Hedge funds: The next generation

Despite headline blowups and depressed returns, not all is bad in the hedge fund world. There’s still growth to be found in the future — by planting a seed.

Now is an opportune time to snag prospective managers at preferred fees, thanks to the shakeout in the industry, suggest panellists at a Toronto discussion on seeding and incubating hedge funds, sponsored by the Canadian chapter of the Alternative Management Association earlier this week.

“The seeding business is always a tough business,” admits Peter Rizakos, president of Accelerator Capital Management in Toronto, which is backed by Arrow Hedge Partners, Marrett Asset Management and three institutional partners. “We’re still seeing some good opportunities in this business.”

Accelerator operates on a private-equity model. With $140 million in capital, it seeks to seed up to seven hedge fund managers. However, instead of seeking an equity stake in the managers, it negotiates a share of the revenue derived from management and performance fees on up to ten times the seed investment as the fund grows, for up to seven years.

In turn, Accelerator provides capital of between $10 million and $25 million, operational support and risk management services, and capital raising and marketing services — “everything from soup to nuts.”

The managers have to have a performance history as well as a strategy that can be clearly explained. They must invest in public securities so that the strategy is scalable, that is, so that the managers can accept more capital. Public securities also permit an exit at close to net asset value. In addition, there is transparency: “We won’t invest if we don’t get it,” Rizakos says.

In return for seeding, apart from the capital itself, a manager gets a third-party endorsement, referrals to service providers such as lawyers, auditors and administrators, as well as a comprehensive due diligence questionnaire that prospective investors can consult.

Overall, Rizakos expects the hedge fund industry to contract in 2009, perhaps falling below $1 trillion in assets under management. Managers with poor performance or who are highly leveraged will be out of business and, as a consequence of the Madoff scandal, funds of funds will continue to shrink. “The whole fund-of-funds platform has come under attack,” Rizakos notes. As well, there will be pressure on fees — which will affect Accelerator’s business model. Still, he says, “this is all to the good of the industry. It will emerge stronger.”

While fledgling managers need access to capital, successful funds of funds still need access to new managers. Where Accelerator is seeding funds to get them to critical mass, New York-based Protégé Partners is looking to build up managers for its own funds of funds.

“We’re not doing seeding for seeding’s sake,” says Tord Stallvik, a principal at Protégé. “If it’s a strategy that we want in the portfolio today and it happens to be with a seeded manager, we will consider it.” Protégé is a $3.2 billion fund-of-funds manager that invests in smaller hedge funds as well as the funds it seeds.

Small managers are a virtue in Protégé’s world. “There are real capacity issues for most hedge fund strategies,” he notes. Capacity constraints apply both to strategies and to the managers themselves.

Seeded managers account for 40% of Protégé’s assets. Protégé offers services similar to those of Accelerator, but Stallvik notes a key issue for newer managers in the current climate: “One of the things that has gotten more difficult is to get the attention of service providers.”

Seeding has another benefit: transparency. “It’s not enough to know what they own, but [you also need to know] why they own it,” Stallvik says.

In the current environment, it has become more difficult for an analyst to step off a trading desk and attract capital for a startup. “Now you have to show you can manage money in a portfolio.”Still, it cuts both ways: “To find the best seeds, you have to give them more money,” Stallvik says. But seeding has an advantage for the prospective manager. With a $75 million allocation, they “can start with a full team from day one.”

In seeding, Protégé also negotiates a fee discount, typically 25%. By itself, that doesn’t yield a lot of money. But if outside investors also put money into the manager, Protégé investors could earn a “structural alpha,” of one or two percentage points. “The real benefit comes from paying less [in] fees and participating in the growth.”

And this is likely to be a continuing theme. “The industry is going through a lot of turmoil; that actually is good news if you know how to structure the best possible deal,” he says.

(01/30/09)