Even if the performance benefits of early-stage managers might be contested, Lynn Strongin Dodds identifies further positives in the form of negotiated fees, revenue sharing and direct-ownership opportunities

It is no surprise that seeders of hedge funds have become more demanding over the past few years. Markets have been volatile, returns have been weak and regulation is ever tightening. As a result, investors are looking to be fully compensated for the risks they are taking.

But the potential spoils are persuasive. While there are certainly issues with survivorship and backfill bias in the data that is used, numerous studies indicate that fledgling hedge fund managers are typically outshining their larger brethren. One of the latest studies, from PerTrac, found that young funds outperformed both ‘middle-aged' and ‘older' funds in 13 out of the last 15 years, consistently beating their larger counterparts.

Hedge funds with less than $100m under management returned 13.04% in 2010 compared with 11.14% from mid-size funds and 10.9% from funds with over $500m in assets. Young funds, defined by PerTrac as less than two years old, gained 13.25% in 2010, versus 12.65% for middle-aged funds and 11.77% for ‘tenured' funds (older than four years).

"One theory explaining this outperformance is that emerging managers are more nimble," suggests Jeff Majit, head of European investments for fund of hedge funds at Neuberger Berman. "There may also be a psychological element at play: smaller managers are much more dependent on returns for the success of their business. A larger manager can generate average returns and live comfortably on the management fee."

Lisa Fridman, head of European Research at fund of funds manager PAAMCO, points out that even firms set up by experienced individuals have to prove that they can succeed on their own as a new business. "As a result they may be more motivated to focus on performance and therefore better aligned with investors," she argues.

Even if performance is stellar, investors still worry that emerging funds lack the liquidity buffers to soften blows from volatile markets. "Ninety-five percent of start-up hedge funds fail to gain momentum in terms of gathering assets or performance," says Cédric Kohler, head of hedge fund advisory group Fundana, which specialises in emerging managers. "Finding tomorrow's stars is not that easy."

While regulation and investor demands have dramatically increased - it is not possible for two professionals to set up a boutique with just a Bloomberg terminal any more - that has not stopped emerging managers from throwing their hat into the ring. Ironically, new rules such as the Dodd-Frank Act and Volcker Rule have prompted a mini boom, as traders spin out of banks and large incumbents. In 2010 there were 1,184 debuts, a 51% hike from 2009, and in 2011 there were 1,100 launches, despite the euro-zone crisis, according to Hedge Fund Research.

But in the present environment, size also seems to matter. Those at the upper end of the spectrum are garnering the most attention, according to a new report from Credit Suisse, ‘Finding Direction in Uncertain Terrain'. The study, which polled 600 respondents managing around $28trn in total, found that 86% were interested in funds with AUM of $500m to $2bn, while 63% would consider an AUM down to $100m. By contrast, only 34% were attracted to funds with AUM of less than $100m, dropping to 24% interested in funds with AUM under $50m.

"Managers tend to be more flexible on terms if they want to attract stable capital," says Fridman. "It is a much more challenging asset-raising environment than it was several years ago and we are seeing investors looking for discounts on management and performance fees if they invest early and in size."

A recent study by Citi Prime Finance, ‘The Day One & Early Stage Investor Allocations to Hedge Funds', revealed that, on average, investors were seeking a 62 basis point discount on the standard 2% management fee, and a 502 basis point cut on the typical 20% performance fee. US investors were the most exacting, with 38% of those surveyed seeking a 75 basis-point discount on management fees - twice the number of those in the EMEA and Asia Pacific regions.

Part of the reason that the US institutions can wield more influence is that they are the most dominant players, accounting for 63% of the universe of day-one and early-stage allocators. They also commit nearly three times more capital to start-up hedge funds than European groups and make early-stage investments that are, on average, 56% bigger than those from European investors. However, the Europeans are following the US lead at the bargaining table.

"We are able to negotiate a discount of about 25% on performance and management fees," says William Benjamin, global head of research at HSBC Alternative Investments, which recently launched the HSBC Next Generation Fund comprising 10-15 emerging managers. "We do not take a stake or have a revenue-sharing agreement but, instead, build long-term investments with emerging managers. At this stage they are satellite positions but can become core over time."

The Citi research on early-stage alocators, which canvassed 90 managers and day-one and early-stage investors globally, excluded allocations by seed investors that negotiate an ownership stake or fee-sharing arrangement with the fund manager in exchange for start-up capital.

Majit believes that the main distinction between taking an equity stake or a revenue share versus being a straightforward limited partner in an emerging fund is that there is less liquidity: LPs can usually get all their money out in any one month, with 60-90 days' notice; it will be much more difficult to find a buyer for equity in a non-listed fund management company. Equity investors need a longer time horizon and face economics tied not only to fund performance but to the success the manager enjoys in growing assets.

"The upside to investors associated with this asset growth can be material," says Majit. "As an LP, however, this asset growth is less consequential."

Indeed, asset growth might be one reason why early-stage outperformance eventually turns into later-stage underperformance - as volume of money starts to drag on flexibility of alpha generation. Taking an equity stake or revenue share could be seen as one way to hedge the asset-gatherer risk to which a straightforward LP is exposed.

Overall, the majority of seed deals are via revenue-share agreements. "We believe in this model because it provides a much better alignment of interests between our investors and the manager," says Patric de Gentile-Williams, chief operating officer of FCA, the seeding division of fund of hedge funds FRM. "The incremental return from revenue sharing can double the potential returns. We do not like equity stakes, because there is the issue of the exit route. The most likely sale will be back to the management team because I think an IPO or M&A in the sector will be very difficult for the foreseeable future."

Equity stakes are popular in certain quarters, however. Seonaid Mackenzie, founder of Sturgeon Ventures, a regulatory incubator, notes that family offices prefer this route. "Many familes have built their own businesses," he observes. "As a result, they want to have some control and like to be involved in the business. Early-stage managers, of course, like this type of investment because it is seen as sticky money."

Should pension funds want to be involved in the business of hedge funds? It is perhaps not so different from being involved in any of the other businesses that they hold in their broader early-stage private equity allocations. It can turn asset-gathering into a potential benefit, as well as a potential risk, and also offers participation in fee revenue. But it also turns what was a clean hedge fund-strategy exposure into a mix of hedge fund and private equity risk - both investment risk and liquidity risk. Investors must decide whether the benefits outweigh those risks, and also the practical difficulties that mixing the two things together introduces.