Hedge Fund Seeding: Hot or Not?

A few years ago, before social networking was all the rage, a website called “Hot or Not” was launched to allow webs surfers to post their photo and generate, shall we say, feedback on their appearance.  Today, the site is used to canvas users on everything from American Idol candidates to political candidates (example: Obama seems to be totally smoking McCain).

But strangely absent from the line-up is hedge fund seeding.  The strategy seems to run hot and cold and would surely have elicited some chippy debate.  (Okay, maybe not.)

At the beginning of this year, seeding was hot (see related posting).  Then it was not (see related posting).  And with the continuation of a difficult fundraising environment for hedge funds, seeding is hot again.  In fact, it was in the news several times last week.

eFinancial News reports on HFR data showing that new hedge fund launches are at their lowest level in 8 years.  One reason, suggests eFinancial News:

In addition to market conditions, start-ups were hit with increased capital needs.

The costs for launching a hedge fund have increased to $250m in the past few years. Companies offering hedge fund seeding services that provide capital to start-ups in exchange for a stake in the fund or percentage of fees are finding a market for their services.

HedgeWorld goes a step further with a piece on the same day titled “Seeding Back in Vogue” in which it observes:

Unprecedented inflows of cash into alternative investments and easy credit conditions provided start-up hedge funds with a way around using seed investors until recently. Most new funds that set up operations during the boom got early backing from funds of hedge funds plump with new allocations from institutional investors.

HedgeWorld was reporting from a Merrill Lynch cap intro conference where the firm’s head of capital introduction, Anita Nemes told the audience that there was a definite step-by-step process involved with raising capital.  Reports HedgeWorld:

Start-up managers, [Nemes] said, need at least $20 million in friends and family funding in order to pick up $50 million from a seeder. “You need a credible amount of money, operationally robust infrastructure and good performance numbers,” Ms. Nemes said. “Then the other allocators will look at you.”

“Seeders are seeing quality people now,” Ms. Nemes said. “It is not just that seeding activity is up, it is that unless you are an über launch you need a seeder."

Also last week, Euromoney Institutional Investor ran the third of a three part series called “Hedge Fund Start-ups Face a New Reality.”  It quoted one service provider as saying:

If you don’t have the contacts and the resume to find at least the first $25 million in assets on your own, you shouldn’t even start a fund.

Yikes.  Things are getting worse.  What about the tried and true “third-party marketer”?  But the official quoted by Euromoney continues:

Placing huge confidence in a third-party marketer as a saviour for your fund is a big mistake.

If you’re a small or start-up hedge fund, you’re probably crying “uncle!” by now.  At least one manager did last week.  According to FINalternatives, Quasi-seeding operation Fairfield Greenwich Group pulled $100 million from one of its seedlings, leaving the fund with only $65 million in assets.  The seedling’s managers promptly announced they would be shutting down the fund at the end of June.  

Although officials with Fairfield Greenwich said “it would be incorrect to state that FGG had caused Manhasset’s current or future decisions,” we have a sneaking suspicion that the two events are somehow related. 

A survey published in May by hedge fund database manager Prequin Hedge found that outright seeding isn’t actually that popular among institutional investors.  The survey found acceptance for “emerging” managers and “spin-outs,” but only 8% of respondents expressed a desire to be the first to jump into a new, unknown manager.  Worse, only 12% would even “consider” such an investment (chart below).

The survey did not include hedge funds of funds - which are much more likely to invest in start-up managers.  Indeed, just last week, AIG announced its entry into hedge fund seeding with a joint venture with Larch Lane, a subsidiary of Old Mutual.  Reports MarketWatch:

While institutional investors still seem willing to put money into large, established hedge funds, smaller and start-up managers are struggling to attract investors.

“Talented investors are leaving large hedge funds to start their own businesses, but many of them have not been able to reach their capital targets,” Mark Jurish, Larch Lane’s chief executive, said in a statement. “The current supply/demand imbalance for start-up hedge fund capital represents the best seeding opportunity I’ve ever seen.”  

So the attractiveness of seeding seems to depend on who you ask.  The recent turmoil in Hedgistan is either an unprecedented buying opportunity or a relentless march toward industry consolidation that will leave thousands of hedge fund casualties.