Q. Its an awfully tough environment for new hedge funds, without a track record, to raise capital… but this is one pretty common way for them to do it. How does it work?
A. Yep, this idea was pioneered by a firm called Topwater several years ago, and has now become reasonably common way of getting a new fund off the ground. The basic idea is that the new manager puts in, say, $1 million into something called a first loss account. Then, the funder puts in $9 million on top of that. All of the first losses are subtracted from the manager’s $1mm, instead of being divided pro-rata across the $10mm total. That’s the bad news for the manager. The good news is that he gets more than 20% of any gains– up to 50%– on the whole $10mm.
Q. So… the net economics work out how?
A. Well, on that example, if the fund is down 10%, the manager is wiped out and the funder probably pulls the plug on the arrangement. But if he’s up 10%, he makes $500,000, a 50% return on his own investment!
Q. Talk about pressure! Sounds like a good premise for a reality show.
A. Yes, and you wonder how that impacts the trading decisions, frankly. Of course, managers don’t love doing it this way, but it does allow them to generate a real track record with significant dollars in a way they might not otherwise be able to.
Q. Well, that’s a good question. What other sorts of structures are out there to attract funding to new managers?
A. The most common is a “seeding” arrangement, in which the manager gives up a piece of the “GP”– the management company that runs the fund and earns the fee– to the group that does the seeding. That is, the seeder will earn a chunk of the manager’s “2 and 20” for all subsequent capital the fund raises.
Naturally, managers don’t like that either– they don’t want to give up so much of their long term upside for running the fund to someone just in exchange for making an investment. So for them, a “first loss” account might be worth a look.