Trading equity for growth
What will it cost you to launch a hedge fund with seed capital from an institutional investor or to get a huge infusion later from an acceleration capital provider?
The vast majority of emerging hedge fund managers start their funds with their own seed capital or with start-up investments from friends and family. Some new managers are lucky enough to find an ‘angel’ investor to lift their funds off the ground. Managers who come out of a pedigreed investment firm with a unique strategy and a successful 3-5 year track record can garner as much as $100 million in initial capital from a small group of primarily large fund complexes willing to act as anchor investors. Not surprisingly, these upfront capital providers probably seed as few as 2-3% of the funds they screen.
Seed capital providers also assist their investees in developing their business plans, building the compliance and operational infrastructures they need to attract additional institutional investment and, in some cases, marketing their funds. In exchange for their capital and operational support, seeders require either a revenue share (which could be as much as half your management and performance fees for two or more years) or a substantial equity stake (20-50%) in your management company. Some insist on both. Seed capitalists also negotiate opt-out clauses for themselves (which can be triggered under any number of circumstances) and buy-out clauses for their managers (effective usually after 5 years). A withdrawal by a seed capital provider, however, could decimate a fund in one fell swoop.
If you don’t qualify for institutional seed capital but your hedge fund nevertheless grows to at least $25 million ($50 million for credit funds), you might then be eligible for acceleration capital which could double or even triple the size of your fund in a single stroke. Like seed capitalists, acceleration capital providers seek pedigreed managers, differentiable investment strategies, solid track records and business plans and sufficiently sophisticated infrastructure to attract institutional investment.
Acceleration capital providers consist primarily of funds of funds, pension plans and family offices. Like seed capital providers, they generally invest in only 2-3% of the funds they see and their terms are similar to those negotiated by seed capital providers. Given the odds of attracting such capital and the likelihood that they will get only one bite at the apple, fund managers are well advised to wait until they clearly meet the criteria of acceleration capitalists before presenting themselves as candidates. They should also consider the risks involved in growing too fast, since a single blow-up could be the end of a manager’s run.
Managers can get a leg up in the acceleration capital game by engaging capital introduction firms to evaluate their likelihood of success, assist them in preparing for rigorous due diligence reviews and ultimately introduce them to the acceleration capital providers most likely to be interested in their funds. Acceleration capital introducers charge managers either a fixed fee or a percentage of the acceleration capital raised.