Sometimes even the best laid plans can require many years before they germinate into something actual and real. This is very much the case with FRM Capital Advisors, the hedge fund seeding business launched by Financial Risk Management (FRM), the $10 billion fund of hedge funds group. Founded in 1991, FRM began as a research house for the hedge fund industry and evolved by mid-decade into one of what was then a new breed of funds of hedge funds.
Its core business was simple: to get hedge funds out to institutional investors by applying an institutional quality approach. In many ways, this still defines the firm’s focus. But with a near-15 year investment track record and a presence that spans the US, Europe and Asia, FRM clearly has the vision and resources to nurture a full scale seeding business. The timing of the foray into seeding is particularly noteworthy given how many other seeders have either shut up shop or have scaled back in making commitments to new and emerging hedge fund managers. With this in mind, The Hedge Fund Journal visited FRM Capital Advisors and met visionary FRM founder and chairman Blaine Tomlinson at the firm’s John Adam Street headquarters just off the Strand in London’s West End.
We began by discussing how FRM came to establish a seeding business after so many years of investing successfully in hedge funds. Tomlinson characterises the move into seeding as evolutionary rather than being the product of a sudden decision. “When FRM began investing in hedge funds in the mid-1990s I started to come across seeding firms and there were two or three I thought were very good,” he says.
“As a small firm we needed to focus on one area, but I always kept in touch with people in the seeding area. I was interested in their business models, the opportunities, the value for them and the value for managers. It’s always been on the back agenda.”
Tomlinson recalls that the launch of FRM was itself the product of a seeding deal. The firm’s original backer took a small equity stake in return for allocating what Tomlinson terms a “decent chunk of capital” to seed FRM’s first fund of funds products. “It was what we wanted to get our co-mingled funds products seeded,” he says. “We had been in business for some time as a research firm, but we wanted something to accelerate our transition to a fund of funds manager. So seeding was a concept we applied to ourselves.”
Day one investing experience
Since the beginning of the decade, FRM had a programme, that later became the Academy Fund, which looked to make small day one investments in new hedge funds. During a time when hedge fund launches were growing the aim was to secure capacity for FRM’s co-mingled funds and get better deals on manager fees. Equity or revenue stakes were off the agenda. It was felt that in traditional fund of funds portfolios it was best to restrict investment decisions to a manager’s fund, as decisions related to sharing in manager economics were better suited to seeding vehicles.
Whilst it was possible in the 1990s to start a hedge fund with, say, just $10 million it was relatively tough to raise capital from external investors. During the early and mid-2000s, the barriers to entry for hedge funds came down substantially. Over this period the role of prime brokers and their cap intro teams grew enormously and capital became much more freely available. Priorto the proliferation of cap intro, High Net Worth individuals were the main allocators to hedge funds. But by mid-decade all that changed with institutions allocating more and having a growing influence on how hedge funds operated. This was creating barriers to entry due to institutional requirements around size, operational strength and length of track records. Against this backdrop, Tomlinson recruited Clive Peggram in 2006 to become the launch chief executive of the firm’s seeding venture FRM Capital Advisors (FCA). The objective was to launch a business that would bring new investment opportunities to FRM’s clients by helping talented managers build institutional quality hedge fund businesses. The men knew each other from AIG, but whereas Tomlinson had set off to launch FRM, Peggram stayed on, eventually running a $10 billion liability matching book at the insurer before moving into venture capital – an experience particularly apposite for taking up the challenges of building a start-up that would itself invest in new and emerging fund management businesses.
Peggram recruited Patric de Gentile-Williams, former CEO of the hedge fund platform operator PCE Investors, to be chief operating officer, while Neil Mason, the former CEO of BlueCrest Capital, joined the investment committee. Other hiring ensued including a number of analysts, some of whom moved across from FRM. Though it works closely with FRM’s much bigger team, the FCA seeding business is set up as a separately regulated entity and manages a distinct pool of capital raised from investors for the express purpose of seeding. Resources are shared but the decision making processes are independent.
The seeding business will both allocate to new managers and provide acceleration capital to established managers. The events of the past 18 months mean that FCA is spoilt for choice and the potential returns are strong. “A number of people with excellent experience in hedge funds want someone like us to support them in terms of re-growing their business,” says Tomlinson. “That is a great opportunity.” FRM’s track record of investing in hedge funds gives it conviction – to Tomlinson the key ingredient in seeding. “We thought as a firm we could do this well,” he says, noting FRM’s long history with the Academy Fund and before that analysing hedge funds. He notes, too, that with FRM seeing 1,000 funds a year, it means that FCA is ideally positioned to leverage off that access. “It is harder to do this business if you do not have that flow, the natural flow of being in the business of seeing hedge funds day in and day out.”
With so many options it is obvious why Tomlinson says the key to the investment process for both FRM and FCA is one of filtering. “Where FRM makes a big difference to FCA is the quality of the opportunities it sees coming through,” he says. Of the five managers (see Table 1) that FCA has seeded, three have been introduced by FRM. Though the seeding process has accelerated over the course of 2009, the launch timing at the end of 2007 proved to be less than auspicious.
“After we set this business up a lot of plans had to change in 2008, and this year,” says Tomlinson. “We anticipate being able to raise anything from $500 million to $1 billion over time. We have raised over $300 million in a very tough environment. So we have capital to invest. If you look at future capital raising plans there are ongoing discussions and we expect to be able to raise more money for seeding in 2010.” He notes that the events of 2008 made investors more nervous about markets, but adds that fears now are more about economic prospects rather than systemic risk. “The conversations now compared with a year ago are totally different,” says Tomlinson. “We are talking with real clients about the timing of real investments.”
The rationale to seeding
Seeding generally earns the seeder either equity or revenue share. FCA took the view that revenue share is the best way to develop both its business and that of the seeded manager. “It provides a much better alignment of interests between our investors and the manager,” Peggram says. “Our rationale for that is we think you can tailor-make it to basically share in a manager’s success which our investors’ capital helps build. Our deals are sufficiently flexible so that as the manager grows and becomes more successful, the seeder’s share will diminish as a proportion of the manager’s business over time.” Indeed, managers can negotiate an option with FCA to buy back some of the seeding economics. The aim is to avoid a contract that operates like a straitjacket where a manager feels little incentive to grow his business beyond a certain level and begins to resent the revenue going to the seeder. The potential conflict Peggram has in mind is one more often observed in equity based venture capital deals.
“Revenue share is very flexible and it allows us to get better alignment of interests,” says Peggram. “These days most seeders tend to do revenue share. They do not like the need to look after a minority interest and it raises issues about how you are going to get your stake out. What is the exit route? These days it is unlikely you are going to see a sale of a hedge fund manager at least for some period of time. From a liquidity standpoint we think a revenue share is a much better way of doing things.”
FCA is also seeking to have managers impose a cost discipline on their businesses and closely watch their operating capital base. “We want it to be their business,” says COO de Gentile-Williams. “We want to provide help, particularly in terms of guidance and expertise in best practices and building institutional quality operations. But it has to be their business with our support and a shared interest both in terms of return and building AUM. Over time part of our business model is to take our capital back and recycle it, leaving managers a stable and sustainable business. Revenue share allows you to do that.”
Other aspects of the approach are worth spelling out. FCA’s executives don’t sit on the boards of fund managers or the funds they invest with. Nor are managers obliged to use the seeder’s branding or infrastructure or modify their exposures to mesh with the correlation exposures that FCA might have from other investments. “We leave them to run their businesses but we are very conscious of ensuring their business is robust and will grow and succeed,” says de Gentile-Williams. “We really are about having managers build autonomous stand alone businesses that they own. Our focus is strongly on this.”
Peggram and de Gentile-Williams argue that the quality of managers open to seeders has gone up dramatically and that their seeding vehicle can drive better returns than seeders could before the crisis. In addition they claim that the returns available from investing in a seed fund whilst having similarities with venture capital, are more attractive than the risk return profile of private equity because seeding investors invest in the fund rather than the operating structure of the business and therefore have much less downside. Seeding is also a much more liquid investment. “If we are making good decisions on the underlying managers, the returns to the investors are going to be significantly higher than you would normally get from a traditional portfolio,” says de Gentile-Williams.
Revenue share formula
The objective for FCA is to earn an annual internal rate of return of 20% over the term of its seeding investments. The IRR comes from a combination of thefund’s returns to all investors from performance and the revenue share accruing to the seeder. Seeding investments are expected to be between $30-60 million and each investment is structured in a bespoke manner for each particular manager. Typically a manager will pay a relatively straight forward top line revenue share of around 20-25%. Such a deal could even see FCA provide some working capital to help make the business more sustainable for a period of time. Conversely, if a manager has $100 million or more already under management, the revenue share might start off from a lower base because there is already a business that is up and running. “We’ll run an analysis on it and see which of the particular points concern the individual managers because they all have a different view on specific aspects of the underlying transaction,” Peggram says. “Our target remains the same for all the deals we do.” FCA is flexible about the percentage of revenue share it takes. “I think philosophically we think different risks should have different prices,” he says. “We will accept a lower revenue share if we think an investment has a higher potential for succeeding.”
Seeding a manager with capital is meant to advance three objectives. One is to give the managers enough money to manage so that they can actually run the diversified type of portfolio they are planning to market to other prospective investors and thereby generate a relevant track record. The second aim is to achieve credibility for the manager, both on the street with service providers but more importantly with institutional investors. “That’s changed a bit in 2009 in that the amount of money that is raised today is possibly less important than the identity of their investors,” says de Gentile-Williams. “We are very fortunate in being seen as a blue chip investor that does good due diligence. Our presence is always very public. That goes a long way to providing that credibility.” The third objective with seeding any manager is to make sure the business is financially robust. Obviously, the fees that accrue to the seeded manager help this, but FCA is adamant that investments aren’t sized to make sure a manager can cover his cost base. “Financial stability can be addressed in many ways,” says de Gentile-Williams.
That there is a substantial overlap between investors in FRM’s funds and in the FCA seeding venture means there is a high level of hedge fund investment experience amongst FCA’s investors. Because of the threat of conflicts of interest – the biggest issue Tomlinson says – FRM’s first port of call when Peggram was brought on board was with existing investors. “We had to confront the conflicts issue right up front,” Tomlinson says. “One or two investors pressed us on the issues of conflicts on fees – sharing and double dipping – and who would get the economics.” Clients, he adds, probed whether something could happen that might not be in their interest.
Several policies were put in place to address such concerns. FCA and FRM have separate investment teams, investment processes and separate CIOs and CEOs. Tomlinson is the only link between FRM and FCA, and he chairs both sides. What is shared is the FRM research team which is always asked to provide an independent second opinion on any manager that FCA considers seeding. In the event that FRM decides to allocate to a manager already backed by FCA, FCA will give up its revenue share for a five year period. Tomlinson says this is necessary to avoid double dipping on fee streams while not excluding FRM investors from best ideas. FRM pays whatever fee arrangement it agrees with the manager but the FCA revenue share is waived for that portion of the underlying manager’s AUM. Once managers have passed FCA’s investment and operational due diligence process, and the investment committee want to take an investment forward, Tomlinson is the only brake on FCA and has a veto on any seeding deal just as he has a veto on any allocation made by FRM.
Credit crunch knocked seeders
When the financial crisis roiled markets in 2008, many investment banks and others discontinued seeding. FRM did not go down this route, preferring instead to take a longer-term view of the venture and extend its roll-out phase. Tomlinson’s thinking was characteristically straight forward. “We see it as a core business activity for us,” he says. “We spent a lot of time researching it and a lot of time explaining it to investors. There is a lot of interest in it. The business is a good investment for us and for clients, so there was no reason to pull out of it. We didn’t even think about it, just like we wouldn’t think of cutting any of the diversified products. They are at the core of what we do and FCA is too.”
A feature of the seeding business is that it will recycle capital from managers to other managers over time but with the economic interest in the revenue share continuing. The capital commitments to managers will average three years with the revenue flowback continuing on a dissipating basis as manager AUM targets are hit. The aim is to do four or so investments per year so that the portfolio at maturity has 12-15 investments which are then recycled roughly every three years.
Data from Hedge Fund Research shows that fund start-ups peaked at over 2000 in 2005, but in 2008 and 2009 the launch rate is coming in at around 500 per year. “That’s a good illustration of the raising of barriers to entry in the space,” says Peggram. “Only a very small handful of managers can launch without the support of a strategic investor of one sort or another. For the vast majority of people it turns out to be a seeder. I think that is a permanent change. You won’t go back to a situation where there will be hundreds of large successful launches without the support of strategic investors.”
The FCA portfolio is being structured to include a variety of strategies, including credit, relative value, trading and long/short equity. The overall goal is to diversify the sources of return in the portfolio, although within each strategy bucket there are obviously a number of different sources of returns.
FCA’s due diligence process begins with looking at the quality of a manager’s investment process and the investment skill. It then considers the ability of a manager to grow the business and build it into a successful asset management firm. Along the way, the scalability of the strategy, the manager’s entrepreneurial skill and the ability to hire the right staff is evaluated. The second leg of the investment process is the operational analysis: the quality of corporate governance and controls; compliance procedures and adept risk management. “While we are going through the due diligence process we will begin an economic discussion with the manager about the appropriate and sensible deal terms,” says Peggram. “We like to do this as we do the diligence so if there is a huge gap in economic expectations we do not waste a lot of time and effort on a deal that is never going to happen.”
“One of the roles we provide is to act as a reference investor,” says de Gentile-Williams. “We take a lot of calls from potential investors to our managers who are looking to understand the processes, why we invested and what process we went through. In this environment it seems to be something that is very valuable.”
Managers seeded by FCA share this view. Eric Phillipps, principal and portfolio manager at WestSpring Advisors, which trades corporate credit, says the due diligence on its strategy, risk management and investment edge was instructive. “Understanding this, helps us to explain it to potential investors,” he says. “FCA is also a respected party in the market and that has helped us when we speak with other investors.”
The timing of ramping up FCA over 2008-2009 is instructive. Out of an earlier crisis of confidence in a much smaller hedge fund universe in the early 1970s sprung firms like Tiger Management, Bridgewater and Soros. FCA is wagering that the coming years will be vintage ones for the seeding business and that among the managers launching in the wake of the credit crisis some extremely successful firms will rise to prominence.