Fewer Seeders Around, But Hedgies Love Them

Date: Thursday, December 3, 2009
Author: Ken Tarbous, IDDmagazine.com

Startup hedge funds want to avoid the time and costs associated with hiring marketing professionals and that's where seeders come in.

Hedge funds are not back to where they were before Lehman Brothers' bankruptcy, but some investors have returned and former Wall Streeters who think they have interesting investment ideas still want to hang out their own shingles.

To do so, these upstart funds are increasingly ready to give up a percentage of equity to specialty firms known as seeders that provide services such as marketing and distribution.

The capital available from seeders is a fraction of what it was just a few years ago and the number of specialty firms willing to back startups is off substantially, according to industry reports. But any help from these seeders remains welcome for hedge fund managers like Tom Grossman, who worked at Goldman Sachs in the early 1990s on the firm's international sales and trading desk.

"Accepting the seed capital was a good idea," says Grossman, principal of Union Avenue Advisors LLP, which opened its doors last year. "It was easier and faster to get to market."

Grossman partnered with New York-based SkyBridge Capital to forgo the costs of building a marketing infrastructure — which his seeders already had — and take advantage of additional existing due-diligence and risk-management teams made necessary by increased investor scrutiny.

"Post-financial crisis, the landscape has changed drastically in [that] the amount of infrastructure and investment [needed] to build a fund is way up," Grossman said. "Before they're going to attach their name to a hedge fund, they're going to do an incredible amount of due diligence."

He views the arrangement as a "true seeding relationship" that strengthens the marketability of his fund. "It's a great comfort to have mature investment professionals who are true partners of the business and not just investors," he said "The seeding role helps [and] adds a layer of comfort for investors."

Prior to starting up Union Avenue, Grossmann started the SAC International Equities fund and his own APC Fund at Aeneas Capital Management.

Scott Prince, managing partner at SkyBridge Capital, believes that today's challenging fundraising environment is a contrast to the 2003 to 2007 period, when raising capital was a seemingly effortless task. SkyBridge owns a piece of the revenue for each investment it makes, and though it has seen an increased demand for capital from emerging managers over the past year, seed capital for hedge funds has become a scarcer resource.

According to New York-based Acceleration Capital Group, a division of Arcadia Securities, the amount of aggregated hedge-fund seed capital available for investment in third and fourth quarters of 2009 dropped to $1.31 billion from $2.35 billion in the first half of 2009. That's a big drop from $7.51 billion available in the latter half of 2008.

Acceleration Capital tracks a pool of 100 hedge fund seeders globally for its Seeder Demand Research. It found that 19 have left the business, while 35 are not currently backing startups. Meanwhile, 14 firms are actively seeding hedge funds while 27 are opportunistically seeding. Five new seeders have come into the market.

For the past 18 months the number of new hedge funds coming to market was down significantly from where it had been three to four years ago, says Anita Nemes, global head of capital introductions at Bank of America Merrill Lynch. Since July, though, the space has been more active as large seeders are returning to make deals putting seed capital with emerging hedge funds. Along with the increase in activity, she estimated that the median deal size has grown from $25 million three years ago to $75 million this year.

With a dearth of capital in the marketplace, seeders are taking advantage of a vast talent pool of emerging managers across the globe. With all the choices, though, they are more selective about where and with whom they invest, doing more due diligence and looking at managers' pedigrees, market participants say.

"It depends on who you are and if you are established and are very strong, that can definitely attract capital, and if you don't have a strong track record, it is more difficult to attract capital," says Michael Gray, head of fund formation and investment management practice at Chicago law firm Neal Gerber Eisenberg LLP. Gray has served as counsel for hedge fund managers and investors.

In addition to being more selective about where and with whom to put their money to work, investors also are exercising their new-found ability to demand better terms from emerging hedge fund managers. But there's no plain-vanilla form of a seed deal, and the terms are specific to each situation.

"Obviously, right now the supply-demand imbalance means seeders have a big advantage negotiating deals," Nemes says. "The majority of seed deals have been negotiated via revenue sharing agreements, however, due to increasing supply and lack of demand from traditional day one investors, active seeding firms have been able to negotiate more favorable terms throughout 2009."

Evolving deal structures such as changes to lock-up periods — some of which have shrunk to as little as two years — seed amount, length of capital commitment, the percentage of management or participation fees seeders get, for example, depend on how strong the proposition is and track record of the managers, Nemes says.

When it comes to deal terms, SkyBridge's Prince — who said even the big established hedge fund managers are having difficulty finding new capital — has seen deal-making dynamics change.

"There has been a new level of scrutiny by investors of hedge fund managers," said Prince, a former partner at Eton Park Capital Management and co-head of equities trading and co-head of global equity derivatives at Goldman Sachs until 2004. "There has been a shift of power between investors and hedge fund managers."