Where Have All the Seeders Gone?!

The nature of seed funding for start-up hedge funds is changing as managers and seeders look for a different skillset from their partners, and it is having an impact on the latest start-up hedge funds.

In the last quarter of 2018, more hedge funds closed their doors than opened them, and exactly the same happened in the previous quarter according to Hedge Fund Research data quoted in Barron’s. The picture is not exactly rosy, as the number of new hedge funds setting up in 2018 – 561 in total – was the lowest number since the turn of the century.

The average minimum initial investment for a hedge fund was around US$2.5m, up from US$1.6m in 2017. For equity funds, the average minimum was lower at US$1.8m, up from US$1.3m in 2017, while non-equity strategies averaged minimums of US$3.8m, up from US$2m the year before.

Part of the difficulty in accessing funding stems from the way the anticipated expenses of the business are being financed in the current climate. Previously, managers would have relied on their own assets to cover the working capital requirements, but increasingly these are tending to be financed through seeders’ capital assistance, according to the latest 2014-2018 Seed Transactions Deal Points Study released last quarter by Seward & Kissell LLP.

This is happening in various ways, “including direct capital investments, working capital loan facilities, prepaid management fees, or a deferral of the seeder’s revenue share” according to the study. But in each method, care has to be taken to “avoid distorting the underlying business deal and/or tax posture of both the seeder and the manager”.

Getting the balance right can be difficult which means problems finding the right amount of funding from the right place, where the investor has the correct risk profile for the start-up hedge fund. For example, a traditional source of significant initial seed funding would come from high-net worth individuals or family offices. But their risk profile seems to be changing as they look towards providing higher investment amounts to the more established funds.

The result is that seed funding is drying up for smaller funds and companies, and while there is still some available, many traditional seed funders are moving away from the inherent risk this type of asset allocation entails.

There are likely to be a number of reasons for this. The level of risk in world markets has increased thanks to various pressures, such as the US-China trade war, and major increases in political risk worldwide. The UK is a perfect example, with a Parliament currently suspended by a Prime Minister who no longer has a majority after one MP defected to the Liberal Democrats and various others were sacked because they did not vote with the Government on Brexit.

The uncertainty surrounding not just the political scene, but financial markets too means regulators are pushing towards a more risk averse environment for those who might otherwise consider investing in smaller hedge funds. It essentially means the definition of a small or start-up fund has changed in the eyes of ‘institutional seeders’ who are less prepared to invest in these funds, as the regulator has worked to safeguard – and yet in some ways all but snuff out – this kind of funding.

Yes, no-one would ever be ‘fired for buying Microsoft’, but the benefits of these safe bets are much less than those a well-run hedge fund managed by an experienced manager can bring. The gatekeepers for high-net worth individuals and family offices are nervous about investing in a start-up fund, and on one level that is understandable. But when it comes to top managers and big funds, there is no guarantee things will go swimmingly either. You only have to look at the Woodford event to understand that.

Risk is a moot point and what one person sees as high risk another will see as a great opportunity. It is a shame that in the current environment, so many advisers and fund managers are failing to see the latter in smaller funds and start-ups, because it means everyone is missing out. It may take a change of regulatory approach, or a change in the political and economic environment for a reasonable shift to take place and small funds to see their assets grow accordingly.

One thing is for sure, there are some real nuggets in the fund start-up arena. So, the advisers and investors brave enough to take the lead and work with them are most likely to make their names for the high-net worth investors looking for good returns in such a low-interest rate environment.