The Art of Seeding

RMF Hedge Fund Ventures

Originally published in the November 2008 issue

Depending on who you speak to in the hedge fund industry, seeding new managers is viewed very differently. Investors have a broad spectrum of views: some are converts, and actively invest considerable time and resources to find new investment talent, while others will require a fund to be up and running with a one to three year track record before they will consider it.

But there is more to the seeding process than simply finding the manager, and being one of the investors who backs him from the start, providing so-called ‘seed capital’. A seasoned seeder of hedge funds will also be looking to profit from the success of the fund as a business, not simply earning a return from the assets managed by its principals. A typical seeding arrangement will involve a fund of funds seeking a share of the fees the manager earns as well as potentially taking an equity stake in the business. Capital invested by the seeding company is not considered to be working capital for the fund management company.

Man Group fully acquired RMF in 2002 partly to provide it with just this sort of expertise. The RMF seeding business had previously been managed as a joint venture called Swiss Life Hedge Fund Partners since 1998, but as Swiss Life reorganised its hedge fund and leveraged activities, the opportunity arose for RMF to develop its own in-house hedge fund ventures arm.

Hans Hurschler has headed its hedge fund ventures unit since 2005. Its objective has been to sift through the new hedge fund talent appearing on the market, and pick out those firms it believes have the makings of future success. In November 2007 it launched a dedicated global emerging managers fund, for which it went on the hunt for between four and six new managers per annum. The plan is to increase the portfolio to 10 investments within 18 months.

The launch reflects the ongoing interest on the part of seasoned hedge fund investors in emerging manager talent and the potential upside that represents in the early stages of a hedge fund’s evolution. The fund of funds structure effectively removes much of the time consuming due diligence which early stage investors would ordinarily need to carry out.

“A true alignment of interest”
The new fund launch represents a radical departure from traditional seeding models because of its stress on revenue-sharing with underlying managers, on top of the performance from the portfolio investments. The idea is to improve the risk/return characteristics by dampening downside volatility while offering a higher degree of upside against traditional funds of funds.

There are also better exit and liquidity terms than other seeding vehicles, which behave more like private equity funds. Investors receive the added benefit of a transparent pay-out schedule and steady cash flows. Hurschler describes it as “a true alignment of interest” with the underlying manager.

Typical sources of profit for a seeder will include a combination of fund performance, participation fees (typically 20-25% of the manager’s fees, both management and performance), and an equity stake which can be realised by selling out further down the line. Seeding firms will generally use some or all of these methods as a compensation for supporting a new fund venture from the outset. In the current climate, as capital flight and higher barriers to entry make it tougher for start-up funds to raise the money they need to succeed, seeding vehicles will be able to drive harder bargains than might have been the case. In RMF’s case, the firm now focuses on a share of the top line revenue stream, rather than asking managers for an equity holding.

“The cake is the same, there are just less people trying to eat from it,” says Hurschler. “When you know what you’re doing, you have to be bullish. There are a lot of volatile situations out there and even government bonds look volatile right now, but investors need to continue to allocate money towards the rewarding opportunities. Hedge funds have to be a part of strategic asset allocation for institutional investors, and for us that means concentrating on the quality situations where there is plenty of capacity.”

With a team of six based in Pfäffikon, near Zurich, RMF Hedge Fund Ventures looks at approximately 500 potential investments every year. It has seeded start-ups with assets under management of as low as US$10 million. “It is very important that a manager has some kind of credibility in the market, and a good feel for the risks,” says Hurschler. RMF itself is wedded to a strategy-specific policy that sees it taking stakes in funds it feels will probably benefit from the economic climate going forwards. Hence, it is staying away from convertible arbitrage and this year was focused on finding new managers in the long/short credit area. A former trader himself, Hurschler says he particularly likes managers who can demonstrate their awareness as traders, and next year expects to be looking for long/short equity managers “capable of moving net exposure around.”

This doesn’t mean, of course, that RMF won’t also be looking at funds that take a more fundamental view, but as the credit crunch sinks its teeth deep into the global economy, the firm’s priorities include funds that don’t rely on leverage, and can run a relatively liquid portfolio. Hurschler himself remains upbeat, despite the palpable doom and gloom currently cloaking the hedge fund sector: “It is difficult to foresee what will happen next year, but I don’t think markets will be particularly bad over the next six months,” he says. “Equity and credit are priced at interesting levels, and while we are not interested in arbitrage strategies right now, we know we still need to look at everything in detail, at how people are trading.”

While avoiding convertible arbitrage due to the lack of financing and leverage such funds need to achieve decent performance, Hurschler expects to be focused on what he calls “simple, liquid, unlevered strategies” next year. His fund has one South American position already (Miami-based Quantek) but he does not foresee adding others: there are simply not enough good managers out there to choose from, he explains. RMF has also reviewed its policy on single country managers in the emerging markets space: prospects will have to take a regional approach at the very least.

A good awareness of risk management aside, future additions to the portfolio will also need as long a track record as possible and a solid operational framework. A minimum of five years in the investment business is a requisite.


Longer lock ups

Investors in specialised seeding funds will be trading a longer lock-up in return for the enhanced participation offered by the fund. It represents an opportunity to gain exposure to the economics of the underlying fund companies, described by RMF as “a call option on the growth of the hedge fund industry.” A lock-up is almost a requirement for such a fund, and lock-up periods vary usually between two and four years. A seeding fund could have a lifespan of as much as eight years. Historically, seeding funds also used leverage to the tune of 1.5 to 2 x capital. Whether this can be maintained in a climate where lending to funds generally is being sliced back remains to be seen.

Many funds of hedge funds include start-up managers in their portfolios, as there is a solid case to be made that managers will tend to realise superior performance in their first three years of trading than subsequently. There is also the obvious attraction of investing with the manager at an early stage in his development, possibly a future superstar manager, before he closes to new investment. In addition, seeders have plenty of leverage with the underlying manager when it comes to negotiating more capacity should it become available.

Specialist seeders like RMF will be bringing more than just investment capital to the table. They have extensive experience, a solid reputation in the market and established business networks. In some cases specialist seeders will be able to introduce the manager to other investors.

Investors and managers also need to distinguish between seeders and incubators, as there are subtle differences between a seeding relationship and a hedge fund incubator. Table 1 goes some way towards illustrating this.

RMF categorises early stage managers according to what they have done previous to setting up a hedge fund. First generation managers it classes as those starting out in the hedge fund industry as entrepreneurs (for example, a long only equity manager setting up a long/short hedge fund). Second generation managers are those professionals with a track record in the hedge fund industry, working for an existing firm, usually as a portfolio manager. Established managers sometimes also seek seed capital when setting up a new fund, for example the manager of a successful onshore fund might want new investors for an offshore fund.

Earlier this year, RMF HFV moved to support thelaunch of Miami-based Quantek Asset Management, a subsidiary of Bulltick Capital Markets. Quantek already manages around US$1 billion in Latin American strategies, but in this case was seeking investors in a new fund, the Quantek Frontier Fund, which would use local trading, thematic positioning, global hedging and special opportunities to provide investors with trading returns based on Latin American asset classes.

Such a situation is an excellent one for a seeder, as there is already a proven business with experienced personnel in place managing existing assets. But it is unlikely a fund of funds can be built relying solely on such opportunities. A seeder has to take the risk of backing new businesses. “The downside is always that you are often going to be faced with less experienced people than in other situations,” says Hurschler. “For a manager like us, it is important that we avoid negative selection bias, for example by having too many inexperienced managers in the portfolio.”

Early stage managers will generally have less than US$50 million in AuM and a track record of less than one year. As such, seeders will place them under an enhanced level of scrutiny, including manager background and reference checks, how ownership interests are aligned, trading/investment style, and the sustainability of key drivers of the strategy being followed. A great deal of attention must necessarily be vested on risk management criteria, as well as operational risk, service providers, infrastructure, and business plan.

“We can easily decide whether certain small funds are what we might be interested in by looking at the leverage they need, and the relative level of liquidity,” explains Hurschler. “With small funds we can pick up on some interesting strategies.”

Although some seeders might commit capital to a manager partly in the expectation that they can make further allocations as the business gains in stature, and matures, RMF does not lose sight of its seeding role. Once initial lock-ups of its capital are waived, it will exit the fund. The aim is to disappear off the manager’s balance sheet once he is sufficiently established to stand on his own feet. “We want to leave him free to build his business,” says Hurschler.

A generation game
According to RMF, most specialised seeders are currently focusing on the second generation hedge fund managers coming out of established shops rather than first generation managers. The attractions are obvious, particularly if the manager in question has understudied one of the more established names in the business. Such managers can usually easily raise US$20-30 million but need the ‘catalyst capital’ to reach the strategically important US$100 million which brings them the access to institutional capital. The success of an early stage manager is contingent on increasing assets at start-up quickly to reach a critical mass and build a scalable business.

Seeders will look for a high degree of manager involvement with the business, for example the commitment of a significant portion of personal liquid net worth to the fund or company. These days extensive investment experience will be needed, and usually there will need to be some hedge fund experience as well. This may not be the case for highly specialist strategies (eg. freight or weather derivatives) but in such instances relevant experience in the sector concerned will be critical. Not all seeders will be happy to back managers in new areas of investment like shipping and climate, however. RMF has been known to support more esoteric ventures in the past, for instance the CCC Carbon Fund, managed by Climate Change Advisory in London, and the Pyrenees Weather and Energy Fund, which was trading weather and climate securities prior to its closure.

A backer will place enormous emphasis on a potential manager’s risk management focus, his business skills, and his likely ability to gather assets and grow a sustainable, profitable organisation. Managers will need to map out their governance structure and relative responsibilities clearly, as well as demonstrating their operational infrastructure and the level of experience of their COO. The ideal formula boils down to a good balance of hedge fund, trading and operations experience with a comprehensive risk management overlay.

“We are looking for fresh situations,” says Hurschler,” for managers with entrepreneurial drive. We’re always going to want someone with hedge fund experience, but we also recognise that having an established COO function is essential. Managing liquidity is a COO function, and right now we are currently only after very liquid situations.”

The challenges facing a seeding fund are many, and the current environment makes them no easier. The hedge fund industry has grown dramatically over the past decade and different seeding models have been pursued as the industry has matured. A good seeding model, in RMF’s view, has to ensure the sustainable alignment of interests between the seeder and his early stage managers.

Some seeders argue that the conventional private equity/venture capital model is flawed, as it is difficult to unwind deals with managers, or monetise the equity stakes in the manager. Given the ongoing emphasis on liquidity we are likely to see in the alternative investment industry for at least the next 12-18 months, this will continue to be a priority for many institutional investors that remain interested in seeding opportunities.

A more appropriate seeding model may be one that is similar to mezzanine financing and is one that RMF has been advocating recently. Mezzanine debt is still cheaper than financing equity, as current shareholders are less diluted and don’t cede ownership of the company.
Seeding investments can be viewed as short to medium term loans with interest tied to the fund’s gross revenue. RMF argues that the returns on successful mezzanine deals should be smoother than a pure venture capital approach. A fund with a VC style relies for its success on a few home runs in the selection of weak managers: not the best route to consistent returns.

Because of the longer lock-ups seeding funds require, the ability of the fund’s manager is critical, both in terms of finding the right funds to back, and in negotiating the right participation agreements. In addition, the objectives of funds of funds, a diverse portfolio with above-average risk-adjusted returns, must still be met.

Hurschler recognises that in the current economic environment, raising money for hedge fund start-up operations is harder than ever. He is still seeing plenty of opportunities for RMF HFV to choose from and estimates that his team will have looked at approximately 500 investment opportunities this year. “It’s been quiet over the last few weeks, but this market is still offering plenty of opportunities to make money,” he says. “There is still high competition for investment; the numbers are there, but not necessarily the quality. However, the money will still go where the decent returns lie.”

With omens of gloom ringing their doleful way around the global hedge fund industry, Hurschler’s voice is a welcomingly optimistic one. He sees more opportunity for funds like RMF’s new emerging managers vehicle, rather than the death knell of the old regime.

“People who survive the current climate with a good return will find themselves in a good situation,” he enthuses. “A lot of investors concentrate on the famous names in this business, but there are some managers out there who are simply not being properly covered. This is a good market situation for a seeding fund to be in: sure we will see some contraction in this industry, but we will also see some useful evolution.”



Hans Hurschler
Hans Hurschler is the head of RMF Hedge Fund Ventures within RMF Investment Management, based in Pfäffikon, Switzerland. Prior to joining RMF in 2003, he worked as an independent risk management consultant for institutional investors. From 1985 to 2001 he was a trader of fixed income derivatives at a number of major banks, including Credit Suisse, Bank Julius Baer, and Merrill Lynch Capital Markets AG Zurich. He began his career as a trainee at Credit Suisse in Zurich in 1985. Hurschler has a degree in economics and management from the Kaderschule Zurich. He is also a certified EFFAS financial analyst (European Federation of Financial Analysts Societies) and holds a Swiss Exchange Trader Diploma, a Swiss Options and Futures Trader Diploma, and a Swiss Diploma as a Financial Analyst and Investment Adviser.