When Dow Kim left his job in May 2007 as co-president of global markets and investment banking at Merrill Lynch & Co. to open a New York–based hedge fund, his timing could have been better. Expecting to raise $500 million to $1 billion in day-one money from Merrill — and hundreds of millions more from other investors — Kim quickly staffed up in anticipation of launching Diamond Lake Investment Group from Goldman, Sachs & Co.’s hedge fund hotel at 900 Third Avenue. He shunned hedge fund seeders — firms that dole out start-up capital to new hedge funds in exchange for a piece of equity or revenue — believing that no-strings-attached money would be plentiful.
Within months, Kim’s plan began to sour. Merrill announced in October 2007 that it was taking an $8.4 billion write-down on losses in the mortgage and fixed-income departments that had been under Kim’s supervision, and the firm withdrew its commitment to help start Diamond Lake. Kim’s other suitors pulled out too. By June of this year, with his projected start-up capital having evaporated, Kim resorted to knocking on the doors of the very firms he had once rejected: hedge fund seeders. But they turned him down.
“The absolute amount of money he was looking for and the cost of his business were too big for us to consider,” says Hugh Lamle, president of M.D. Sass, a New York private equity firm that specializes in seeding start-ups. Lamle says the firm declined the request even though Kim seemed fully prepared to grant M.D. Sass an equity stake. The firm, which has been seeding alternative-investment managers since 1985, limits its commitments to $50 million apiece. But even firms that supply more capital — up to $200 million — said no to Kim, according to executives at other seeder firms he approached.
Kim is not alone. Indeed, renowned hedge fund managers are finding it all but impossible to get a hedge fund off the ground these days. A few months after Greg Coffey announced in April that he was leaving GLG Partners, a $17.3 billion London hedge fund firm, to start his own fund, Coffey seemed to scale back his dreams. He opted instead to become co–chief investment officer at Moore Capital Management, the $20 billion hedge fund firm Louis Bacon runs out of London and New York. Coffey appears to have reached a realization that has swept the industry.
“People now accept the fact that it has gotten harder to start a hedge fund,” explains Chris Acito, chief hedge fund operating officer at Investcorp, a $17 billion asset management firm headquartered in Bahrain.
In an abrupt turnaround from a time when accepting seed money carried a certain disrepute, almost 100 percent of hedge fund start-ups now are seed deals, up from only 10 to 15 percent just a few years ago. Stars like Coffey — who spent four years running a GLG emerging-markets fund that delivered annual returns of 50 to 100 percent — can take easy cover in an established fund like Bacon’s. Others have few options beyond seeders. With the average hedge fund down about 20 percent through October, according to Chicago-based Hedge Fund Research, more hedge fund investors are cashing out than putting in. The upshot is that seeders are being restored to their former role as crucial players in hedge fund creation.
“Almost everyone needs help getting started,” notes Jeffrey Tarrant, CEO and CIO of New York–based Protégé Partners, a $3.5 billion seeding firm and fund of hedge funds that has stakes in about 50 hedge funds, both seed and arm’s-length managers.
“We’re going back to the way it used to be,” says Scott Prince, co–managing partner of SkyBridge Capital, a New York–based seeder firm with $1.56 billion under management. Prince says it is long overdue for hedge fund managers to be realistic about who will invest and how much investors will commit. The success of hedge fund seed investments in the 1980s and 1990s — such as those that helped launch hedge fund giants Farallon Capital Management in San Francisco and Och-Ziff Capital Management in New York — set the template.
Traditional seeding firms were passé for much of this decade, as institutions poured pension and endowment assets into increasingly numerous hedge fund vehicles, seeking safety after the bursting of the dot-com bubble. The subsequent 20 to 25 percent annual growth in the overall number of hedge funds spawned a cottage industry of newer hedge fund–seeding businesses. Many funds of hedge funds, financial services providers and investment banks created in-house platforms for doling out start-up capital and services. By 2003 seeders had begun to come under pressure from rivals crowding the field, among them prime brokers and third-party marketers. If a manager could raise a half-billion dollars at a capital-introduction meeting with a prime broker, why would he or she need a seeding deal that would cost a piece of the firm or a chunk of the gross?
But that was then, this is now — credit has dried up, the markets have tanked, and hedge funds have lost much of their luster. By October 31 the industry was down $200 billion on the year, and sages in the business foresaw more losses to come. In a late-October speech at the Massachusetts Institute of Technology, hedge fund pioneer George Soros predicted that one half to two thirds of the world’s roughly 10,000 hedge funds would disappear before a reversal ensued. Still, although funds are indeed vanishing, managers aren’t, and many are looking to start anew only to find the usual doors closed. That leaves seeders in extreme demand — and in a position to drive hard bargains, such as 30 percent revenue shares or provisions that cede them sizable equity stakes.
In the meantime, even established hedge funds are asking seeders for help as their assets are pared by sliding markets and investor redemptions. Sometimes unable to pay the rent — much less retain talented staff — many funds with less than $5 billion in assets under management are in the market for rescue capital.
“A lot of seeding activity will be involved in relaunching or rescuing firms,” predicts Daniel Stern, the founder and co-CEO of Reservoir Capital Group, a New York–based seeding firm with $3 billion in assets. Seeder firms have noble roots. Fifteen or 20 years ago, when there were few hedge funds and not a lot of capital to set them up, Goldman Sachs alumni and aspiring hedge fund managers like Daniel Och and Thomas Steyer turned to private equity investors like New York–based Ziff Brothers Investments and San Francisco–based Hellman & Friedman to get their starts. These early seeders bestowed both money and advice, helping young managers build infrastructure, teams and assets, often even providing operations support and office space. Hellman & Friedman invested $4 million with Steyer to start Farallon in 1986, then helped him raise an additional $11 million. Farallon today has about $30 billion under management.
In 1994 the Ziffs gave Och unusually generous terms: $100 million in return for a 10 percent equity stake. They also gave him space in their New York offices, the classic incubating model of seed deals. Stern, who helped found Ziff Brothers, went on to start his own firm, Reservoir Capital, in 1998 with Ziff colleague Craig Huff. Stern is credited with giving a number of prominent hedge funds their start while at Ziff, including Och-Ziff; Dallas-based HBK Investments; and Ellington Management Group in Old Greenwich, Connecticut.
By 2000, 3,900 hedge funds ran a collective $500 billion in assets, according to HFR, and seeder firms had begun to proliferate. Two years earlier, Laurence Cheng had opened New York–based Capital Z Asset Management, a private equity firm dedicated to seeding new hedge funds. That same year, Swiss alternative investment house RMF Investment Management had established its hedge fund–seeding business. (In 2002, RMF was purchased by London-based Man Group, which also had a seeding platform.) Mark Jurish set up Larch Lane Advisors in Rye Brook, New York, in 1999.
In 2002, Tarrant and Ted Seides launched Protégé Partners. To get off the ground, Tarrant had reached out to Robert Boldt, then CEO of the University of Texas Investment Management Co., which manages the university’s endowment funds, whom Tarrant had known when Boldt was a senior investment officer at the California Public Employees’ Retirement System. Boldt was looking for ways to invest in the often richer, early returns of emerging hedge funds and to get guaranteed future access to them in return. He gave Tarrant $175 million in seed money to launch Protégé.
In a sign that seeding is beginning to take center stage once again, Chicago-based hedge fund Citadel Investment Group announced in late October that it would close its $1 billion Fusion fund of funds and move the assets to its Discovery seeding and PioneerPath Capital incubation platforms, launched in January 2007.
After spending 20 years running equity-trading businesses in the U.S. and Europe at Salomon Brothers, Citigroup and BankAmerica Corp., Peter Forlenza in mid-2007 was more than ready to start his own hedge fund. He was optimistic about his prospects at first, having just exited a five-year stint as head of global equities at BofA in early 2007. Forlenza set up a New York office for his budding global macro hedge fund, Outpost Investment Group, in early 2008 with his own money and some from his partners. By mid-2008, with no sign of additional investors and feeling increasingly frustrated, Forlenza turned to seeding firms, a source he would never have considered during the heyday of hedge funds.
“Two years ago the market was different — and it’s unlikely we would have considered a partner,” asserts Forlenza, who made pitches to six seeding firms before sealing a deal with SkyBridge Capital. “They are a seeder and a third-party marketer and an advisory service,” he says in explaining why he thinks Skybridge is a good fit for his firm.
SkyBridge’s seeding model is based largely on marketing. “The hedge fund manager is getting branding and risk management,” says Anthony Scaramucci, who founded SkyBridge in 2005. “We then go into the market with a very aggressive early-stage marketing plan.” The firm’s marquee names don’t hurt: co–managing partner Prince, best known as the COO who helped Eric Mindich raise $3.5 billion in 2004 to launch New York–based Eton Park Capital Management, and senior adviser Frank Meyer, who in 1990 seeded Kenneth Griffin, founder of now–$18 billion Citadel.
SkyBridge raised $500 million from its initial investors, using that money to seed eight managers, including Forlenza. It raised an additional $1.4 billion in total assets under management before this fall’s market crash, which drove the firm’s asset value down to $1.56 billion as of September 30. But the accompanying credit crunch offers SkyBridge an opportunity: The number of hungry hedge fund managers exceeds the amount of available capital, so SkyBridge can structure better terms for itself. The economics of seeding are compelling for the seed firm — and for its investors — especially if one subscribes to the theory that most hedge fund managers perform best in their early years. But even those who question whether small managers deliver better performance than their larger, more established peers admit that seed firms have an inherent advantage over traditional funds of hedge funds. Investors in Capital Z, for example, report that the firm earns 300 to 400 basis points more per year than it would if it were a pure fund of funds, thanks to its cut of the profits from its equity stakes in the underlying managers.
Capital Z has taken equity stakes in 17 managers representing a total of $12.8 billion; today 11 managers remain on board, with a combined $7 billion in assets. One of the firm’s most successful start-ups, Passport Capital in San Francisco, was seeded with about $50 million in 2003 and now manages $4.3 billion. As with most successful seeds, Passport bought out Capital Z’s equity stake in January 2006, though Cap Z remains an investor in the fund.
Lamle’s firm, M.D. Sass, has nine seeded managers in a $273 million fund raised in 2006 with Australia’s Macquarie Bank. “Our business model is to be real working partners in the business,” he says. “We provide the entire infrastructure: tax, legal, portfolio accounting, risk management. We have rights in our agreement to intervene if the portfolio is out of alignment.” His team sees every transaction in real time, has seats on seed managers’ boards and even provides office space to managers who need it. Lamle doesn’t believe in giving huge chunks of capital to untried teams. “What kind of risk manager would I be to take an unproven team in a difficult market environment and give them $100 million?” he asks.
Other seeders seem quite willing to risk $100 million, however. Investcorp adopted its model after Acito helped the company set up its seeding platform in 2004, while he was still a partner at consulting firm Casey, Quirk & Acito. As a consultant, Acito examined both business models. Giving out $15 million to $25 million and taking a quarter or more equity stake was not providing much hands-on support to a manager, he reasoned. “One hundred million dollars is a magical threshold — that point when other investors and funds of funds will give managers money,” says Capital Z chief executive Christy Wood, whose firm gives new managers their first $50 million or still-emerging managers their second $50 million.
With many investment bank seeding platforms shut down or disabled, much of the seeder firms’ traditional competition is gone. Now their main rivals are several dozen large multistrategy firms, including FrontPoint Partners in Greenwich, Connecticut; Millennium Partners in New York; SAC Capital Advisors in Stamford, Connecticut; and Brevan Howard in London, as well as Perella Weinberg Partners’ Austin, Texas–based hedge fund program. These firms offer managers a platform to run their investment operation separately from — but still within — the parent company. Pure seeder firms say that true entrepreneurs, however, won’t be satisfied with passing out a parent company’s business cards. Those independent spirits are a seed firm’s sweet spot.
Patric de Gentile-Williams, chief operating officer of London-based seeder firm FRM Capital Advisors, sees a harsh evolutionary weeding-out under way. “The set of highly efficient animals that will come out of the hedge fund industry will be the most nimble, the most likely to adapt,” he says.
As market and liquidity risks persist, hedge funds and the firms that seed them will no doubt face huge dangers. The shakeout promises a rare opportunity for seeders. “As a significant number of hedge funds contract or shut down and new launches are shelved, there will be a flood of talent for seeders to choose from,” says Dominic Freemantle, the London-based head of European capital introduction for Morgan Stanley. That puts them in the position of being able to deal only with managers with proven track records at prominent hedge funds, though of course even that is no guarantee of success, especially in these markets.
Jonathan Urfig, a former portfolio manager at $5.7 billion New York–based Third Point Capital, for example, was seeded last October by SkyBridge. His new firm, New York–based, $128 million U Capital Group — like many funds — has delivered a sodden performance this year and is down 19 percent through September 30. SkyBridge itself was down about 12 percent for the first nine months of this year.
Most seeders are reacting to such difficulties by tightening the yokes on their progeny and negotiating tougher terms. A seed firm can structure a deal whereby it can cut a hedge fund loose, taking back whatever is left of its capital if the fund’s assets drop by as little as 5 percent, says Alex Benasuli, founder of Barcelona-based emerging-markets fund Pyrenees Capital, which was seeded by Protégé Partners in 2004. Benasuli was able to negotiate more-lenient terms: Protégé can’t pull its capital unless Pyrenees suffers at least a 15 percent drop in assets.
Wood says Capital Z is well protected and that the firm’s seeds must stay within certain levels of risk and transparency: “We have significant negative consent rights, such as antifraud and strategy-migration protections, where if they are violated, we can say we’re taking our money back.” (Wood knows the business: In a previous life as a senior investment officer at CalPERS, where she was tasked with investing a $150 billion global equities portfolio, she was deeply involved in seeding new managers.)
Some seeder firms are lying low for now. Acito, the seeding COO at Investcorp, says he will hold off on any new commitments until 2009. FRM Capital’s de Gentile-Williams is taking a similar approach. “We have deliberately been slower in allocating money in 2008,” he notes. “We hope to do six to eight deals next year.”
FRM Capital was approached by more than 500 managers this year and has seeded only two: Victory Park Capital Advisors, an established Chicago-based firm that provides asset-backed funding to small- and middle-market companies, and London-based Beechbrook Capital, which invests in leveraged financial assets. After receiving $75 million in seed capital from FRM Capital in May 2008, Beechbrook Mezzanine I launched in September. “We are carefully selecting a diversified portfolio of assets that will be resilient to the economic downturn,” says Beechbrook co-founder Nick Fenn, whose partner, Paul Shea, says choosing a seeding partner isn’t just about money. “We are benefiting from their advice in building up a fund management business that will meet exacting institutional investor standards,” Shea explains, adding that FRM Capital is providing technical support and payroll, accounting, compliance and legal help.
The number of established but stalled managers who need acceleration capital to reach a size that will attract institutional investors is growing along with the ranks of those who have lost assets and need rescue capital. Two examples: Max Trautman and Gary Link, who exited Peloton Partners in 2006 (long before Peloton became one of the notable hedge fund failures of 2008) to launch London-based Stoneworks Asset Management, a global macro hedge fund firm. They were able to raise only $20 million and found they were trying to run the business with too few assets under management.
“Given we’re a ten-person outfit, we need more than $100 million in assets under management to cover the people and infrastructure costs,” explains Link, the CEO and COO. “Investcorp was ready, willing and able to commit more capital than the others.” In August 2007, Investcorp agreed to seed Stoneworks $100 million.
Similarly, David Moradi needed a bailout after Merrill Lynch pulled out of a joint seeding venture with Pequot Capital Management last year. “I was interested in a committed strategic partner that would provide a long-term base of capital and allow for full autonomy to manage and grow the business,” says Moradi, who had left his job as a long-short equity portfolio manager at Soros Fund Management for the incubation program at Pequot in August 2006. After declining offers from several firms, including Citadel, Moradi took a deal with Protégé Partners, which offered $75 million in seed capital to launch Anthion Management, a New York–based long-short equity fund.
It seems safe to expect a lengthening line of hedge fund managers with their hands out in the coming months. Seeder firms are anticipating this and are poised to shore up those parts of the industry that are salvageable: “There will be big winners and a lot of losers,” says Stern, the Reservoir Capital CEO. “Seed capital will be used to pick the winners.”
