Seward & Kissel partner Gerhard Anderson explores the latest trends in structuring seed investments.
Capital-raising is a major hurdle for hedge funds and other alternative asset managers. Without AuM, fledgling managers with considerable talent are weighted down by the significant working capital requirements of managing an investment advisory business in an ever-more competitive and highly regulated industry. Yet, amid an increasingly challenging environment, top managers have been able to marshal high expectations of future performance – both in asset management prowess and fundraising ability – to address this problem and secure their best chance at future success by entering into a seed deal.
At its core, a seed deal is an agreement by a large investor to allocate a sizable amount (frequently $50m to $100m) to a manager, often locked up for two years, in exchange for a share of the economics in the manager’s business (and certain other investment enhancements).
In some sense this share is “found” money for any investor who is willing to make a large allocation to a new fund manager. The seeder’s risk is generally limited to the risk profile of the strategy (admittedly somewhat increased due to the relative illiquidity of the investment during the lock-up period), but the return profile is linear (ordinary investment returns) and exponential (a share of the business that was effectively purchased for nothing other than an incremental increase in risk).
This enhancement provides large investors considerable incentive to make seed investments; indeed, a large number of new players have emerged to pursue these deals, including large family offices, non-bank financial institutions and pension funds, adding to the historical landscape of seeders, which primarily consisted of investment funds with a seeding mandate and existing fund managers who seed their top investment talent when they spin out.
From the manager’s perspective, a seed deal can be highly attractive. In addition to providing a stable asset base at the inception of the business (creating dependable cashflow and scale), a seed investment provides a new manager with the implied endorsement of a major institution – a “Good Housekeeping seal of approval”, if you will.
The benefits of scale go beyond pricing power in negotiations with vendors and a greater ability to get preferential allocations of new investment opportunities. Very large institutional investors have difficulty allocating capital in increments under $10m, $20m or more, so it is difficult for them to invest in new hedge funds where they will immediately represent a large percentage of the fund’s asset base, either because internal policies or other regulatory or tax reasons may prevent them from owning more than a certain percentage of a fund. Accordingly, a seed investment provides a large, stable asset base which allows other institutions to make investments in these funds without being the largest investor – an essential step on the path to growth for a manager.
In short, the foregoing motivations provide both sides with excellent incentives for pursuing a seed deal – a transaction which, at its core, is a partnership, although the challenges in forming and negotiating its terms are ever-present.
While a manager easily understands the benefits of a seed deal, they are also keenly aware of the limitations on autonomy that entering into financial partnerships often bring; indeed, many managers strike out on their own precisely to gain autonomy over their business activities, from a portfolio management stand point and to be able to craft and execute their vision for an ideal business.
A seed deal, likewise, presents similar challenges for the seeder, including that even as a passive owner (particularly as it relates to investment decisions) the spectre of reputational harm or liability for investment misfires (or worse) of the manager looms. Fortunately, careful structuring of a seed deal can, to a large extent, address these concerns without losing the efficiencies and advantages of a conventional partnership structure. There are essentially three main structures for seed deals:
(i) an equity interest in the manager (sometimes with the economics calculated as a percentage of profits or revenue)
(ii) a contractual revenue share
(iii) a special interest in the fund itself that receives the prescribed economic entitlement
An equity interest, while on the face of it is an obvious way to structure a seeder’s participation, has fallen out of favour for a number of reasons. It has the perception of increased liability, increased regulatory scrutiny, a loss of anonymity and aloss of autonomy for the manager.
Seeders do not want to be owners in the business due to potential reputational harm, or worse, being tied as deep-pocketed owners to massive losses due to a fund strategy’s failure, and few seeders will take the risk – however small – that the “corporate veil” protection enjoyed by limited partners and shareholders in a business could be pierced.
Likewise, regulatory requirements continue to increase for investment advisors, and in addition to possible required disclosure on a manager’s Form ADV, regulations and best practices suggest that a seeder that directly owns a manager may be subject to its compliance and other internal policies and procedures.
Managers also have reasons to disfavour a seeder having a direct stake, as this structure requires significant amendments to their operating agreement to include a variety of provisions which protect the seeder (typically including oversight over expenses, borrowing, hiring, etc.). This can ultimately create a severe loss of autonomy for the manager and negotiating these amendments is usually quite complex and expensive.
Almost all of these problems can be addressed by structuring the seed economics as a contractual payment. In such an arrangement the seeder is no longer a “bottom line” owner of the business, and an investor in a fund who happens to receive additional payment for its early investment would seem a tenuous link on which to build a case for liability if a fund blows up. But this structure includes some notable tax-driven inefficiencies. The portion of the seeder’s revenue share, which is based upon the carry allocated to the investment manager, loses the ability to be treated the same as the underlying gains of the fund (notwithstanding the changes to how carry is treated for the managers under the 2017 tax reform). Additionally, in the event of the sale of the manager (or an equity stake in the manager), the seeder’s share of the purchase price would not be eligible for long-term capital gains – as any share of the purchase price paid to the seeder would most likely be characterised as a termination of a contractual payment, not a purchase by the buyer of a capital asset. For these reasons, the contractual revenue share approach is also typically disfavoured.
There is a third structure which retains the best attributes of the equity stake and contractual revenue share structures and largely solves the negatives. Seed investors can instead structure their economic participation as a special limited partnership (SLP) interest in the manager’s underlying fund vehicles. The agreement then provides that the seeder will receive its revenue share through the SLP interests, which allows for the allocation of the revenue share from fund profits – thereby preserving the same character of gain as the underlying investments.
Moreover, in the event of a sale of the manager, the seeder is granted rights to cause the buyer to purchase a proportional amount of the SLP interest, a capital asset, from the seeder, which should generally allow them to receive long-term capital gains treatment. Beyond tax efficiency, in an SLP structure the seeder is not an equity holder of the manager, and therefore both have a far superior liability profile and the seeder receives its economics off the top and so will not be subject to any expenses of the business.
Through careful tax planning, this structure can even be used where a seeder is making a working capital investment in the manager. In addition, as the seeder is not an equity owner in the manager, the manager is able to retain some additional autonomy in running its business. For this reason, very few seed deals are now structured to grant an equity interest in the manager or a con- tractual revenue share.
The SLP approach represents the “state of the art” in seed deals and is used in the vast majority of arrangements.
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