Acceleration Capital Group, a division of Arcadia Securities LLC, is a financial services platform that assists managers in raising their day-one, seed, acceleration, and institutional capital.
It has recently issued “Seeder Demand 2012,” a concise report on trends in early stage capital that makes reference to two other reports on the same theme, one from Citi Prime Finance, and another from the interstate law firm Seward & Kissel.
Looking at these three reports in tandem I get a vivid sense of the state of play in the competition for that seeding.
ACG says that there were 1,113 new hedge funds in 2011 (and 775 funds liquidated). This is the highest number of new funds in a year since 2007.
The increase in the number of supplicants has coincided with a “decline in [the] traditional seed capital currently deployed by fewer dedicated seeders.” It is, thus, unsurprising to read that hedge funds have had to pursue as many as 100 meetings to win from two to four allocations, and in the process come under a good deal of pressure to provide significant discounts in the traditional fee structure, or concessions on such other matters as liquidity, and transparency/reporting.
What ACG considers an evolved 21st century seeder is a conduit of institutional capital that is looking for exposure to emerging talent.
ACG quotes an anonymous seeding vet who says, “From the managers’ perspective, you feel you have won the race against your peers for day one money when you fund launches with founders share investments….”
But it is important for the managers to remember that although they may have won that race, there is no time to be cocky, another race is just beginning, the race to get the “regular” limited partner money. If they fail to keep this in mind, they fall victim to what that individual calls the “victims curse.”
ACG cites the Seward & Kissel study of hedge funds sponsored by new U.S. based managers who entered the market in 2011 and thus excluding new funds opened that year by existing managers.
Sewkis found that the sort of competitive pressures described by ACG are pushing down the management fee rates, but that are not yet having much of an effect upon the incentive fee. The old mantra is “20 + 2,” in other words, 20 percent of annual net profits as performance incentive and 2 percent of net assets per annum as management fee. The 20 percent benchmark is holding up. The 2 percent figure, though, now holds true for only a little more than half of the firms surveyed. The mean per annum rate is now 1.71 percent.
Chart Source: Seward & Kissel LLC
The competitive pressures may also be having consequences for liquidity. Only 10 percent of the funds Seward & Kissel surveyed had a “hard lockup” of funds for the first year as part of the conditions of investment. Likewise, most of the funds involved in the study had no redemption gates, either at the redemption or at the fund level.
Chart Source: Seward & Kissel LLC
Early investors make a wider range of demands than that, though. As the Citi report indicates, they also often want special redemption rights, additional reporting/ transparency requirements, and “most favored nation” treatment. Managers have to be careful not to give away the proverbial store here in their eagerness to get this seeding.
“These issues need to be properly positioned and structured with all investors … in order to minimize potential conflicts and hurdles” Citi says.
One way to structure preferential fee terms is through the creation of a “founders’ class” of shares, a structure that may be set out in the offering memorandum.
Investors concern themselves with launch size too. Before the global financial crisis, there were some $1 billion AUM launches. In the new normal, those fond memories can be put aside, but investors (especially in the U.S.) still have threshold AUMs in mind when looking for promising emerging managers. According to the Citi survey, two thirds of the EMEA and APAC respondents Citi surveyed said they had made day one or early stage allocations to managers with AUM under launch below $100 million. Only one third of U.S. based respondents acknowledged having done the same.
Finally, investors have decided views on who should be running the emerging management firms, what their resumes should look like. Said a large fund of fund questioned by Citi, “Ex-prop desk managers need more of an education to understand that they should not try to do it alone. If they launch with a senior COO to manage the business aspects of the firm they will greatly improve their chances of success.”