# Hedge fund seeding via fees-for-seed swaps under idiosyncratic risk (2022)

ScienceDirect

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Volume 71,

October 2016

, Pages 45-59

## Abstract

We develop a dynamic valuation model of the hedge fund seeding business by solving the consumption and portfolio-choice problem for a risk-averse manager who launches a hedge fund through a seeding vehicle. This vehicle, i.e. fees-for-seed swap, specifies that a strategic partner (seeder) provides a critical amount of capital in exchange for participation in the funds revenue. Our results indicate that the new swap not only solves the serious problem of widespread financing constraints for new and early-stage funds (ESFs) managers, but can be highly beneficial to both the manager and the seeder if structured properly.

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## Introduction

There has been a significant increase in both the number of hedge fund seeders and the amount of capital available for hedge fund seeding since the aftermath of 2008׳s market upheaval.1 However, there still remains a tremendous shortage of capital for new and early-stage funds (ESFs). This is mainly because most capital providers or institutional investors increasingly focus on larger established hedge funds whose assets under management (AUM) are usually larger than 1 billion and who are considered highly credible. Additionally a larger talent pool of ESFs managers is now competing for the scarce available seed capital. Worse still, barriers to entry for ESFs are much higher today than in the period before the 2008 financial crisis.2

Therefore, navigating the terrain to a successful launch of a hedge fund has become more difficult and the financing constraint faced by ESFs managers nowadays is much more serious than before. In order to reach the initial AUM target and cover organizational expenses, more and more ESFs managers are likely to turn to seed investors for early stage of capital through a seeding vehicle. This is an arrangement to which we refer as fees-for-seed swap that specifies that a seed investor (or seeder) commonly commits to providing a remarkable amount of seed capital to an ESFs manager as an “anchor investor” in a new fund in exchange for a share of “enhanced economics” which is usually the fees that the ESFs manager generates from the entire pool of assets in the fund. If structured properly, the seeding approach can be highly beneficial to the ESFs manager and to investors who provide the seed capital. It is not uncommon that the hedge fund seeder receives a portion of the hedge fund׳s revenue stream to get greater return potential than an ordinary investor.

In general a seeder can expect about 1% of revenues for each\$1 million of seed capital for seed transactions no larger than\$50 million. However, seed arrangements can vary substantially based on factors such as the experience of the manager, the alpha record, the amount of seed capital provided, the withdrawal and lock-up period terms, and the relative negotiating power of each party.3

While the seed investor will often demand the flexibility to redeem her4 investment as soon as possible, the manager needs (and should require) the seed capital to remain invested for a period sufficient to set its strategy, create a track record, and procure other investors. Generally, during the lock-up period, the seed investor should be prohibited from redeeming the investment if, in the reasonable judgment of the manager, doing so could adversely affect the interests of the other investors in the fund.5

The ordinary investors may withdraw capital if the fund shows poor performance. For simplicity, we assume that the withdrawal rate is constant. This is a common assumption in the hedge fund literature and has been employed by Goetzmann et al. (2003) and Lan et al. (2013). Also, depending on the terms of the deal, the seeder will generally commit to keep the investment in the fund for a defined lock-up period, typically two to four years. It makes sense to assume that during this initial phase, idiosyncratic risks take a more pronounced role as compared to later stages in the fund׳s life, possibly due to ordinary investors entering (or leaving) the fund and/or the fund manager experimenting with different asset classes in order to set up a successful strategy. As seed commitments expire, AUM will be divided among the ordinary investors, the seeder, and the ESFs manager according to a ”waterfall” schedule.6 After the initial seeding stage, the fund becomes more stable and in our idealized setup we assume that the ESFs manager no longer bears any idiosyncratic risk after the lock-up period has been completed. Therefore, we can apply Goetzmann-Ingersoll-Ross׳ (Goetzmann et al., 2003) model to calculate the market value of the fund at termination of the lock-up period. While the manager׳s performance incentives during the lock-up period are implemented through a waterfall schedule, performance incentives after the lock-up period are provided by a high-water-mark (HWM) incentive, compare (Goetzmann et al., 2003).

As there is no publicly available data on the historical performance of seeding strategies, there are only very few simple models in practice focusing on hedge fund seeding return, volatility and liquidity profile.7 To our knowledge, this paper provides the first dynamic framework on valuation of the hedge fund seeding business by solving the portfolio-choice problem for a risk-averse manager.

Several other studies evaluate the performance of hedge funds focusing on different aspects. Goetzmann et al. (2003) provide the first quantitative inter-temporal valuation framework of investors׳ payoff and managers׳ fees in a setting where the fund׳s value follows a log-normal process and the fund managers have no discretion over the choice of portfolio. Carpenter (2000) shows that it is optimal for hedge fund managers who face no explicit downside risk to choose infinite volatility as asset value goes to zero. This behavior is referred to as risk-shifting. Basak et al., 2007, Hodder and Jackwerth, 2007 and Aragon and Nanda (2012) argue though that a manager׳s convex payoff structure does not necessarily induce risk shifting when the fund shows poor performance as long as the manager is exposed to downside risk, either through her ownership of fund share or through her annual fees. Panageas and Westerfield (2009), and Lan et al. (2013) analyze the impact of management fees and high-water mark based incentive fee on leverage and valuation. None of these studies, however, model the hedge fund seeding innovation in the context of the ESFs manager׳s portfolio choice problem, and hence they do not assess the costs of illiquidity and unspanned risk of hedge fund seeding investments.

Our article also relates to the literature about valuation and portfolio choice with illiquid assets, such as restricted stocks, executive compensation, illiquid entrepreneurial businesses, and private equity (PE) investments. For example, Kahl et al. (2003) analyze a continuous-time portfolio choice model with restricted stocks. BothChen et al. (2010) and Wang et al. (2012) study entrepreneurial firms with unspanned idiosyncratic risks under incomplete markets. For PE investments, Sorensen et al. (2014) develop a dynamic valuation model of PE investments by solving the portfolio-choice problem for a risk-averse investor, who invests in a private equity fund, managed by a general partner. We are unaware, though, of any existing models that capture the illiquidity, managerial skill (alpha), risk attitude and compensation of the hedge fund seeding business. Capturing these important features in a model that is sufficiently tractable to determine the subjective value of fees in the hedge fund seeding business is one of the main contributions of this study.

The paper is organized as follows. Section 2 presents a dynamic valuation framework for modeling hedge fund seeding innovation and the impact of incentive contracts, managerial stake and hedge fund liquidation on a risk-averse ESFs manager׳s consumption and portfolio-choice behavior. A solution for this model is derived in Section 3. 4 Breakeven alphas and seed costs, 5 Seeding investments with lock-up period, subjective value of fees, and idiosyncratic risk discuss numerical results for breakeven alphas, seed costs and subjective value of management compensation. The main conclusions are summarized in Section 6. The appendix provides detailed computations relating to the market value of the hedge fund after the initial seeding stage.

## Hedge fund seeding investment opportunities

We consider an infinitely-lived risk-averse ESFs manager who has the opportunity to launch a take-it-or-leave-it hedge fund at present time 0, which requires to raise the target AUM S0. All sources of uncertainty arise from two independent standard Brownian motions B and Z defined on a filtered probability space $\left(\Omega ,\mathcal{F},\left\{{\mathcal{F}}_{t}:t\ge 0\right\},\mathbb{P}\right)$, where $\mathbb{F}\equiv \left\{{\mathcal{F}}_{t}:t\ge 0\right\}$ describes the flow of information available to the seeder.

## Model solution

In this section, we first derive seed costs with fees-for-seed swaps for the ESFs manager and the breakeven alpha for the ordinary investors. Then we analyze the manager׳s consumption and portfolio choice in a dynamic valuation model taking account of illiquidity, ESFs managers׳ value-adding skills (alpha), incentive compensation, and the fees-for-seed swap. However, the idiosyncratic risk which is present in the hedge funds seeding business invalidates the standard two-step complete-markets

## Breakeven alphas and seed costs

We have derived the solution of the fees-for-seed swap portion ψ referred to as the seed cost and the subjective value of the ESFs manager׳s compensation in Section 3 In this section we provide some numerical results in order to develop more economic intuition. Baseline breakeven parameters are chosen according to Sorensen et al. (2014). Table 1 summarizes the parameter values used in our baseline breakeven case.

## Seeding investments with lock-up period, subjective value of fees, and idiosyncratic risk

In this section, we further analyze the effects of the lock-up period, seeding investment, and idiosyncratic risk on management compensation, illiquidity discount, and the economic value of the fund.

## Conclusion

In this article, we developed a dynamic valuation model for the hedge fund seeding business by solving the consumption and portfolio-choice problem of a risk-averse manager who launches a hedge fund through a seeding vehicle. As traditional approaches to attract the initial AUM and covering of organizational expenses becomes much harder for ESFs managers in a much tighter financial landscape, nowadays more and more ESFs managers are likely to turn to seed investors for early stages of capital

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View full text

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## FAQs

### What is seeding in hedge funds? ›

A seeding vehicle commits capital to individual hedge fund managers for a certain number of years and as those commitment periods expire, money is available to be reinvested or returned to investors in the seed vehicle. If reinvested, the money may be subject to the standard liquidity terms of the seeded hedge fund.

### What is seeding in private equity? ›

A seed deal is essentially an agreement by an investor to invest an agreed (often significant) amount of capital in a manager's fund for a locked-up period in exchange for participation in the manager's business and/or certain other beneficial investment terms.

### How do new hedge funds raise money? ›

A hedge fund raises its capital from a variety of sources, including high net worth individuals, corporations, foundations, endowments, and pension funds.

### What is a hedge fund incubator? ›

An incubated fund is a fund that is first offered privately in an incubation period. Investors in this type of fund are usually employees associated with the fund and their family members. Hedge funds also commonly use incubated funds to test new strategies and offerings.

### Do you have to pay back seed funding? ›

If it is a small enough amount of money, you'll be able to pay them back over time even if the venture fails. If the venture succeeds, you can pay them back quickly and you have not given up any stake in the company.

### Is seed funding private equity? ›

The term seed capital refers to the type of financing used in the formation of a startup. Funding is provided by private investors—usually in exchange for an equity stake in the company or for a share in the profits of a product.

### What do seed investors get in return? ›

The TLDR; seed investors shoot for a 100x return; Series A investors need an investment to return 10x to 15x and later stage investors aim for 3x to 5x multiple of money. This translates into portfolio returns from 20% to 35% targeted IRRs.

### Can you start a hedge fund with no money? ›

Yes, you could start with much less capital, or go through a hedge fund incubator, or use a “friends and family” approach, or target only high-net-worth individuals. But if you start with, say, \$5 million, you will not have enough to pay yourself anything, hire others, or even cover administrative costs.

### How do you pitch a hedge fund? ›

A hedge fund pitch should be structured as follows:
1. Identifying the firm.
2. Investment strategy.
3. Performance results.
4. Marketing strategy.
5. Firm management.
6. Equity knowledge.
28 Apr 2021

### What is the biggest hedge fund in the world? ›

Bridgewater Associates

### How much does it cost to start a hedge fund incubator? ›

How much does it cost to establish an incubator fund? One of the primary catalysts for the growing popularity of the incubator fund is its cost effectiveness. Generally, an incubator hedge fund can be created for \$2,500 – \$3,500, plus state filing fees to establish the fund and the management company.

### Do incubators provide funding? ›

Most accelerators and incubators provide mentorship and funding to startups in exchange for some equity, while others do it for a separate programme fee. Both programmes mentor startups and help turn promising ideas into sustainable businesses.

### How are incubator funds taxed? ›

An incubator fund is generally set up using a pass-through fund entity (typically a Delaware limited partnership). The fund's realized income and gains are only taxed at the individual level for federal income tax purposes. Taxation at the state level will vary depending on state.

### What percentage do seed investors take? ›

Seed capital rounds: (founders, F&F, employees and angel investors): expect anywhere from 10 percent to 25 percent as a normal range, with a median 15 percent dilution to be realistically expected. Series A round: 25 percent to 50 percent dilution is the typical range.

### How much equity should you give a seed investor? ›

"There is no set standard, the amount of equity will depend upon the valuation and amount raised. However, as a target figure, founders shouldn't share more than 33% of the equity in a seed round."

### How much is seed funding usually? ›

Pre-seed vs. Seed Funding
Pre-Seed FundingSeed Funding
Funding AmountWithin \$100 – \$250k rangeLess than \$5 million.
1 more row
7 May 2022

### Why do startups need seed funding? ›

Corporate Seed Funds

Usually, mega-corporations and tech giants are looking for a way to invest in new innovation that they may spot in the market. This source of funding brings big visibility for the startup brand and is usually an early indication of an acquisition in the future.

### How much do companies give away in seed round? ›

In a series A round, founders are advised to give up around 20-25% of equity to investors. These equity investments are often dependent on the kind of startup or business. Some businesses may give up more, while others must give out less equity.

### Is seed money considered income? ›

Your balancesheet will reflect the seed money as your equity (ownership) in thecompany. It isn't income. Income is money that comes into thebusiness as a result of sales or interest on invested money. Yourseed money is investment capital, and you're the investor.

### How much equity do you get at seed stage? ›

The general rule of thumb for angel/seed stage rounds is that founders should sell between 10% and 20% of the equity in the company. These parameters weren't plucked out of thin air, they're based on what an early equity investor is looking for in terms of return.

### How do you raise capital for a fund? ›

How to raise capital for a startup: 6 capital raising strategies
1. Fund it yourself. It might not sound ideal, but dipping into your personal savings is probably the easiest way to raise capital for a startup. ...
3. Crowdfunding. ...
4. Angel investment. ...
5. Personal contacts. ...
6. Venture capitalist.

### How long does it take to raise a fund? ›

Raising a fund can take substantially longer than raising money for a single investment. Depending on interest from investors and the timeline to complete compliance requirements, a sponsor should expect to spend at least six months on a fund, and the process can often take more than a year from concept to close.

### How do I get investors for my hedge fund? ›

There are many potential sources of investors, including:
1. Seed-capital providers.
2. Family and friends.
3. High net-worth individuals.
5. Wealth-management offices and RIAs.
6. Single- and multi-family offices.
7. Fund of hedge funds.
8. Corporations.
12 Mar 2021

### How do I start my own investment fund? ›

How to legally start a hedge fund
1. Define your strategy. The first thing you need to do is define your investment strategy as clearly as possible. ...
2. Incorporate. ...
3. Complete the proper registrations. ...
4. Write your investment agreement. ...
5. Get your team together. ...
6. Market yourself. ...
7. Launch.

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