Capital inflows into the hedge funds sector have reached record levels, but the emerging managers are still finding it harder than ever to raise capital. While much of the empirical research suggests that smaller fund managers have outperformed their larger counterparts, most new allocations have been concentrated in a handful of funds and strategies with assets in excess of $4 billion.
Smaller and emerging fund managers often go unnoticed by investors because they lack track records, face compliance restrictions, lack internal business resources and have few assets under management. It makes sense, therefore, for them to open up to alternative sources and models of capital raising, which can better attract investors by minimising their investment costs and risks. The first-loss capital or risk-based system is one such alternative way to raise funds outside the typical seed capital or limited partner accelerator channels. This art of seeding has gained importance in recent years, due to the current low-interest rate environment and the generally lagging performance of hedge funds. Given that historically, net hedge fund flows in the first quarter have been a good indication of what to expect for the full year, expectations for overall industry growth in 2022 should be tempered.
Industry Flows: Q1- 2022 brings redemptions to the majority of hedge funds strategies
Investors withdrew an estimated $8.96 billion from hedge funds in March, but the strong performance of some strategies (see table below) led to an increase in their assets, resulting in a decrease in the sector's overall assets under management, estimated at $3.623 trillion.
Overview of First-Loss Type Programs
In a first-loss capital arrangement, the capital provider typically allocates to a separately managed account, and the manager is required to contribute capital equal to a fixed percentage of at least 10% of the total managed account. The manager has discretionary trading power over the account and bears, as the name suggests, first losses. The flexibility of the fee structure makes it a valuable way for emerging hedge fund managers to attract sticky capital and broaden the investor base to investors who are not typically early-stage allocators.
Under the first loss guarantee, first losses up to 20% of the managed account volume are fully covered and 50% of any subsequent losses are also covered to a certain extent and under certain conditions. This fund seeding structure makes the cost-adjusted risk/return profile of the investment more attractive to investors than a traditional loss-sharing investment model.
Under this arrangement, the manager receives a higher-than-normal performance fee, and this fee will be higher the sooner any losses in the account are absorbed into the manager's capital. Indeed, within months of losses, the manager receives 100% of all future profits until it is restored and the guarantee amount is replenished in the modified account. Therefore, this seeding model is effectively a "win-win" account, as losses are first absorbed by the manager's capital account and then returned to the manager's capital account in the form of future profits.
Benefits for first-loss capital vs. Traditional Seed and Acceleration Capital
A first-loss managed account program should be seriously considered by managers when evaluating seed capital or acceleration capital. There are distinct advantages for managers entering the first-loss arrangement as opposed to a seed or acceleration relationship. The most significant advantage of first-loss over seed/acceleration is ownership.
The various restrictions of seed investments (including capacity rights, information rights, preferential redemption rights, capital or income shares, basic income shares for 5-10 years and, in some cases, in perpetuity) are some of the reasons why many managers choose to run first-loss managed accounts. By choosing first-loss managed accounts rather than standard seed or accelerator capital, managers retain their autonomy and discretion in managing their business.
In addition, first-loss managed accounts typically pay performance fees to managers on a monthly basis, which can provide the cash needed to manage day-to-day business operations, as well as hire and retain key employees. First-loss managed account programmes can also help to increase the visibility of managers, which, depending on the first-loss capital provider, can lead to additional direct allocations into their funds.
The basic benefits to the prospective managers
The basic benefits of the investment model may include the items listed below, but this list is not exhaustive, as there is no standard first-loss contract. It is a bespoke investment model, with each condition subject to discussion and agreement between the parties involved in the transaction.
High-performance payout – higher than industry standard performance payout
Increased capital base – the investors often allocate significant amounts of initial capital 25-100MM
Monthly payouts – the manager receives his split on the P&L on a monthly basis vs. having to wait till year-end or post an audit
Cost-effective and turnkey – the investors handle all of the set-up and administration-related costs
Establish a track record with the best ideas or second strategy – the track record is owned by the manager, and the manager may run portfolios that are different from the manager’s core fund.
Traditional allocations - some first-loss capital providers are affiliated with traditional allocation vehicles, such as multi-manager funds, or family offices and may use these managed accounts as a form of active due diligence and reference, to provide a traditional capital managers who have a consistent performance.
Fund manager considerations
Due to the bespoke nature of these arrangements, not all potential problems or considerations can be listed here. Managers who ultimately decide to participate in a first-loss capital or risk-based managed account program will need to discuss the structure of the arrangement and any disclosure issues with their legal counsel.
All aspects of the deal need to be examined, focusing on conflicts of interest, drawdown/volatility risks, the possibility of matching different terms for different investors (if a fund structure) and/or weighing the pros and cons of using managed accounts versus a fund structure. Managers entering into these arrangements may also need to review compliance procedures and may need to receive certain representations and warranties from the programme sponsor.
Conclusion
More and more investors and managers are participating in first-loss capital programmes for good reasons, including transparency, risk control and alignment of interests. First-loss capital programmes can be valuable for emerging managers, as they allow them to raise more capital, over a shorter period of time, and build quickly a reputation. But there are a number of pitfalls for the unwary, and many of these can be identified and mitigated by careful legal structuring. In short, first-loss capital arrangements are an area where careful legal consideration can produce tangible investments.