By Anastasia Donde
Illustration by Ted McGrath
When to let go... if ever. That’s one of the most important decisions for firms that help launch start-up hedge fund managers—also known as seeders for the role they play in financing new growth. Revere Capital Advisors, one of several new firms trying to profit from the need for capital since the financial crisis of 2008, grows a seedling to a certain size, then sends it out into the cold world. And that’s why it will soon be spinning out Broadmark Asset Management, a long/short equity fund that that started out with $200 million about a year ago and now has about $1.3 billion in assets.
Revere focuses on a relatively new type of seed capital, which is actually more like fertilizer. To managers that already have some capital, Revere offers what it calls acceleration capital of about $15 million and then helps the managers raise money from other investors. Broadmark, from which Revere bought a revenue share agreement for an undisclosed sum of money two years ago, rose 20.23% last year. It also eked out a 1.54% return in 2008 and is up 1.42% through May.
“We don’t think it’s right to overstay your welcome,” says Daniel Barnett, founder and chief executive officer of Revere Capital and previously was a chief financial officer at Man Group. He thinks managers need to get to a certain asset size—usually about several hundred million dollars—to make themselves marketable to institutions, and Revere helps them get over this hurdle. It typically invests as much as 20% of a firm’s initial capital and tends to reduce its investment to about 10% when the manager is ready to grow on its own.
Other seeders disagree that letting go is necessary, and some of the oldest and most successful names in the business often remain partners in the funds they help launch forever. Tiger Management’s Julian Robertson is famous for keeping an equity stake in the dozens of funds he has seeded over the years.
But funds want their independence, according to Barnett of Revere, which is just one of several new firms trying to muscle in the growing need for capital by new funds. Like other upstarts, such as CYAN Management Group, Revere faces heavy competition with well-established firms like Investcorp, SkyBridge Capital, The Blackstone Group, Protégé Partners, Reservoir Capital Group, a joint venture between Larch Lane Advisors and Pinebridge Investments that used to be American International Group’s asset management arm, and even Robertson’s Tiger, which now has about 38 seeds under its wing.
The seeding business is ripe with opportunity. After the market crash in 2008, about 200 hedge funds closed in the U.S. and again in 2009. Investors lost hundreds of billions of dollars in hedge funds, and hedge funds themselves were down 15.54%, according to the AR Composite Index. Dozens of funds erected gates that kept investors from taking their capital out of the funds. All these factors resulted in a dearth of capital for new launches.
Meanwhile, other funds are sucking up what’s out there. The top managers that had heavy redemptions in 2008 are still raising capital, and investors are flocking to the brand names they can get into for the first time in years, such as SAC Capital Advisors and Tudor Investment Corp., among others. Then there are the superstars who were hard hit by market conditions and are now coming back with new funds. James Pallotta, for example, who used to run the Tudor Raptor Global Fund that closed last year and once had $11 billion under management, is starting a new fund called the Raptor Evolution Fund. Bank traders displaced by the decline in proprietary trading, as well as the potential ban on it by regulators, are also trying to get into the hedge fund business.
None of this makes sense to Revere’s Barnett. “Investors took comfort in the bigger names. Isn’t that what got you in trouble to begin with?”
But the reality is that new funds usually don’t have enough assets or a long enough track record to be looked at by institutions, which forces them to go through seeders first. Add in the fact that pension funds are looking to invest in single-manager hedge funds for the first time, and the need for seeding grows.
Seeders give these funds their initial investment, provide distribution and marketing and supply operational, legal and technology support to get them off the ground. In exchange, seeders take a profit share in the firm or a cut of the fee revenue.
Investcorp, SkyBridge, Blackstone and other seeding firms provide all of the above. Investcorp has $1.6 billion in its seeding platform. SkyBridge runs $5.6 billion. Blackstone also runs about $1.1 billion in its first seeding fund, the Strategic Alliance Fund I, and plans to raise more in the second such fund. But while these are considered the established players, seeding itself is a new concept. Most of their seeding platforms were started in the mid-2000s, during the hedge fund boom years.
Everyone is growing. Blackstone’s fund of funds division, Blackstone Alternative Asset Management, is in the process of launching a second seeding fund and plans to seed 12 managers in two years with the initial ticket valued at approximately $100 million. J. Tomilson Hill, president and chief executive officerof BAAM, said in an interview in the March 2010 AR that he looks for a strong track record from new managers, character, integrity, an operational focus and a will to succeed. “These managers must possess the entrepreneurial drive and competitive spirit necessary to sustain them when markets inevitably throw them a curve ball. We love it when managers have something to prove—it’s a great motivation to work hard and generate returns,” says Hill.
Seeders know they must be careful about financing start-ups in today’s tough environment. “There is no pressure to deploy money just for the sake of deploying money,” says Deepak Gurnani, Investcorp’s head of hedge funds and chief investment officer. “We are looking for outstanding hedge fund managers.”
Jeff Gabrione, head of consulting firm Mercer’s hedge fund research department, warns that seeders should be on the lookout for firms that don’t have a strong business plan or enough experience managing money or trading in a specific strategy. Investcorp, which has $12 billion under management across several lines of business, has seeded eight managers since 2004 and wants to do more: It says it can seed two to three managers per year, giving them anywhere between $50 million and $100 million in capital. But so far, it hasn’t found enough quality funds to invest in.
One of Investcorp’s seeds, Interlachen Capital Group, was formed in 2005 by a team of portfolio managers and analysts who had worked together at another hedge fund, EBF & Associates. Andrew Fraley, Interlachen’s managing partner and chief investment officer, says the group had been planning the launch for about a year at the time and had talked to about 20 or more seeders. He says he found most seeders put in $15 million to $20 million in investment capital and “put together a portfolio of different options and hope one of them takes off.”
Investcorp was different. “They were willing to commit a significant amount of capital to getting us launched, are a well-known participant in hedge funds and had unique avenues when it comes to fund raising, particularly in the Gulf region and institutional space,” says Fraley, explaining Interlachen’s reasons for choosing Investcorp, which is owned by a Bahrain-based wholesale bank, Investcorp Bank BSC (IBBSC). With $400 million under management, Investcorp Interlachen Multi-Strategy Fund returned 44.58% last year and 5.56% this year through May, according to AR’s database.
In return for its capital investment, Investcorp usually gets a portion of the seed’s revenue. The share percentage could initially be very low, then rises as the fund’s assets under management go up, and then drops again once the manager is ready to oversee marketing and other business aspects on its own. Gurnani says the seeding agreements vary depending on what Investcorp is providing to the manager, for how long, and how quickly assets rise. Although Investcorp wouldn’t reveal the cut it takes from managers, Gurnani says, “Most of the economics are going to the manager.”
Joelle Weiss, former president and chief investment officer of fund of funds CBG Investment Advisors, says that most seeding agreements have sunset provisions that give the hedge fund the option to return the initial capital to the seeder to no longer have to pay a cut of its fees. “The manager can actually say, ‘Here is the money back. I no longer want to pay,’?” she says. While every deal is different, Weiss says that as a manager becomes more successful, the revenue share percentage typically goes down and eventually disappears.
SkyBridge, launched in 2004 by Anthony Scaramucci, a former co-founder of Oscar Capital, and backed by Dell’s Michael Dell, takes a cut of between 15% and 30% of a manager’s fees and usually retains that amount as a manager grows and becomes more autonomous. Managing partner Scott Prince views seeding as a partnership that should last. “If you’re putting your name and brand behind somebody, it’s a bad business model to let them go,” he says.
Reducing a stake in a manager as it gets more successful or pulling out altogether could result in the seeder winding up with just the losers on the platform, he warns. He notes that Och-Ziff Capital, for example, was initially seeded by the Ziff publishing family, and that relationship has stayed intact even as the hedge fund grew to $25.6 billion and went public.
SkyBridge, which is poised to grow its seeding platform with the recent purchase of Citigroup’s funds of funds business, normally seeds two to four managers per year and invests $20 million to $50 million to start. One of the firms that SkyBridge recently gave investment capital to was Capital Returns Management, a long/short equity shop that invests in the insurance industry. The firm was launched in 2003 by Ronald Bobman, previously a portfolio manager at Bedford Oak Advisors. He also had run mergers, acquisitions and corporate financings for real estate investor Samuel Zell and Capsure Holdings, an insurance company controlled by Zell. Another SkyBridge seed was Ironshield Capital Management, a distressed and special situations fund formed in 2007 by David Nazar, formerly the head of European special situations trading desk at Bank of America in London.
Old and new seeders alike agree that what a start-up firm needs most is a seeder’s distribution capabilities. “First and foremost is marketing. It’s very hard for early stage or first-time funds to raise capital. They often don’t have the resources to do it,” says SkyBridge’s Prince. While the seeder helps raise assets, the manager is able to focus on investments and returns. SkyBridge also provides risk management, operational and legal support to start-ups. When the managers are ready to perform these tasks themselves, “we let them go, from an operational standpoint,” says Prince.
SkyBridge is also in the acceleration capital business—something that has taken off since many new and small firms struggled through the financial crisis. U Capital Group, founded by former Third Point Management portfolio manager Jonathan Urfrig in 2006, initially raised $75 million from investors. Urfrig says it then sought a seeder to raise assets and distribution capabilities to make itself more marketable to institutions. The event-driven fund now has $100 million under management and is hoping to get to $1 billion. Urfrig won’t comment on the specific terms of the deal but says that SkyBridge offers business support services, risk management and marketing to U Capital in exchange for a revenue share agreement. “We were looking to bolster our capital base to make the business more attractive to larger institutional investors that wouldn’t want to be the largest investor in a smaller fund,” he says. Urfrig notes that it made sense for both parties to stay partners for a long time and retain the revenue share agreement that can change over time. “It’s not a static deal that exists forever,” he explains.
The newly formed firms or spin-outs are trying to be more flexible with respect to how they take stakes in managers, what services they offer and for what price, while competing with the established models on terms, agreements, fee cuts and just how to go about it.
“We don’t mind the managers who have had a couple of lumps on their heads,” says Barnett of Revere. In return for its seed or acceleration capital, Revere structures both equity stake and revenue share agreements with managers, and the percentages depend on the specific deal with the manager. “We don’t treat every manager the same. We do what’s best for them and for us to keep the incentive strong and aligned,” he says.
Some funds of funds also help managers get started with initial seed capital or an early investment. GAM, which has $17 billion under management, likes to develop relationships with traders either on a proprietary trading desk or at an existing hedge fund and help them get started should they decide to launch a hedge fund, says Arvin Soh, investment manager of GAM’s multimanager team. “Our willingness to do so is tied to the fact that we develop these relationships well before a trader has given serious thought to running their own fund,” he adds.
Pacific Alternative Asset Management also likes to find successful managers in their early stages and provide them with capital, but the firm usually won’t help the managers get started in other ways or invest in the business. PAAMCO managing director Maarten Nederlof warns of conflicts of interests and the “double dipping” problem if a fund of funds takes an ownership stake in a hedge fund and, at the same time, invests client money in the same fund. “This creates all kinds of concerns; I don’t know how they do it,” he says.
Blackstone’s Hill says that when the firm was developing its Strategic Alliance platform, executives were considering walling the Strategic Alliance managers from the main funds-of-funds platform to avoid conflicts. “If our investment committee determines that a Strategic Alliance manager is appropriate for our main platform, we will rebate to the investors any related fees associated with those Strategic Alliance investments. We are therefore eliminating the conflict of two fee streams to Blackstone,” he said in the March AR interview.
The established seeders say they’ve taken careful steps to avoid any conflicts. Investcorp, for example, only invests its proprietary capital in the managers it seeds, but the money from the fund of funds doesn’t go toward these, Gurnani says. SkyBridge’s Prince says that if SkyBridge takes an ownership stake in a manager, the same stake and its benefits go directly to the investors as well. “We market and raise money for the managers, and the same benefit accrues to both managers and investors,” he says. “It would be a conflict if we take those funds and market them and then invest our own fund-of-funds money in it,” he says. “We take extraordinary steps to avoid conflicts.”
With the urgent need for hedge fund capital since the financial crisis, existing hedge fund investors have branched out into the seeding business and the established seeders have spawned spin-outs. The newest is CYAN Management, started in May by a group of Investcorp executives. The $2.5 billion hedge fund firm Q Investments, which was founded in 1994, also recently launched a seeding platform and made its first seed investment in June. Citadel’s two hedge fund incubation programs, Surveyor Capital and PioneerPath Capital, also seed portfolio managers with capital.
“Seeding has become a remarkably important aspect of the hedge fund landscape today. Virtually nobody launches without some sort of partnership in the beginning,” says Chris Acito, who founded CYAN along with Hank Murphy and David Cranston. The three also founded Investcorp’s seeding platform.
Acito thinks that in addition to providing seed money to managers, his firm’s most important role is helping the funds raise money to be able to access institutional investors. “Even if you get $50 million to $100 million in capital, now what?” he says. “You’re still too small for anybody to be covering you or watching you.” The critical period is getting from about $75 million to $350 million or so, Acito thinks, and the CYAN model helps managers do that.
The firm creates a joint venture with funds that they cobrand and arranges a revenue sharing agreement. “They primarily run the money, and we primarily work with the clients. Together, we build a successful fund,” he says. Acito says revenue share agreements with managers are usually structured depending on what a manager is getting. If it’s operational support, distribution and investment capital, for example, then the revenue share agreement could be as high as 40% to 50%. If it’s just investment capital, then it could be 15% to 30%, Acito says. And several other combinations are available.
CYAN plans to take a cut of a manager’s fees when doing seed deals. Acito thinks equity shares are more cumbersome than revenue share agreements. Weiss agrees: “You don’t need to get into legal matters and you’re not part of the GP,” she explains.
Most seeding models, including Investcorp’s, have moved toward revenue share agreements over the years, Acito says. “The deals are easier to negotiate. If a dollar comes into the fund, we agree on how to split it up,” he says. The business decisions about how to spend the money are best left to the managers themselves, he adds.
CYAN, which is in the process of doing its first seed deal, plans to do only two partnerships per year. Acito is not focused on finding an exit strategy and believes that partnerships with managers can and should go on for as many as 20 years. “We’re partners in building their business. We’ve helped them and been with them every step of the way, so hopefully they will see us as a constructive part of building that business,” he says of the managers CYAN will seed.
Revere’s Barnett doesn’t think the partnerships need to last that long. The Broadmark fund that he soon will be spinning out was founded with Christopher Guptill in 2000. Guptill, who previously worked at McKinley Capital Management as its chief equity strategist, developed, launched and co-managed Broadmark’s alternative investment portfolios. Barnett has reduced his role in the firm over the years and now holds the title of chairman, while Guptill is chief executive and chief investment officer.
In addition to Broadmark, the other managers on Revere’s platform are Bayswater Asset Management, a systematic global macro shop with $10 million in assets; Dickson Capital Management, a European long/short equity shop with $26 million; and Quest Partners, a CTA strategy with $125 million.
“You get in telling them when you want to get out,” Barnett says. Revere’s plan for letting managers go out on their own, for the most part, depends on the strategy in question and its capacity. “We will get out well below any capacity he [the manager] thinks he has,” Barnett says. In general, Revere has initially stayed away from more illiquid strategies and has focused on seeding strategies that might be out of favor at the time. In the future, Barnett plans to span the gamut of hedge fund strategies.
Revere’s first pool of capital came solely from its executives, and it’s now in the process of launching a second seeding pool with capital from investors. Barnett hopes to have this up and running by the end of next year and find three to five new hedge funds to invest in. He’s already talking to some. He expects to find another long/short manager, as Broadmark is leaving the platform. Barnett is also interested in the emerging markets as well as equity special situations funds and relative value. He has raised close to $75 million for this pool from investors in Europe and a Middle Eastern sovereign wealth fund. The total pool should be around $150 million and will provide a variety of options to managers, including seed and acceleration capital, distribution capabilities, legal and operational support, as well as anything else the manager might need to get firmly off the ground. The investors will be family offices, smaller institutions and other organizations from around the world that have a sound background in the hedge fund investment industry, Barnett says.
The investors helping new managers get started are usually of this variety, according to other seeders. Acito, who worked with seeding at Investcorp since 2004, says the investors tend to be small to midsize funds of funds, family offices, endowments and foundations, sovereign wealth funds and smaller institutions.
“There is an esoteric group of investors who pride themselves in getting in day one,” he says. “Some even do it for bragging rights to be able to say, ‘We knew this guy when . . .’”
