U.S. regulators grow alarmed over ‘hedge fund hotels’

Hedge Fund Regulation 02 Jan 2007

By: Jenny Anderson, International Herald Tribune
Published: January 1, 2007

In this piece about hedge fund incubators, the International Herald Tribune makes several comparisons to the business incubators of the technology boom.

“Just as venture capitalists and others during the technology boom created incubators to help entrepreneurs start businesses without the headaches of finding real estate and office support, so a few big investment banks are offering young ambitious hedge fund traders a temporary home, complete with receptionists, espresso machines and consultants to help manage their information systems.

“As the technology incubators sought to oversee the birth of the next Netscape, so these hedge fund hotels hope that the small hedge funds may some day become big clients of the bank.”

Apparently, regulators are uncomfortable with the cozy relationship between the banks that run these incubators and the hedge funds that use them.  Some have even called them a conflict of interest for the banks due to the issuance of (trading and prime brokerage) soft dollars to their own tenants.

Given the parallels between “hedge fund hotels” and traditional business incubators that we have opined on in the past, we thought it might be useful to put these potential conflicts of interest issues in the context of old-fashioned technology incubators.

Hedge funds and tech start-ups are both ideal candidates for an incubator.  Both are driven by intellectual property, have low start-up costs and capital requirements, require extensive use of outside services and are generally established by highly intelligent, independent thinkers with little interest in running a business day to day.

While tech incubators came to prominence as part of the integrated services of a VC in the 1990’s, the dominant traditional form did not involve equity financing at all.  Instead, these university or government-run “technology transfer” centres provided office space and administrative services only.  Even today, the vast majority of incubators remain, essentially, shared office space.

With equity participation came management oversight by the VC/incubator.  Naturally, the extent of this oversight depended on the level of investment.  At one end of the spectrum there were the traditional incubator “tenants” and at the other end were companies that were essentially subsidiaries of a mini-conglomerate (CMGI being a prime example of such a conglomerate).

In the middle of this spectrum lay the same conflicts of interest currently faced by hedge fund hoteliers.  Questions often arose about whether the tech incubator would backstop its tenant’s commitments or whether they were providing the tenant with services at a fair value.  Like today’s hedge funds, technology start-ups were captive and could not easily jump to another supplier since their operation often depended entirely on one firm.  The VC/incubator would run the back office, pick the lawyers, secure further financing, even head-hunt additional managers.

As a result, entrepreneurs would sometimes feel squeezed out of the picture.  Back then, some described to me how they felt they had “sold their soul” for a shot at the big time.  If the omnipotent VC/incubator forced them to take a haircut, they had little choice.  The entrepreneur was caught between a rock (her customers, over whom she had little pricing power) and a hard place (the full-service VC/incubator).  Usually she was the one forced to give up some of the economics.

And therein lies the major difference between a hedge fund hotel and an old-fashioned technology incubator.  Unlike technology companies, hedge funds are able to pass along price increases to investors in the form of higher fees & fund costs.  Investors may be locked in and unable to push back, or they may simply not be aware of soft-dollar relationships.  Conversely, the customers of a technology start-up can simply elect not to purchase its products and walk away.

Hedge fund investors are also “customers” of the fund manager.  But unlike regular customers they face constraints more analogous to the tech start-up’s minority shareholders or limited partners.  To protect their (locked-in) capital, minority shareholders will usually demand certain guarantees from the majority owner or general partner – especially if that GP was a technology giant whose primary aim was to create a market for its own products. (Academic research has since shown that these “corporate venture funds” often underperformed their more flexible peers.)

So to make an apples-to-apples comparison between a technology incubator and a hedge fund hotel, imagine the following:  You are a minority shareholder in a start-up tech firm where the founder has relinquished control to an outside firm with no investment in the company at all – only a guaranteed long-term agreement to provide services.

No wonder regulators (especially in the tech incubator heartland of Massachusetts) say something smells a little funny with bank-owned hedge fund hotels.

– Alpha Male

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  1. Hedge Fund
    January 24, 2008 at 5:21 pm

    Great article. I just read 4 articles on this exact topic across different topics and this was my favorite, I’ll probably add it to my blog this weekend.

    – Richard

  2. Tranche Warfare
    February 13, 2008 at 10:51 am

    Interesting article — I well remember the heady days when it seemed like CMGI would become GE.

    One quibble: “Therein lays” should be “Therein lies.”

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