- “Hedge Fund Seeding: A Compelling Alternative,” Larch Lane Advisors LLC, 2009
The institutionalisation of hedge fund investing, coupled with the difficult markets of the last 18 months have made it increasingly difficult to raise money for new launches that are not extremely high profile. Previously, hedge funds that started with small sums of capital could find investors to commit to invest once the critical level of assets was reached (approximately $50 million).
However, the institutionalisation of the hedge fund investing community is pushing this critical level to a minimum of $100 million. Seeding therefore has become a very popular route for new and emerging managers to overcome the hurdle of reaching the critical size to gain visibility and profitability from Day One. There have also been a large number of investors moving into this space in order to benefit from the potential upside if one seeds a successful manager.
Both seed investors and hedge fund platforms have found in the seeding business a solution for diversifying risk and smoothing returns, while securing capacity rights. As many as 17% (86 firms) of the investors we canvassed for this survey seed managers. This is slightly down from last year (20% of investors), however, still a surprisingly high percentage. Seeders typically consider their businesses to be global in nature – with respect to both the strategies they invest in and the managers they work with, however, the lion’s share of seeders are US based. Of those investors that seed managers, 59% are based in the US, 30% in Europe, 9% in Asia and 2% in Australia. Funds of funds still dominate the investor type that seed, however, asset management companies are increasingly a particularly prevalent force in the seeder market.
Business models
Seeders typically operate under one of three business models:
Revenue split: Seeders provide capital in exchange for participation in management and incentive fees.
Equity split: Seeders provides capital in exchange for equity ownership and typically takes an active partnership role.
Platform: Established hedge funds and financial institutions provide capital and “turnkey” solutions in exchange for significant profit share.
The revenue share model is generally the most prevalent, however the give-up of equity in the fund management company also remains in demand. The manager needs to consider the support offered by the seeder in the form of operations, risk management, marketing and strategic assistance. As well as money, managers can also benefit from a public stamp of approval from a well-respected hedge fund investor, and the chance to build an institutional quality business as their seeder often knows about quality operations and best practices. Striking the right balance in terms of commitment and revenue share is vital as it helps to align the interest of both parties.
Small tickets
Deals typically range from $25 million to $75 million. We were surprised though by the large percentage of seeders who say they give managers tickets of under $10 million. Our suspicion is that these tickets are coming from family offices who are doing one off, opportunistic deals. Larger deals of $100 million and higher are not common, as is reflected in Fig.4.
Attractive environment for seeders
The current environment continues to provide a large pool of talent looking for seeding deals. There is also a shortage of seed capital in the industry in this survey looking to seed. This makes the current environment very attractive for seeders and allows them to strike more favourable deal terms with managers. Seeders, therefore, have an increasing ability to secure talented individuals on terms that are favourable to the seed investor. While two years ago they were more likely to let managers hold on to capital for three to four years, the recent trend has been in favour of shorter seed capital lock-ups. Notably, about a third of the responding seeders let managers utilise the seed capital for only 12 months. Although numerous investors seed managers, they still part with their cash very sparingly throughout the year. Fig.6 shows that 35% of seeders will only be looking to seed 1-2 managers in 2010.
Seed deals often less than two years
Seeders are therefore increasingly able to secure talented individuals and teams on terms that are favourable to them. It seems, however, that they will not take on this risk indefinitely with the vast majority of investors only considering allocating to funds for a period of less than 2 years. Although numerous investors have indicated that they are willing to seed managers, they still part with their cash very sparingly through the year and remain highly selective in terms of the managers they will consider. A seeder also needs to know that the manager they take on is potentially marketable to the vast majority of other investors or else they will always struggle to increase their asset base and therefore become a profitable entity.
