Has the cost of seeding hit an all-time low?

Mon Oct 3, 2011

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Emerging-manager allocations have become a private equity-like deal with investor and manager incentives being more fully aligned for a set period of time


By Susan Barreto

In the coming months, the hedge fund industry's grand experiment to support its next generation of managers will be in full swing.

The search for lower fees and greater alpha has moved on to greener pastures. Institutional investors are fertilising new seed deals at a faster pace in search of up to an additional 5% in annual return, industry studies estimate.

Previously, we have seen a flurry of $100 million-plus mandates going to the same mega-funds. The unintended consequence has been the growing divide between the $1 billion-plus single-manager hedge funds and those groups that manage less than $100 million. It has also made the search for new talent difficult.

Researchers tell us that funds with $1 billion or more in assets under management represent only 16% of the total number of hedge funds, while they account for almost 90% of the assets.

Institutions seeking to take advantage of this trend are now moving forward with seeding deals after having completing their basic hedge fund allocations. Examples in this issue alone are the World Bank, Abu Dhabi Investment Authority, the California Public Employees' Retirement System and the Chicago Police Benefit and Annuity Fund, which is still considering allocating to emerging managers. Meanwhile, Cairn Capital is understood to have received seed capital from San Bernardino County Employees Retirement Association and the Stanhope Pension Trust in the UK.

To tap into this institutional appetite Hermes BPK, the alternative multi-manager of the BT Pension Scheme in the UK, has teamed up with private equity firm Northern Lights Capital to create a dedicated seeding vehicle.

It is a story of supply and demand - or, in the words of one pension fund executive, it is a matter of "cost/benefit analysis". These questions focus on what is the upside from generating alpha versus the downside from picking a smaller, unknown fund that may blow up.

During the significant "flight to quality" events such as 2002's tech burst and the mortgage crisis of 2008, large funds outperformed small funds, according to industry research. But young funds generally outperform mid-age and old funds, and various sources put the outperformance over time between 2% and 5% on an annualised basis over their older peers, who are less likely to allocate to riskier investments in an effort to keep returns stable.

So we have heard this all before. What has really changed? The pricing mechanism is what is new. Emerging-manager allocations have become a private equity-like deal with investor and manager incentives being more fully aligned for a set period of time. This is popping up in the form of founder's share classes. These share classes encourage investors to allocate assets early by creating more favourable terms.

Barclays Capital found that on average the founder's share class management fee discount is approximately 50 basis points and the average incentive fee discount is 5%. There is often a set hurdle rate as well, which is something similar to what was offered in the early days of the hedge fund industry.

Also discounted may be other add-ons. Rather than allocating to an emerging manager fund of funds or a platform, institutions are able to lean on a specialist consultant or fund of fund manager acting as an advisor. For funds of funds and consultants, this means they are charging less than if they were offering a set product or overseeing an entire investment portfolio.

Why would consultants and funds of funds want to offer a discount? Simply because they, too, are able to source new forms of alpha for their own benefit in the future.

A new alignment of incentives is just now underway and institutions willing to research their options more fully will find less pricey performance in early-stage hedge funds. Whether this discount comes with any hidden costs such as illiquidity or volatile performance has yet to be tested.

Institutional mandates: August 2010