Hedge Fund Startup Fundamentals: Key Financial and Strategic Factors for Novice Fund Managers
In the ever-evolving world of hedge funds, alternative seed arrangements are revolutionising the way funds are launched and grown. These innovative models, including managed account seeding, third-party fund platforms, and first-loss capital models, offer unique benefits and challenges for both fund managers and seed investors.
Managed Account Seeding
Managed accounts, a customised investment approach, are becoming increasingly popular. These accounts, managed directly by the hedge fund manager on behalf of a seed investor, offer greater transparency and flexibility. Seed investors can see and control the underlying investments, risk exposures, and trading activity in real-time, contrasting traditional fund structures where information is restricted.
However, managed accounts can raise concerns about independence, as managers may become less autonomous due to seed investors exerting more influence. Additionally, the operational burden increases as nearly half of seed investors now require daily trading reports.
Third-Party Fund Platforms
Third-party platforms offer infrastructure and capital to hedge fund managers, providing launch support, operational scale, and access to investor networks. These platforms help managers overcome barriers to entry by offering seed capital, compliance services, technology, and distribution channels.
While platforms provide numerous benefits, they also present challenges. Managers may face pressure to align strategies with the platform’s preferences, potentially reducing autonomy. Additionally, platforms often negotiate lower fees, which can impact the manager’s economics.
First-Loss Capital Models
First-loss capital models demonstrate a seed investor's confidence in a manager's strategy by agreeing to absorb initial losses before other investors take any loss. This model aligns interests by putting the seeder’s capital at risk first and can be a powerful tool for emerging managers, making their fund more attractive to subsequent investors.
However, first-loss capital is typically scarce and expensive, as seed investors demand higher returns for taking on higher risk. Structuring these deals requires careful negotiation and legal documentation to define loss allocation, clawbacks, and exit mechanisms.
The Future of Hedge Fund Seeding
The hedge fund seeding landscape is rapidly evolving, with increased regulatory scrutiny and cost barriers to entry leading to a concentration of assets. Managed account seeding is an alternative to investing in a fund, allowing investors to increase capital with multiple managers through a non-segregated investment.
Managers should understand the consequences of incurring a loss in the account, as capital providers may require additional capital from the manager or reduce their exposure to the account. In the first-loss model, the capital provider provides access to a managed account for the manager to trade. Any profits remaining will be shared between the capital provider and the manager on a pre-agreed basis.
Launching on a third-party platform may result in a lack of control, limited choice in service providers, and potential issues when moving to a separate fund structure or the platform going out of business. To receive an allocation, the manager is required to contribute capital equal to a fixed percentage of the total size of the account, making it a cost-effective option for managers due to economies of scale in setting up the account and engaging service providers.
The first-loss capital model is an interesting source of capital for new or emerging managers. Managers agreeing to managed account seeding should ensure that the capital is not subject to investment restrictions. Managed account seeding may involve a revenue or equity share for 'seed' capital, leaving the manager to seek alternative capital.
In conclusion, the hedge fund seeding landscape is undergoing significant changes, with managed accounts, third-party platforms, and first-loss capital models offering new ways to launch and grow funds. Each model presents unique trade-offs in terms of transparency, control, independence, and risk-sharing, reflecting broader industry trends toward greater investor scrutiny and demand for alignment of interests.
Seed investors are increasingly exploring managed accounts as a customized investment approach, offering greater transparency and flexibility compared to traditional fund structures. However, this model may raise concerns about independence as managers may become less autonomous.
Third-party platforms are providing crucial infrastructure and capital to hedge fund managers, helping them overcome barriers to entry. However, the alliance may lead to pressure to align strategies with the platform’s preferences and potential reductions in manager fees.
