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Paul Smith explains how to seed a hedge fund

Date: Thursday, February 19, 2009
Author: Simon Osborne, Asian Investor.net

Asia’s Sultan of Seeding, Paul Smith of Triple A Partners, talks about distribution woes, flying economy class and the "undefinable id" of hedgies.

Triple A Partners was founded in Hong Kong in mid-2007. It offers working capital, seed money and distribution to hedge funds. AsianInvestor speaks to Paul Smith, a co-founder of the firm.

What are the conditions for seeding at present?

Smith: It's a great time to be a seeder. Pricing power is on the seeders' side as there is not much capital around. Secondly, there is a lot of talent around and that's not just people who have been laid off. Thirdly, the opportunities for investment returns have never been better as so much capital has left the market and the upside is so much greater.

What you don't have though right now, once you have seeded a fund, is the ability to distribute it. Seeding only gets you so far, as the reason you want to seed a fund is to see it grow many times larger, and that is where you get your leverage from being the source of fees. At the moment, nobody is buying anything. So the cycle for laying down managers is great but the harvesting phase is being pushed out. To say that distributing the funds we have seeded is tough at present is an understatement. Nowadays you can seed a manager and launch him but then have to wait for the payoff. Everyone has to bring their return expectations into what will be a much longer cycle this time round.

How do you work out a price with a hedge fund you are seeding?

The process for Triple A Partners is quite easy. Because I'm not an investment bank, they can't talk telephone numbers with me. In our first meeting I'll say to a hedge fund manager that our deal size in the seeding fund is $20 million.

We also buy a share of the management company in return for giving the manager some working capital, and that sum is proportionate to what the manager is doing and based on what fees he's projecting to receive. We then ask how much the manager himself is putting in, and then what Triple A is doing is covering the first two years of any shortfall in working capital.

So if a hedge fund manager puts in, say, $500,000 and needs $2 million, then a seeder would received 75%?

It's not linear, because it doesn't take account of what the hedge fund manager brings with him - his undefinable id. Those numbers might have been a workable deal two years ago, but a deal like that today would be unrealistic, and I wouldn't get that through my board. Once you get north of a million dollars people start twitching. A deal like that would have to be closer to 50-50 to work. A manager has to have significant skin in the game.

Triple A doesn't want to own more than 20% of a fund management company. It is at this point that the seeding business fractures into a series of different philosophies. We are trying to build up a series of minority interests.

We think that if you want to back an entrepreneur, yet own 51% of him, then that is rather stupid. Either he's an entrepreneur or he's not. And if he's prepared to sell 51% of himself, then perhaps he isn't. There are other seeders who pursue a different endgame to ourselves. For example, perhaps they may be trying to build a branded product, so they want to control the process and end-ownership of the brand. 

Our approach is to take minority stakes and look to mergers, trade-sales or listings that will make these stakes valuable. Beyond a handful of names, there are no local independent asset management businesses that have been built up.

Why are existing hedge fund firms looking to be seeded as well as start-ups?

The seeding business has moved from just start-ups to being a mix of start-ups and new managers. An existing business is vastly more exciting and less risky -- but more expensive, given a manager has a brand and experience, which means that there is less operational risk. There's twice the chance of making money as a seeder if you are with an existing manager than a start-up. There are a number of existing hedge funds seeking seeding that six months ago would not have been looking. Good guys like these, as well as bad guys, are all being caned at the moment and have taken 30-40% redemptions.

What sort of people do you want to partner with?

I want someone who wants me and what I have to offer. Working capital, seed capital and distribution and understands that they need those three things. Some say, 'I've heard you're a necessary evil', but they don't really want you. They just want $20 million. Now, nobody is as blunt as that, but these negotiations go on over a period of several months and you want to develop the right chemistry. If your seed target doesn't want to partner with you, then it's best not to do it.

Are there any strategies that you currently prefer?

No, but we do want a balance of strategies across the portfolio. We're also looking for funds of hedge funds and private equity funds too.

Once you've seeded someone, do you pester them for information all the time?

We don't need to as we have full daily transparency on their portfolio. You'd have to ask them if they felt we were pestering them, but I'd be sad to learn that they felt that way. In any event, as their distribution agent, we have to talk to them every day.

What about the dialogue about performance matters?

That's something we set out at the start. Every seed deal has a series of parameters and performance expectations built in, especially on the downside. They would raise red flags that would lead to our seed capital being pulled, and we have had to do that.

Do you check what they are spending their working capital on?

They don't have to tell me before they do anything. Each deal has different constraints. We are on the board of directors though, so there may be rules, such as for example, not being able to spend more than $100,000 without permission.

There are caps upon the principal's ability to pay himself. However, I've never met a manager who didn't know where every penny of his business was going.

Do you think hedge fund managers should fly economy or business class? And should they charge travel expenses to the fund?

Economy class. And I personally travel everywhere economy class too, long haul or short haul. I don't see why people should spend my money to travel business class. Let them spend their own money.

I have never worked with a hedge fund who ever charged travel expenses to the fund and I've worked with about 600.

How have your seed investments performed?

Our Japanese manager was down in 2008 by 8% against a market down 30-40%. So we're content with that. Jadeite was down 16-17% in 2008. It's been a tough year.

What will you be doing in 2009?

We're seeding a multistrategy arbitrage fund for EIP. We're looking at high-yield, distressed and convertible bond funds. We're less interested in plain vanilla long/short equity unless you really find someone who is first division.