Incubators on look-out for start-up managers

FT REPORT - FUND MANAGEMENT: Incubators on look-out for start-up managers:

The upheaval in global capital markets is creating abundant new investment targets for hedge fund incubators.

London's FRM, ADI Gestion of Paris and SkyBridge Capital in New York are among seeders that are seeking fresh capital to back start-up hedge fund managers around the globe.

Toronto's Arrow Hedge Partners, along with partner Marret Asset Management, will soon begin deploying the $150m (£76m, €95m) it has raised for what is being billed as Canada's debut incubation fund.

"We're seeing a lot more investment opportunities than we'd expected," says Patric de Gentile-Williams, chief operating officer of FRM Capital Advisors, the new incubation arm of the large fund of funds operator.

"When we started out, we expected to maybe see 200 managers a year. We now expect to see between 500 and 1,000 this year. The opportunity is currently huge."

A cross between venture capital that backs new businesses and a multi-manager hedge fund, FRM's new $1bn fund is one of a growing number of incubator funds cropping up. A mix of higher institutional due diligence requirements and a tougher fund-raising environment is making such funds an increasingly important source of seed capital for new managers. And the unwinding of global credit markets is only boosting their pickings in distressed and asset-based lending plays.

"June 2007 to May 2008 has been a tumultuous period that's already cost the investment banks half a trillion dollars," say Anthony Scaramucci and Scott Prince, co-heads of SkyBridge Capital.

The banks' angst has had a dramatic impact on hedge funds: it has drastically trimmed the leverage banks are willing to offer and is forcing them to separate out proprietary traders that previously ran such risky funds in-house. "The flow of potential managers is outstanding, given the current turmoil," the SkyBridge duo says.

Having fully invested its maiden $330m fund in nine deals, SkyBridge is believed to be raising a $500m subsequent fund. As announced on May 15, SkyBridge inked a partnership with Australia's Challenger Financial to expand its geographic reach into the Asia-Pacific region to target both potential managers and institutional investors.

Challenger, which is 25 per cent owned by Australian billionaire James Packer, is believed to be investing $100m in SkyBridge's fund and will also take a small stake in the company. It plans to open an outpost in London and will expand overall headcount to 30 from 18 this year.

"Our vision has been to make SkyBridge a global seeding business," says Mr Scaramucci, who founded the business in mid-2005 and brought Mr Prince, an alumnus of Eton Park and Goldman Sachs, on board as a managing partner early last year.

SkyBridge's global aspirations are the face of today's incubation business. Once, small players with $100m-$200m to deploy could thrive by doing deals of about $10m apiece. Not any more. The average ticket has risen to at least $25m, with some large funds chasing even larger investments for the sake of economies of scale.

The due diligence it takes to select a manager makes the very small deals unprofitable. What is more, institutional investors require incubators to exhibit the ability to hunt down portfolio managers with substantive performance history and risk management skills in different corners of the world.

As the contest for best-pedigreed managers and traders escalates, incubators are trying to set themselves apart from each other and prime brokerages, which also have the expertise to assist managers to set up funds and market them via their capital-introduction units. FRM, for example, provides guidance on best practice in areas such as operational infrastructure and risk management.

Additionally, it encourages its managers to use the FRM moniker to give them credibility with institutions. The incubation unit is assembling its own research effort to vet investment targets and conduct ongoing operational risk analysis.

SkyBridge, meanwhile, typically invests about $50m apiece. Once launched, it helps its targets to raise additional capital and encourages its limited partners to make direct investments into its portfolio funds.

Its sales team gets referrals from existing investors and maintains what it calls "a MySpace of alternative cheque writers", referring to the popular online social networking site. While placing a premium on risk management, it stays away from providing general operational support.

"We see a general flaw in the whole concept of risk management in the hedge fund space today," says Mr Prince, who leads the charge on risk management. "Most firms do the risk management internally and have no checks and balances."

It pre-negotiates risk limits with its managers and wants full transparency. For instance, it would not work with managers that employ high leverage and monitors its funds closely to ensure that.

Investors in seeding programmes make money via capital appreciation in underlying seed capital and revenue share for extended periods. This is how the mathematics works: the incubator charges about 100 basis points for key infrastructure and an additional 200-300 bps for $50m or more. All told, the price of capital has come down somewhat and incubators now generally charge 0.5 per cent of revenue for each $1m invested, says Mr de Gentile-Williams.

The revenue share model will get tested in current turbulent times, says Antoine Rolland, who was installed as chief executive of ADI's NewAlpha incubation subsidiary in January 2008. NewAlpha is raising $250m for its third-generation incubation fund. Picking winners in this market will be the test for incubators, he says.