Contributed by Gary Anderson, Partner at Seward & Kissel LLP
The overall climate for hedge fund seeding activity warmed considerably in 2018, as the hedge fund industry and the financial markets moved beyond the volatility of 2016 and the perception of being overheated in 2017, resulting in one of the busiest years we have observed for seeding activity in the last decade. Our data indicates that seed deal activity increased decisively year over year, with institutional seeders reasserting themselves as the dominant drivers of activity in the marketplace.
As in prior years, traditional long/short and macro strategies remained quite popular for seeders, as did other strategies which tend to have significant investment capacity. Further, strategies which are more resistant to fee compression pressures were in high demand, as were strategies that are able to provide favorable liquidity to their investors. Nonetheless, a number of capacity constrained and/or illiquid products were also funded; while these products tended to attract smaller day one investments, the strong expected return profile of these strategies created a compelling case and generated a number of seed investments in 2018.
With capital formation for new funds remaining a challenge, managers who were able to obtain a seed investment had a considerable head start for their businesses and ability to attract additional investors. The persistence of two- year (and longer) lock-ups as the market standard incentivized seeded managers to invest greater resources in their businesses and orient their decisions – both investment and operational – with an eye towards the long-term.
Our 2018 data suggests that the core economic terms of seed deals continue to reflect a trend toward more “manager-friendly” structures. Evidence of this includes a greater willingness of seeders to bear some of the start-up costs of the new business by phasing in – or outright suspending through a “hurdle” – the revenue share until the business has achieved a base level of revenue sufficient to fully fund its minimum capital requirements; these structures often include “catch-up” provisions when the revenue share is restored so as to ensure that the overall return to the seeder is not distorted. Seeders have also shown an increased willingness to be subject to a liquidity profile (post-lock-up) that is similar to other investors in the fund, particularly as it relates to the speed at which a seeder can exit its investment from the fund upon a lock-up release, or agreeing to be subject to the same “gates” and other liquidity management tools as other investors – a significant difference from the historical approach of seeders having highly preferential liquidity following the expiration of the lock-up.
Our 2018 study includes a retrospective of our historical data sets, allowing us to identify market trends which have developed over the last five years. This data shows a myriad of adjustments to the classic seed deal structure – demonstrating an increased willingness of seeders to be responsive to managers’ concerns of how to provide the best launchpad for their new businesses. This improved alignment between seeders and managers will help ensure that there remains a robust opportunity set for seeders and managers alike. Accordingly, we expect that seed capital will remain a key factor in a new manager’s path to success.
For more information about the current state of seeding, or seed transactions generally, contact your primary attorney at Seward & Kissel or Gary Anderson at anderson@sewkis.com. You may also wish to receive a copy of the article “Recent Developments in Hedge Fund Seeding”.
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