Typical hedge fund seed investing is subject to four disadvantages in the current investment climate.
- First, it is generally well known that, in most circumstances, managers who need seed capital are those who are otherwise unable to raise it themselves. This creates adverse selection bias of an indeterminate amount. Post-crisis, those seed investors who were still offering to provide capital were only willing to do so at materially disadvantageous terms – such as 25% perpetual revenue shares – which further drove away better candidates. A 25% revenue share is roughly equal to a 50% interest in the management company. Therefore, if a seed investor was willing to provide $40 million – a fairly typical amount – the manager is starting with a management fee base of $600-800k. This is insufficient today to support building out the infrastructure that most investors expect.
- Second, the biggest issue today for smaller funds is how to grow from, say, $40 million AUMs to $250 million. The revenue share makes it uneconomic to hire outside marketing support, especially third party marketers who will bear most of the costs of marketing in return for yet another revenue share. Since investors generally want to speak to the manager, not marketers, any concerted effort to raise capital draws the manager away from investment decision-making and further reduces the likelihood of generating outsized performance.
- Third, the pre-crisis investor base for smaller funds – family offices, European private banks, and smaller funds of funds – is still largely absent from the market. The consolidation of the funds of funds industry means that most funds of funds must invest predominantly in larger funds. Institutions and their advisors generally shy away from smaller funds due to perceived headline risk.
- Fourth, a lower return environment means that all-in fees for funds are lower on average than they used to be. A fund averaging 15% net might take in 5-6% on AUMs; a fund at 5% net two-thirds less.
In light of this, I would contend that providers of seed capital are inadequately compensated in most seed transactions. To use some simple assumptions, if the seeded fund grows to $250 million in three years, the seeder is picking up an excess return of $1.5-2.0 million per annum (assuming 25% of management fees plus carry of $7.5 million). While this represents a compelling 4-5% of excess annual return on the original $40 million investment, on a probability-adjusted basis the actual benefit is perhaps one-fifth of the amount, or around 1% per annum.
Most investors require an expected return premium of around 300 bps per annum for locking up money for multiple years. Given that seeding vehicles require multi-year commitments, I would argue that this simple example shows that in most circumstances, on a probability and liquidity adjusted basis, seeding has negative net present value relative to direct investing.