Hedge fund start-ups, the engine driving industry’s creative renewal, forced to adapt

26 Jan 2009

Hedge fund seeding is back in the news this week. But unlike a year ago, the news is not all that good.  Small funds, which were once coddled by their prime brokers, then were recipients of meaty seed investments from “incubators” now face a harsher environment where bigger players might either support them or eat them.  But it still seems that the creative renewal so important to the hedge fund industry will thrive in one form or another.

Enlightened Self-Interest

You don’t have to be a financial rocket scientist to figure out that prime brokers are interested in their hedge fund clients’ success.  More assets under management for them equals more trading, lending and stock loans for them.  This is why prime brokers have always been champions of “cap intro” events – a proto-seeding activity.

But enlightened self-interest wasn’t the only thing driving the growth of early hedge fund seeding.  Many investors in these early stage hedge funds also did well.  In fact, research showed time and time again that smaller, newer funds did better than older ones.  While some argued that this was a mirage caused by “backfill bias” in hedge fund databases, there was considerable interest in emerging managers for most of this decade.

That interest translated into huge opportunities for both those considering the launch of their own hedge fund and those thinking of seeding them.  In September 2005, Forbes reported:

“With new regulatory requirements and the tougher demands of pension funds and other institutional investors, new hedge fund managers are flocking to incubators, or seed capital firms, for that extra startup boost. What they get is what any good fledgling hedge fund needs–a lot of money, a lot of technology and office resources in a very short period of time.”

Too much “Self-Interest” and not enough “Enlightened”

During the summer of 2007, however, regulators challenged one of the original sponsors of these incubators – prime brokers.  As the International Herald Tribune reported at the time…

“Secretary of State William Galvin on Wednesday filed an administrative complaint accusing UBS of running what he calls a “hedge fund hotel” in a Boston high-rise by providing office space to fund traders who relied on UBS for various investment services.

“Galvin says such alleged arrangements create a conflict that hurts investors who are unaware the funds may be paying higher than normal brokerage commissions in exchange for the favors, and ultimately passing the costs on to investors.”

Small funds with very little asset raising capabilities had flocked to these cap intro events in the hopes of reaching critical mass.  So what were they to do if prime brokers were no longer allowed to incubate them?

Big fish to the rescue

Thankfully, in early 2008 larger “institutionalized” hedge funds began to yearn for the free-wheeling creativity of their youth.  So companies like FRM, and Man set up seeding operations of their own to grow the next generation of mega-funds.

So life was still pretty good for the small fry.  In January 2008, the FT reported:

“Clive Peggram, chief executive of FRM Capital Advisors, claimed start-ups that needed seed capital to get their business off the ground were no longer perceived as weaker players.”

Small no longer beautiful

Fast forward to 2009.  What a difference a year makes.  The FT reported last week that:

“In the world of hedge funds, it seems small is no longer beautiful…”

The world has changed and you’re going to see a bifurcation between the bigger groups that are going to survive and the smaller funds,” says the manager of one small fund.

“Most of the investors who might have told you a few years ago that small is beautiful would these days think completely the opposite: they don’t like the business risk of being invested with small funds or small organisations. The same goes for prime brokers [lenders to hedge funds].”

What little interest that prime brokers still had in hedge fund seeding seems to have finally evaporated now as they re-focus on their largest clients.  In late November, for example, Citigroup pulled the plug on its tech support for hedge fund start-ups.  As Wealth Bulletin reported:

“Citigroup has ended a technology support service offered to start-up hedge funds following a downturn in hedge fund launches and as part of wider cutbacks at the embattled bank.

“The business consulting group helped prime brokerage clients with technology issues and their infrastructure. A fee was not charged for the service, which was offered as part of a broader service package to hedge funds, according to a source familiar with the situation.”

Still hope for new funds – in a new form

While the Madoff effect may have scared investors away from less operationally-mature start ups, several larger players still remain focused on new managers.  Citadel, for example, closed a $1 billion fund of funds in October and redeployed nearly all the capital to its own internal seeding operation.

The resurgence of managed accounts also suggests that it’s small fund companies, not small funds that worry investors.  Just last week, Hedge Funds Review reported on a new initiative to “design and build separately managed account platforms (SMAPs)”.

So the creative renewal that is so important to the hedge fund industry looks like it will endure the recent calamities in some form or another.  But it’s safe to say that gone are the days when, as Forbes’ observed in 2005, the “best career move isn’t to start your own hedge fund but to back others.”

Be Sociable, Share!
← Let The Data Set You Free Despite operational risk reporting standards, chasm remains between hedge fund investors and managers →

Leave A Reply