Groups seeding money into new hedge funds expect this year, 2011 and 2012 to be vintage years. After the financial turbulence, the process of putting money into hedge funds has seen big changes. Specialist investment firm FCA takes a look.

Start-up companies in the asset management business are often launched with the backing of an anchor client or an “angel” investor. This has also been the case for alternative asset management (or hedge fund) businesses. Such “seed” investors become a firm’s launch client in return for receiving economic incentives from the manager for their early support.

A seeding firm provides new and young managers with day-one assets to manage, operational guidance and financial stability. The backing of a respected investor provides a "stamp of approval" for institutional investors, who recognise that the seeder will have conducted in-depth due diligence before making a commitment.

In return for providing assets for the manager to manage, seeders earn returns as an investor in the manager’s fund and also participate in the economics of the managers’ business. A mature seeding portfolio may be expected to generate 5 per cent to 15 per cent more per annum above the base return of the hedge fund investments themselves.

Hedge fund seeders need four key ingredients to be in place to provide a fertile backdrop for their strategy:

A financial market environment which offers good investment opportunities;

Investors keen to allocate capital to managers exploiting these investment opportunities;

A strong flow of good candidates wanting to launch asset management businesses;

The pricing power to negotiate seed deals that benefit both managers and investors.

Dislocation

It is not controversial to suggest that markets are now more dislocated and have less efficiency capital committed to them than was the case pre-2008. The first ingredient for successful seeding is therefore in place; markets currently offer savvy investors opportunities the likes of which have not been seen for some years.

Although the performance of the hedge fund industry as a whole in 2008 did not live up to expectations, hedge funds did perform better than almost all other risk assets, 2009 then proved to be the best year for hedge fund returns in a decade (rising more than 20 per cent, according to Hedge Fund Research). As a result, institutional investors have, as a whole, reaffirmed their appetite for hedge funds and some have announced plans to double their hedge fund exposure.

At the same time, the standards required of hedge fund managers have risen again. It is now even harder for young managers to get traction with investors. It is imperative that new launches be supported by a seed investor to provide credible and stable assets under management, guidance on fund governance, fund terms, operational infrastructure and most importantly to provide these managers with institutional validation.

Launches

Two distinct phenomena have led to an increase in the number of high quality teams looking to set-up their own hedge fund business. First, as investment opportunities have improved, the most talented investors are seeing 2010 as a great time to launch their own business. Second, many investment banks have dramatically curtailed their proprietary trading and some funds have had difficulty paying their best performing staff, leading many talented investors to choose to set up their own firms in order to control their own destinies. The upshot is that the field of prospective managers looking to set up new businesses has never been stronger.

Seeders are also being approached by strong managers who launched their businesses prior to 2008 and who have lost their anchor investors in 2008 and 2009. These are looking for strategic investors to shore up their asset base and provide some positive momentum from which to re-launch their businesses. Some of these managers present outstanding opportunities with solid track records, experienced investment teams and a robust operating platform.

By 2009 many of the larger seeders from prior years had exited the seeding business as their core activities: investment banking, insurance or private banking have become challenged. The number of seeders and the amount of capital available for seeding has reduced dramatically, leaving the field relatively free for the few remaining seeders. This reduction combined with the increased need for seed capital from managers to maximise their chances of success have given seeders vastly improved pricing and an almost free choice of the talented managers seeking seed capital.

As we have discussed, all four criteria for success are currently in place and as a result hedge fund seeding groups expect 2010, 2011 and 2012 to be vintage years.