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Alternative Investment Management Association Representing the global hedge fund industry

Seeding - it is a funny old game!

Paul Mack

Arundel Iveagh Investment Management Limited

Q4 2007

Perhaps with the exception of the words “hedge funds” themselves, there are probably few descriptors in the alternative investments space that have so many meanings and misunderstandings as the words, “hedge fund seeding”. They may cover a myriad of transactions, investment approaches and transactional philosophies. They may also contain a number of myths and hearsay about dark secrets and opaque transactions. Of course they do - though I thought it would be quite nice to set the record straight and perhaps explode a few of those myths.


The objectives of seeding


At first blush the objectives of seeding are quite clear, namely to add assets (typically to a fund) to build out a firm’s corpus, thus providing either a stable capital base whilst a track record is being built (in the case of younger funds) or to provide capital to allow a fund to break through one of the industry’s self-imposed glass ceilings of AUM, thereby putting the seeded fund “on the radar”.


There are, however, other important categories in the seeding spectrum which are often overlooked in the drive for simplification and these are set out below (fig.1).

 

Figure 1

 

CATEGORY
DESCRIPTION
INVESTMENT RATIONALE
1. Pure Start-Up
New/early stage funds
 
Initial capital provided by partners/close contacts
Manager often lacks resources in key areas e.g. marketing, distribution, risk and development
2. Partnership with   
    Long Only
    Institution
Established institution
 
No hedge fund capability/expertise
 
Require knowledge transfer and staff retention
Looking to convert proven alpha generation capability into a hedge fund style
3. Fund of funds
   “Arbitrage”
Existing, recently established well performing fund
 
Unable to reach critical mass to attract larger asset allocators
Investment assistance with distribution/marketing to helpfund achieve critical mass for marketability
4. Partnership with
    existing hedge  
    fund
Existing, longer established fund that has failed to grow its AUM for reasons other than poor performance
Understanding why and our ability to  facilitate change
5. “Tiger Cubs”
Spin off of manager from an existing hedge fund
Encouraging managers to leave with appropriate support and resources

Table source : Arundel Emerging Managers Ltd

There are no hard and fast rules as to how one approaches these different categories but it is fair to say that each has its own idiosyncrasies and challenges.


The mechanics of seeding – is NASA involved?


Contrary to popular belief there is no rocket science to seeding but it does come in a number of flavours and guises. It does also vary according to the category of seeding undertaken (as per the table above). For the record I set out a spectrum of what we see in the market:
• Investment on a lock-up basis (more of this later) into a fund. No other services provided.
• Investment per above plus on-going “coaching” or tools and assistance (especially relevant in start-up or early-stage funds).
• Provision of working capital (either through loans or capital) into the management company alone. No investment in fund.
• Provision of seed capital plus working capital.
• Provision of premises, trading, clearing, settlement, operations, technology and compliance plus or minus any of the above.


It is important to draw a line between what I would regard as “incubation” and the hedge fund hotel / platform style of businesses and what we regard as core seeding transactions. Whilst some operators provide a mixture of the two, it is most certainly more common for them to be provided separately. I will focus upon the latter from hereonin.

Why would anyone want to seed someone?


Why indeed? What we have found is that seeding is a time-consuming, albeit rewarding, venture. The concept of the “Friday afternoon seeder” is a dangerous one in my view and an appropriate level and depth of resources need to be allocated to the venture to ensure its success. It is important to note, however, that from the seeder’s perspective one should approach a seeding transaction on the basis of a 30 percent hedge fund and 70 percent corporate finance/VC mindset. To look at seeding as purely a hedge fund investment is probably doing all parties a disservice.

Why would anyone want to be seeded?


I think that was answered in the table and paragraphs above. Clearly it involves relinquishing a share of economics in the business and not all people are aligned to that mindset. The ones who are recognise that they would rather potentially own x percent of a larger business than 100 percent of a smaller (or non-existent) business. The same equally applies when a fund looks to another party to act as a mentor or a partner to bounce ideas or strategies off. It is very much on a person-by-person or fund-by-fund basis that such a determination can be made.

The seeding process
 

Seeding is very much a process of elimination. Experience suggests a 4 percent hit rate (give or take). Starting with one hundred possible managers, of those:
• One half can be set aside at first pass. So that is fifty left.
• A further half can be eliminated after initial due diligence. So we are now down to twenty-five.
• Of those, one half again will be eliminated as a result of detailed due diligence. So that is twelve or so.
• Halve it again for the parties that you can come to acceptable commercial terms with and that will leave you with six or so.
• Assume a 25 percent or so “final deal” fail-rate (in terms of execution), and you end up with circa four seeded managers. Simple really.


Due diligence, quantitative, qualitative and risk-focus, cannot be over-estimated. That is where the manager should be rigorously challenged. We would not expect a manager to be totally versed, polished and to have considered all avenues at this stage - indeed this is part of our process - to ensure that the issues we raise are taken on board and assimilated as part of this process.


Once done, you can move on to the “legals” in terms of the seeding agreement itself. I have seen some monsters here but frankly a number really miss the point. It is important that you establish a spirit of co-operation and partnership with the funds you are seeding. If you do not, watch out in times of corporate events, buy-outs or awkward changes - and I wish you well!


There are two schools of thought in terms of seeding agreements - prescriptive and principle-based. We fall into the latter camp. I rather like to regard this as analogous to US versus UK GAAP. Under the former you set up rules for all eventualities and wait for the lawyers to find a loophole to drive a bus through. In the case of the latter, you establish broad principles and objectives. It may come over as more of a woolly (albeit much shorter) document but it really strikes me as a more pragmatic and commercially sensible route to adopt.

Seeding Activism


There are both passive and active operators in the seeding space. There is typically value that may be added in this latter area during seeding. In many cases, a start-up may be (by definition) run by traders or portfolio managers, with little or no experience of running businesses, aggregated risk frameworks or indeed teams of other people. Assisting start-ups, with a clarity of thought in such matters, can be real added-value, thereby allowing them to concentrate on the core issues of portfolio and risk management.


The life-cycle of a seeding relationship is set out below (fig.2):

 

Figure 2

Seeding - Figure 2 

 
Issues to consider as a seeder
 

The commercial terms under which seeding agreements may be negotiated are clearly of utmost importance, to ensure the target outturn IRR is achieved. Of equal importance, however, are the operative provisions of day-to-day interaction with the seeded firms. It is, therefore, important to ensure that adequate transparency, representing, reporting (performance, portfolios and risk) as well as governance, are addressed. There also need to be suitable provisions in place to allow a seeder to withdraw capital ahead of expiry of a lock-up period, should circumstances dictate.

Issues to consider as a seedee (if that is a word)

 

Once the mindset issue has been dealt with, (as above), it is important that the oft-overused “chemistry” of the relationship, between the seeder and the fund, is correct. We spend a lot of time explaining to potential seeding candidates, that an active seeder, is a team of people, that they will spend more time with than their partners or spouses, over the seeding term. They, therefore, need to “get on”. “Bonne chance”!


 

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