fund on the platform,” confirms Heijman. 

Platforms like Privium are used for all middle office and risk monitoring tasks that today’s start-up manager must address, and which investors and regulators expect to see. Heijman uses a computer analogy to summarise the proposition:

“We see ourselves as the insourced COO to the fund. When you buy a laptop today you see the little ‘Intel inside’ sticker; we’re that chip. We make everything work.” 

Privium runs in the background, providing the power and processing capability to successfully run a hedge fund, “but very much in tune with the portfolio management team”. 

Each manager – of which there are approximately 25 on the platform – is able to leverage the resources and expertise of the Privium team without having to worry about support for their regulatory compliance, hiring operational staff, and waiting too long to get their fund to market.  

The Privium Capital Fund is Privium’s Cayman structure, while the Privium Selection Fund is a Luxembourg SICAV structure for those looking for European fund structures.

“We started in 2008 and came from a range of different hedge fund investors, providers; prime brokers, custodians, accounting and fund administration firms. We were puzzled as to why new hedge fund managers would visit, say, three different service providers and come back with five different opinions on what needed to be done. It is hard for new managers to know what the right format is. 

“We thought there was a quicker way for start-ups to get to market by offering a solid infrastructure that they could afford, and which presented a much more plausible solution for investors to invest in,” explains Heijman.

So far, investors have committed over USD800mn to the various investment structures on the Privium platform including:

  • Systematic derivatives fund
  • Equity long/short fund
  • Fixed income fund
  • Sustainable fund​
  • Cleantech venture capital fund

“Prior to 2008, if a manager joined a hedge fund platform the perception was they weren’t serious in investing enough of their own money. After 2008, with all the checks and balances taking place and the regulatory hurdle increasing, that perception changed. Incubator platforms were recognized as a better way to minimize operational risk for new hedge fund ventures. All that is needed is the portfolio management team. It avoids the need to hire operations and compliance staff,” says Heijman. 

Privium has roughly 25 separate counterparty relationships in place covering prime brokers, fund accountants, fund administrators and custodians. With AIFMD now in effect, the fact that Privium is a fully regulated AIFM also means that start-up managers can avoid the travails of having to become regulated should they exceed the EUR100mn Gross AuM threshold.

“The timeframe it takes to attract capital and grow the fund’s AuM often takes longer than people anticipate. This means it takes longer to break even, as operating costs rise and revenues get eaten up. This is especially true today under AIFMD, where a manager is required to have a separate risk manager to the portfolio manager, a fully dedicated operational staff and a compliance oversight. Those activities require people, and therefore square footage and salaries. 

“We deal with all the operational and risk compliance tasks and interact with all the different service providers on behalf of the fund. That gives the portfolio management team a lot more time and opportunity to focus on their core competencies: generating performance in the fund and building the track record,” stresses Heijman.  

The Privium team takes care of all aspects of regulatory reporting as well: European Market Infrastructure Regulation (EMIR), Foreign Account Tax Compliance Act (FATCA), Annex IV, Form-PF in the US and so on. This is a huge benefit to any start-up manager.

Privium sets each fund structure up so that the manager is able to piggyback on the firm’s AIFM license. It has an affiliated depositary that helps both onshore and offshore funds meet the requirements of AIFMD. At a later stage, once the AuM has reached a sufficient size, the manager might decide to take on some of the functions in-house but according to Heijman, “the majority of managers and investors on our platform are very comfortable with the arrangement. They prefer to pay a fee to have us take care of everything as the registered AIFM than take on the burden themselves. 

“Most managers don’t want to become an expert on rulebooks; they want to manage money and generate performance fees.”

The majority of managers on the Privium platform are based in London. That said, activity is beginning to pick up in Asia after a dormant few years thanks to an increase in institutional assets coming out of Japan and China looking to invest in local hedge funds. 

From a fund perspective, Heijman confirms that Cayman remains the preferred choice among start-ups. 

“With reverse solicitation in Europe, it’s cheaper to set up a Cayman fund using the structure we have in place but if the manager has an institutional client base in Europe we tend to see people switch to either Dublin, The Netherlands or Luxembourg. Also, if they have a relationship with distribution platforms such as private banks then they tend to set up separate legal fund entities; we see managers setting up funds for distribution in the Netherlands, in the UK etc.,” says Heijman, who continues:

“It’s largely investor-driven. If people are starting with investments from institutional clients in Europe then it’s pretty much a given that they’ll establish a European structure, which is more costly because of the depositary requirement. If they are starting off with friends and family money, or just proprietary money, then the Cayman structure is still the default choice.”

When it comes to establishing a business relationship with incubator platforms, there are necessarily a number of steps involved. 

From the outset, the Privium team, as with other incubator providers, takes time discussing the business plan and investment strategy of each prospective manager. These are frank and honest discussions based on prevailing market views: which strategies are in vogue with investors, which are not. The end goal is to assess where each particular start-up stands in relation to the rest of the competition. 

As Heijman explains: “We look at their marketing plan, their pitch, and from that work out which kind of investors would be best suited to their strategy.” 
Next, the platform provider assesses to what extent the manager will face difficulties building the business. Few managers can expect to be a runaway sustainable success after 12 months. 

For someone starting with a low AuM, Privium will look closely at their AuM threshold in terms of absorbing costs and determine how far those costs will impact performance. If the strategy uses derivatives then the AuM can afford to be slightly lower as the fund is trading on margin. 

“By having those discussions right from the beginning, the management team knows what kind of rollercoaster they can expect as they look to grow the business. 

“This then leads us to determine the best kind of structure for the manager to consider; it could be an onshore structure, an offshore structure, it could be a managed account as opposed to a collective investment scheme and so on. 

“Once the structure has been agreed upon, we then start to identify the best service providers to support it; the administrator, prime broker, executing broker, depositary. We are service provider agnostic. 

“The biggest step after that is becoming regulated as an investment management team and as a fund; you have to be regulated for both today. For start-ups, it’s easier for them to get up and running using a fund platform because they’ will be working with a business partner that has done it for multiple clients since 2008,” comments Heijman. 

Although managers can choose to be in the same building as Privium, most operate from their own location. Heijman says that Bloomberg has been a big help linking portfolio management teams to its operational backbone. “That allows us to see what’s going on in their portfolios. We don’t have any management teams operating from our office at the moment but we will in 2015; it’s more a luxury for us than a necessity,” confirms Heijman.

At the end of the day, the incubator platform has to be totally confident with the investment strategy before accepting to support a new manager. If something cannot be fully explained, or they feel there’s a missing piece of the puzzle, managers can expect to be politely shown the door. 

“We want to build a long-term relationship with start-ups whereby both the portfolio management team and our operations, risk and compliance team feel happy with the business relationship. We do due diligence on them and we expect them to do due diligence on us in order to make sure it’s the right fit.

“Between our different offices we see about 275 prospects each year,” confirms Heijman. 

Determining the right structure to have on the incubator platform – i.e. a collective investment scheme or a managed account – will ultimately depend on size of assets and the number of investors. If the manager has two investors allocating USD10mn each, as opposed to 10 investors each willing to commit USD2mn, then it may be considered to avoid the accounting, auditing and admin costs of setting up a fund and establish a managed account. 

The added benefit of doing this is that by not being a collective investment scheme, the manager would not need to appoint a depositary under the AIFMD. 

Privium does not seek to take any kind of equity stake in the managers they support on the platform. In their view, the manager has taken the initiative to set up a hedge fund and they should be rewarded for that if the fund proves successful. From a cost perspective, Heijman says that the team assesses the investment strategy and the anticipated amount of work that will be needed to support it. 

“Then, we charge a specified number of basis points on the AuM. We do not take a stake in the fund’s performance. The reason for this is that if we were to do so, we would have a financial incentive if the risk or leverage being employed in the fund were to rise. The approach we take is a very good way of showing that the investors’ interests are aligned with the manager,” confirms Heijman, who concludes by offering the final piece of advice:

“It’s incredibly hard for managers to set up everything themselves. We would encourage them to speak with managers who have been successful but who suffered in the first couple of years; that is the most critical time. That’s when you need to establish yourself, your track record; otherwise you’re toast.”

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