06/10/2010 Author: Elana Margulies

Joining forces

The flight to the security of big-name funds has seen many smaller managers struggle in a parched capital-raising environment. But for many, strategic partnerships and seeding deals are offering a way to tick due-dilligence boxes and harness the versatility of smaller funds

Asset Alliance Advisors (AAA) planned launch this fall of its Manager Participation Fund, which will predominantly seed emerging managers, comes at a time of conflicting approaches to investment in smaller managers. It’s a dichotomy that means for every investor willing to take a punt, like AAA, there are a multitude of others who just wouldn’t contemplate the risk.

Bruce Lipnick, founder of AAA, sees this divergence as an opportunity. An investor who is willing to take the risk, Lipnick points out that with lots of good managers struggling to gather assets, firms like his have started to become more open to forming strategic partnerships with small, talented, start-up hedge funds.  

“There is a big opportunity now in partnering with firms, the best I’ve ever seen,” said Lipnick. “We think this is a unique period. Funds can’t go out and raise $500m anymore.” The funds the Manager Participation Fund will seed and re-seed will typically have less than $50m under management, a two-year track record, have made money during the global financial crisis and have a solid infrastructure.

HFMWeek previously reported that AAA’s Manager Participation Fund will be the first time the New York-based firm is allowing outside investors access to its emerging manager programme. It intends to raise $250m-$500m – for a lucky few.

It is no secret that the majority of hedge fund managers with a small number of assets under management still have difficulty in capital-raising – even if they have a strong track record or solid pedigree. As a result, many have begun to entertain the idea of forming strategic partnerships with investors, at the expense of giving up equity or
revenue in the investment manager.

Davis Capital Management, which runs a fund primarily focused on S&P 500 large-cap equities, is one hedge fund manager currently open to the idea of a strategic partnership. Founder Eric Davis is open to forming a relationship with different types of seeders – including advisory firms/wealth managers, funds of hedge funds (FoHFs) or family offices. He argues it would accelerate the marketing process and catapult the fund into the orbit of pensions, endowments and foundations.

“The strongest reason for forming a strategic partnership is that the institutional community is very aware of the reputation of some of the potential partners out there,” he points out. “Going through the due-diligence process with the seeders is very helpful in raising money. Internally, they re-market the funds themselves and have industry contacts themselves. Their name alone carries some weight.”

Typically, there are three types of strategic partnerships. In an equity relationship, the investor owns a piece of the fund’s management company. In a revenue deal, the allocator doesn’t want any equity, but rather a percentage of the revenue. Finally, in a profitability relationship, investors want a percentage of the profits.

Ron Suber, senior partner, Merlin Securities, believes that of the three types of strategic partnerships, no single one dominates the industry but often a combination of two of the three options since hedge fund managers don’t want to give up equity. Some funds still baulk at this, but Suber certainly regards it as beneficial to business development.

“Institutional strategic investors often become an ally to help funds raise capital, and frequently appear as a stamp of approval or validation to other investors,” he said. “I think it’s been very successful for a small number of managers who have found the right seed investor who has been able to accelerate their growth and enable them to execute their edge.”

Most hedge funds who take on a strategic partner have less than $200m under management and give up 20-30% of the management company, depending on the amount of capital the partner puts in and the length of time that capital is locked up.

Others are willing to explore similar alternatives. Sam Hocking, global head of prime brokerage sales at BNP Paribas, said he has noticed that some hedge fund managers have decided to manage money on a full-service trading platform, where they trade the firm’s capital and construct a 50/50 revenue pay-out. “This initial step minimises the risk of setting up a fund and gives the platform seeding group a real look at who might be the next successful hedge fund manager,” he said.

Hocking added that if these managers perform well, the platform’s owners – with Citadel Investment Group and SAC Capital Advisors among them – may allow them to start their own hedge fund and seed them with capital.

Although there is no set duration for a strategic partnership, if either the investor or manager wants to part ways, they can agree to separate and the manager can buy out a seed investor at a specific metric, depending on the clause of the original deal. Meaning that once the duality of being a small fund has been eased, the partnership is dissolved and the manager can become a single entity again.