Seed money becoming vital element for fledgling hedge funds

A fully mature industry and the stringent size requirements of asset owners are forcing many would-be hedge fund proprietors to go out with hat in hand to find a firm willing to provide seed money.

The amount of assets under management by a hedge fund firm is one of the critical factors for the increasing number of institutional investors that have moved to direct investment, and that has raised the bar for new managers.

“Roughly 90% of institutional dollars go into hedge funds managing more than $1 billion, leaving very little to be invested in early stage hedge fund firms,” said Donald A. Steinbrugge, managing partner of third-party marketing firm Agecroft Partners LLC, Richmond, Va.

Unless a new manager secures backing from an old employer or wealthy family and friends, the early marketing experiences for many hedge fund firms likely will be with the cadre of alternative investment managers that have created specialized seeding funds, such as Blackstone Alternative Asset Management, Goldman Sachs Asset Management, Protege Partners LLC and Reservoir Capital Group LLC.

They might also show their wares to the purveyor of an investment platform, which provides the young firm with middle- and back-office infrastructure, access to trading and risk management systems, and business services of the kind that Ramius LLC provides to Quadratic Capital Management LLC (Pensions & Investments, Sept. 21).

“Marketing to a seeder or an investment platform is no different from marketing to a big pension fund,” said Andrew Saunders, senior managing director at Castle Hill Capital Partners Inc., New York, a specialist consultant to hedge funds. “That's just business, having to hit the circuit to get first investors and seeders,” he said.

Making the rounds is exactly what CEO Aurelia Lamorre-Cargill and Chief Investment Officer Marcos Bueno — managing partners of new multistrategy commodities hedge fund manager Argon Capital Management LP — have been doing since mid-September.

In possession of good pedigrees — Ms. Lamorre-Cargill was global head of fixed-income structuring at Barclays Capital PLC and Mr. Bueno was a partner and senior portfolio manager of a commodities strategy for Graham Capital Management LP — the two have good access to seeders, even receiving unsolicited interest, Mr. Bueno said.

“Reaching critical mass is critical. We need a partner,” Mr. Bueno said, to provide assistance with infrastructure, distribution and risk management together with the cultural alignment. The firm will not launch and start trading until it has received a seed investment, Mr. Bueno said.

Critical mass for New York-based Argon Capital would be $400 million, although it's probably more realistic that the firm will attract $200 million and be expected to drum up the balance on its own, Ms. Lamorre-Cargill said.

“Seeding is a sign of the maturation of the hedge fund industry,” Mr. Bueno said, noting “seeders are valuable to both end-investors and the hedge fund manager.”

“The hedge fund industry is an extremely mature industry,” said one former seeder who asked not to be indentified. “The allocator side also is nearing maturation. There aren't many new ways to manage a hedge fund and distinguish yourself. The world doesn't need another hedge fund. There's a strong lack of appreciation of this fact by young hedge fund companies.”

“Anybody who needs a seeder isn't somebody you should seed,” said another former seeding veteran, quoting an old industry adage, who spoke on condition of anonymity.

There might be some truth about the overabundance of new hedge fund launches.

Grosvenor Capital Management LP, Chicago, for example, has probably looked at 1,000 potential seeding deals in the past three years, but provided startup capital to only six firms, said Jon Levin, managing director.

Hollis Park Partners LP and Pinyon Asset Management LP were among recipients of GCM's recent seed deals.

GCM, an alternative investment manager, has been seeding new hedge funds since 1991 and often is the recipient of the first call from a new firm.

“There is tremendous supply of new hedge funds out there right now,” Mr. Levin said. “People are coming to us because our approach hasn't changed much nor have the terms of the deals. The only real difference is that it requires more capital today to launch, closer to $100 million,” he added. However, over time, hedge fund managers who accept seed investments frequently find the terms of the deals irksome, sources said.

That's partly because “the whole seeding relationship is extremely relationship-based” and partly because the more successful the new hedge fund firm, the more it has to keep paying to the seeder, said Eric Seigel, senior managing director at hedge funds-of-funds manager Mesirow Advanced Strategies Inc., Chicago.

The initial seed investment generally is locked up for two to five years, but the revenue share of profits the hedge fund must pay to the seeder — usually 20% to 25% of profits — goes on infinitely unless the original contract included a buyout clause or the two parties come to an agreement, said attorney Steven B. Nadel, a partner in the investment management practice of Seward & Kissel LLP, New York.

Managers at young hedge fund firms are “approaching seeders with extreme caution because they know the deal will be hard. They only want blue-chip deals,” said Jeffrey D. Willardson, managing director and partner, of hedge funds-of-funds manager Pacific Alternative Asset Management Co., Irvine, Calif.

“For hedge fund managers, accepting a seeding deal is a kind of indentured servitude,” Mr. Willardson said, stressing that “even after the seeder has redeemed its assets, the revenue share can continue forever. That 25% is a pretty high tax to pay in perpetuity.”

GCM's Mr. Levin said not all hedge fund seeding deals are the same, and transparency about what the seeder will provide is crucial.

GCM for example, provides an investment platform, marketing and strategic advice and other support services to its seed partners.

“People who we want to seed are coming to us for more than capital. The cost (of the seeding deal) is worth incurring to grow their business,” Mr. Levin added.

Bloomberg contributed to this story.