SAN FRANCISCO (MarketWatch) — Managers in the $2 trillion hedge fund industry increasingly are tapping a source of money known as first-loss capital as they compete to raise assets and make their businesses more sustainable.
Topwater Investment Management LLC started providing this type of funding in 2002, but the firm says there’s growing interest in it lately.
“We are currently in a sweet spot, as we are seeing a lot more talent without sufficient capital that we have been able to partner with in a mutually beneficial way,” said Bryan Borgia, who founded South Norwalk, Conn.-based Topwater with Travis Taylor.
Borgia wouldn’t disclose how many hedge funds Topwater has backed, but he said the firm expects to double the number of managers on its platform in the next nine months.
Hedge funds typically charge 2% management fees and they get about 20% of any profit each year. First-loss capital changes this in a big way.
Allocators like Topwater usually invest about $45 million as long as hedge fund managers agree to put up 10% of that from their own wallet — in this example $5 million.
Topwater pays a performance fee on the $45 million that’s more than double the industry standard of 20%. This fee is paid monthly, if the manager makes a profit in the period.
However, if the manager loses money during any month, that money comes out of their own capital and Topwater’s $45 million remains intact. In this way, the hedge fund managers put themselves in the “first-loss” position, in return for the capital.
For new hedge funds and other managers looking to lift assets under management, this arrangement can be attractive. That’s partly because they don’t have to give up a stake in their business to raise the capital.
So-called seeding firms have been around for decades. They invest with new and emerging hedge funds, but often demand an equity stake in the business. That’s a concession many managers are loath to make.
Another benefit is that first-loss capital can help hedge funds increase assets under management quickly. That’s especially important now because a wave of new managers have launched funds in the past year or so. Read about the lack of fuel for launches here.
In the wake of the financial crisis, many investors were reluctant to back new or smaller hedge funds, leaving managers looking for different sources of capital.
“This method of funding is creative and much more widely accepted by managers than most people think as it provides rapid acceleration of assets under management,” said Ron Suber, senior partner at Merlin Securities, a hedge-fund brokerage.
If managers can generate steady returns, first-loss capital can increase cash-flow through monthly performance fees, Suber explained.
That’s important for smaller hedge fund firms that may be struggling to cover their costs from annual management fees collected on lower asset bases, he added.
For investors, first-loss capital gives them exposure to potentially high returns generated by new hedge funds, while protecting their money in case managers suffer losses.
“New investor groups are entering this method of capital allocation,” Suber said.
Freestone Capital, a Seattle-based wealth-management firm, became a big investor of Topwater’s in 2004 and in 2009 the two firms formed a joint venture to pursue first-loss capital further.
More recently in the game is Prelude Capital, which allocates $10 million to $50 million to emerging hedge funds. The New York-based firm says it pays managers “an above industry average” performance fee in return for “contributing a nominal portion of first loss risk capital.”
The downside for managers is that, if they suffer a big monthly loss, they lose their own money quickly. And first-loss capital providers can pull their money fast to protect their investment.
There may also be some baggage about the reputation that comes with what some in the hedge fund industry call acceleration capital. One hedge fund manager told MarketWatch that he wouldn’t want other investors knowing if he accepted this type of funding.
However, the benefits seem to be outweighing the risks for many managers. That’s especially true if they believe strongly in their investment strategy and are willing to put more of their own money on the line to support it.
Another benefit of Topwater’s approach is that managers get a chance to recoup monthly losses. So if a fund is down $100,000 in one month, that comes out of the manager’s own capital. But if the manager makes $100,000 the following month, all that money goes towards topping his or her capital back up.
First-loss capital isn’t just for new hedge funds either. Topwater also provides this type of funding for existing managers who want to start a best-ideas fund or even set up a single-themed trade that can only support a limited amount of capital.
View more information: https://www.marketwatch.com/story/more-hedge-funds-lured-to-new-source-of-capital-2011-05-23