Below please find my latest interview for CAIA’s www.Allaboutalpha.com. Enjoy, Andrew
By: Andrew Saunders, AllAboutAlpha.com Editorial Board.
When launching a hedge fund, managers face an implicit conundrum – how do you raise money without a track record and how do you develop a track record without the money?
The increasingly acceptable approach is to accept seed capital – the venture capital component of the hedge fund universe. But that wasn’t always the case. Strong arguments were made for a selection bias in managers that opt for a seed investment, the argument ran something like, “if you’re that good, you won’t give away equity” approach. However the environment has changed. Recent research from Acceleration Capital Group offers some metrics around the trends. To provide an informed view from the seeding perspective, we direct our 7 questions this month to Anthony Scaramucci, Managing Partner of SkyBridge Capital, to help us understand the current dynamics.
After graduating from Harvard Law School, Scaramucci started his investment career at Goldman Sachs, built a managed account business and started four hedge funds before selling the business to Neuberger Berman. Scaramucci launched SkyBridge Capital in 2005.
Q1: How would you describe the change in perception of the seeding industry from 2000 to now?
Earlier on, seeding was largely unknown and used as a one-off product.
It has taken time to educate the investor community on seeding, but now there is wide acceptance of the model and the perception has shifted from adverse selection to affirmative selection. Originally, it was perceived that no “good” manager would need to give up a fraction of his business to receive capital. However, markets have normalized and the hedge fund bubble has burst. There is a clear investor shift to affirmative selection, where talented managers view seeding as an endorsement of their skill as a manager and viability as a business. There are several economic factors that are lending to this shift:
- Migration of talent from larger hedge funds and major banks;
- A scarcity of capital has forced even the best/brightest new managers to have difficulty attracting capital. (Approximately 70% of new capital flowed to the 100 largest hedge funds in 2008.);
- Distressed pricing in many asset classes and volatility makes this market the best opportunity to launch a hedge fund. The lack of capital creates distressed pricing, which translates into buying opportunities for those contrarians that have capital to deploy.
Q2: In crafting a seed partnership, has the balance of power shifted from manager to investor? How have the agreements changed?
At the moment, the balance of power has shifted more toward the investor, and the best mechanism for capturing that is a seeder. A seeder aligns the interests of both parties. We have the ability to have transparency into the manager’s portfolio, dictate certain risk parameters and expedite capital withdrawals from the fund if the manager steps outside his initial agreed upon strategy and/or risk guidelines.
In general, with the scarcity of capital and the increase of talented mangers looking to launch their own hedge fund, the seeder definitely has the upper hand. With that being said our goal when partnering with a manager is to never suffocate him with onerous terms. We enter our seed deals to build long-term relationships rather than to take advantage of the moment.
The process of negotiating with managers has become much easier as the industry begins to professionalize and seeding becomes more mainstream. SkyBridge requires that its hedge fund partners adhere to specific risk parameters and provide full portfolio transparency. Managers are “pushing back” much less on the terms then in 2005-2007.
Q3: What are the challenges in establishing a seeding/incubation program?
Most people think that seeding is simply finding the right manager, conducting due diligence and providing capital to early or start-up hedge funds. People don’t recognize that there are two other vital aspects of the seeding model.
A seeding program must also assist and help new managers navigate the operational and strategic risks of running a new business. There are significant headwinds facing a manager as he scales his business, and seeders must be there to assist managers during their normal growing pains. I believe there isn’t a “one-size-fits-all” infrastructure template for each manager. We provide operational support to new managers, but we allow them to tailor their infrastructure specific to the needs of each manager’s team, strategy and investor requirements.
Another aspect of the seeding model that people often overlook is the ability to help the manager raise capital. It’s important to get managers to critical mass and we play an active roll in putting our managers in front of interested and relevant investors. SkyBridge’s success is largely attributable to our global network of investors who invest in new and emerging managers.
Q4: What are the biggest risks when building out a portfolio of underlying managers?
The greatest risk is the temptation to be short-sighted, and partner with a manager that has a “flavor of the month” strategy. When looking at potential managers, a seeder needs to identify a manager that is capable of building a successful business with a strategy that generates alpha regardless of where we are in the business cycle.
Q5: What types of investors seed investors directly or participate in dedicated seed funds?
The seeding model has gained mainstream acceptance. We are beyond the “early adoption” phase when only a few high-net-worth individuals and family offices were investing in the seeding space. These early adopters can be characterized as “opinion leaders”, forward thinkers who try new ideas, but do so carefully. That small group now has become a much larger group. We have transitioned to the “early majority” phase of recognition for the seeding model. There is now greater institutional/mainstream acceptance, which will only increase as investors realize the potential of new and start-up hedge funds.
There are numerous studies and ample evidence to show that early stage managers perform better than their larger, more mature peers. The reasoning behind the data is that new managers are hungrier to succeed and have a smaller asset base that enables them to get in and out of trades more easily, and find opportunities that larger funds would overlook. It’s difficult to identify new managers with limited resources, and there is significant risk in investing in one manager; a dedicated seed fund addresses those needs and provides a more diversified investment opportunity.
Q6: How successful has seed investment been to the growth of the overall HF industry? Do you have any sense of how the most “successful” managers have got their start? Was it on their own or through seed investment?
Some of the most successful, high-profile managers got their start with help from a seed investor:
- Citadel – Ken Griffin was seeded by Frank Meyer, founder of Glenwood Capital
- Och-Ziff – Daniel Och was seeded by the Ziff brothers
- Maverick Capital – Lee Ainslie was seeded by Sam Wyly
- GLG Partners – Noam Gottesman was seeded by Lehman Brothers
- Farallon Capital – Thomas Steyer was seeded by Warren Hellman of Hellman & Friedman
…and then there are the 38 “Tiger Seeds” seeded by Julian Robertson.
Q7: Can the industry continue to grow without the seed/incubation industry?
With the hedge fund bubble bursting, investors have become much more selective with their hedge fund investments. We are now in the era of Hedge Fund 2.0, which is about institutionalization, transparency, liquidity, professional investor relations and stringent risk limitations. It has become more much more expensive to run a hedge fund and investors are taking longer in their due diligence and writing smaller checks. In this environment, most small managers find it exceedingly difficult to raise capital and are open to the seeding model.
Seeding is absolutely critical to the future growth of the industry. The old saying goes that the first $100 mln is the hardest. Only a seeder gives a manager 50% and then works hard to support the business and raise the other 50% so that managers can focus on the portfolio. Without this critical support, fewer managers would get to scale and the industry would not be ready for coming waves of institutional allocations.
We want a robust and diverse hedge fund industry and our goal is to raise overall awareness of small and emerging managers. To that goal, SkyBridge hosted its first SALT (SkyBridge Alternatives) Conference earlier this year bringing together investors, managers and service providers. The conference was a huge success, and we plan to make it an annual event to promote and help increase awareness of the hedge fund industry.