Institutional investors face challenging allocation decisions in the current low-yield environment. Mark de Klerk explores how seeding could enhance returns of a hedge fund allocation
For investors with a long-term horizon, seeding or acceleration capital investments can help decrease their hedge fund investment costs. They can also enhance returns by directly participating in a greater proportion of the industry economics.
The contribution from hedge fund allocations has disappointed some investors in recent years. Sophisticated investors understand that most hedge fund strategies are not designed to participate to the full upside in a bull market. They are designed to protect capital, or at least to limit losses, in a declining market. Many of these investors are recalibrating their overall portfolio return expectations in the face of persistent low rates and depressed volatility.
However, what is less palatable to investors is that as expected returns compress, the percentage of gross returns received by hedge fund investors has decreased as well.
Much has been written about fee compression in hedge funds and the institutionalisation of the industry has certainly resulted in a lowering of fees since 2008. However, perhaps surprisingly given the level of media and investor attention in this area, industry surveys suggest that fees have settled in a range of 1.50-1.55% for management fees and 17.5-18% for performance fees.
Investors have also found that recent returns from some larger, established managers to be disappointing. There is significant academic evidence suggesting that, on average, both smaller and emerging managers outperform their larger and more established counterparts. A recent study by Clare, Nitzsche and Motson of Cass Business School, came to a similar conclusion after analysing data from 1994 to 2014.
Asset allocators are paying more attention to this so called “emerging manager premium”. But these allocators also often require a minimum asset base to invest in a fund. This creates an opportunity for seed investors to benefit by investing in potentially lower-risk acceleration capital opportunities, with skilled managers who are managing funds already.
Since 2008, the industry has bifurcated noticeably, with most of the asset growth going to the largest managers. To illustrate this, the top 428 firms managing over $1bn (€900m) (the so-called ‘billion dollar club’) accounted for $2.48bn or 89% of assets under management (AUM) at the end of 2015, compared with 79% of AUM in 2009, according to the most recent Hedge Fund Intelligence Global Review.
The growth in the hedge fund consultant industry, often in direct competition with fund of funds, has had two main effects on seeding. The increased competition and margin compression has decreased the number of fund of funds in the industry through either consolidation or closure. As fund of funds traditionally had the expertise and resources to support a seeding programme they made up a significant source of early stage capital for start-up managers.
Secondly, consultants historically have not managed discretionary assets, although this is changing. This trend towards direct allocation, supported by advisory relationships, has decreased the number of traditional seed investors in the market.
Increased regulation, rising operating costs, a shift in the industry investor base and a decline in the number of traditional seed investors have made it increasingly difficult for early-stage managers to attract sufficient capital to build a long-term viable business. One option to overcoming these difficulties is for managers to partner with a strategic investor. These can provide patient, seed or acceleration capital, often contractually locked in for a minimum period of time. In many cases, the seed investor will also work with the manager to develop the business infrastructure and distribution capabilities given the alignment of interest on both performance and asset-raising.
In exchange for making an early-stage investment, the seed or acceleration investor receives an economic interest in the underlying alternative investment manager. This can be a share in either of equity or gross revenue. Revenue share participation is more common as these agreements are often simpler and quicker to negotiate. They also come with less potential liability and taxation risks, require less involvement in the manager’s business decisions and are simpler to administer.
There has been a more recent trend for some of the larger traditional seed investors to acquire minority equity stakes in established large managers. New entrants from the private equity sector have joined such investors. Such a strategy can be perceived as lower risk, with yields provided from the start.
However, this model is distinct from the traditional seeding model in that investors put their entire capital at risk to the management company closing down, typically with no clear exit strategy. The new model involves making an investment in the underlying fund with drawdown protections and a clear timeline for the return of capital. Although this approach is typically premised on buying stakes in mature managers with a $2bn-5bn plus asset base, a diversified client base and multi-portfolio manager/product structure, there is significant competition and a limited supply of these types of managers.
Time will tell which model provides better long-term risk-adjusted returns. But one outcome may be smaller capital-seeking transactions that trickle-down down to smaller managers. This could present potential exit opportunities for traditional seed investors over the long term.
For the institutional investor able to harvest a liquidity premium by locking up capital, hedge fund seeding can provide excess returns over and above investing directly in hedge funds or via a fund of hedge funds portfolio. This is an opportunity to add convexity (revenue participation can only ever be positive) to a hedge fund portfolio. It can also dampen volatility and benefit from access to some of the potentially high margins earned in this industry.
In a low-yield environment, the revenue share participation could make up almost half of the return over the life of a seed investment, if the right manager and strategy are selected. Given the strategic nature of the relationship, this also provides the opportunity to negotiate several other benefits, including preferential fees, capacity rights, co-investment opportunities, as well as risk-mitigating protections.
Mark de Klerk is the head of seeding strategies at Tages