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    Seeding Top 5

The HFMWeek Seeding Top 5

HFM Week – November 23, 2016

 

In what is arguably a continuation of last year’s trend, news of seeding fund-raises and capital deployed in deals has been infrequent, with macro-economic and political events grabbing the majority of 2016’s headlines. “Activity in our view is probably down between a quarter and a third, and the cheques are smaller as well,” observes Gerhard Anderson, a senior associate at Seward & Kissel.

The data collected by HFMWeek* for seeding activity between November 2015 and October this year paints a similar picture. An estimated $965m was deployed over that period from traditional seeders, representing a 14% rise on the $847m spent for the corresponding 12 months in 2014/15.

Tickets have ranged from just over $20m to $75m with only one firm, Drobny, tending towards the larger end of the spectrum with a single, undisclosed deal worth $300m.  But of the $2.3bn in dry powder that was identified last year as being available in 2016, less than half appears to have been spent. Seeding has been relatively quiet for a number of reasons, participants indicate, and this must be assessed in a broader context: the industry has seen fewer launches get off the ground and less investor capital deployed. Allocators have pulled some $77bn from the space this year as of October, eVestment estimates.

“With market disruption beginning in the summer of 2015, continuing with Brexit and other events, it’s definitely been an environment where people are nervous and that means – for one – that they are a little bit more worried about investing in blind pools, and from the seeders’ perspective, they worry a little more about locking up capital,” Anderson says.

“I think managers are becoming a lot more realistic about what it takes to launch, how much it costs, the regulatory and asset-raising challenges,” Mark de Klerk, head of seeding at $2.4bn Tages Capital, says.

The result is less launch volume, with fewer but potentially better quality managers setting up alone, he adds.

“Perhaps 30% to 40% of the managers which, 10 years ago, would have just launched hoping to print some good numbers and raise decent amounts of capital, are now speaking to prime brokers, consultants, platforms and guys like us to make a much more informed decision about whether to launch on a stand-alone basis,” he says.

 

Dedicated vehicles vs opportunistic seeding

A trend becoming more prevalent is the split between dedicated seeding vehicles and allocators that prefer to seed on an opportunistic basis. Of the fi ve fi rms tracked by HFMWeek that have inked deals this year, Tages Capital, NewAlpha Asset Management and Stride Capital have dedicated funds, while Drobny Capital operates a “hybrid” model. A number of opportunistic, and signifi cantly larger, deals have also been reported. Canadian public pension PSP has written a €500m ($530m) ticket for AlbaCore Capital, the credit fi rm being launched by ex-CPPIB and GoldenTree pro David Allen, while Singapore-based HS Group has made its fi rst investment with a manager not trading Asia, with Vivian Lau’s OneTusk reportedly receiving an undisclosed allocation.

Dedicated and opportunistic approaches have their pros and cons, proponents argue. Seeders that have dedicated funds which raise a certain amount distribute it among managers for a defined lock-up before redeeming/recycling can face pressure to do a certain number of deals, regardless of how fruitful the pipeline is or the quality of managers available, one pro at a firm taking an opportunistic approach remarks.

“It becomes a problem when you have a lot of capital supply in the market and there’s competition for good opportunities, which I would argue we probably haven’t seen to a certain extent in the last couple of years,” the head of seeding for a dedicated fund concedes.

But having a dedicated fund with several prospects in it is the best way to maximise the chance of creating outsized returns, argues Stable Asset Management’s CEO Erik Serrano Berntsen.

“In theory, seeding has a significant portfolio effect –your losers don’t lose you much but your winners win a lot.

“With seeding you should be aiming for at least 10% returns, and if you have an outlier, they can effectively double that, so you want a number of them [in the portfolio],” he explains, adding that with the ad hoc model, the chances of finding that “outlier” are much slimmer.

 

UCITS interest

For Tages and NewAlpha, firms based in London and Paris respectively, there has been an increasing focus on onshore, UCITS structures over the past year.

“Our investors are quite interested in deals where they would seed more liquid or less leveraged versions of an investment strategy, and this is a trend we see increasing,” explains Philippe Paquet, managing director at NewAlpha.

Their ideal scenario is working with US managers who have built up a good track record running client money in managed accounts but may struggle to launch a fund with more than $10m to $15m.

“There are examples of managers annualising 20%+ with a standard deviation of 15%. That’s too high for our institutional continental European investor base, which prefers volatility of 10% or less, so in this case we ask the manager whether they would consider doing deal where they advise on or launch a modified UCITS fund,” he adds.

Tages’ de Klerk sees UCITS seeding as a natural extension of their activities backing offshore structures, and the development also ties in with the firm’s development of a dedicated UCITS platform. Indeed, three of its five seeding deals this year have been UCITS funds, although one recipient – Selwood – previously launched an offshore fund with Tages’ backing.

 

Buyers’ market?

Participants are unanimous in describing the last 12 months as a buyers’ market, although there isn’t necessarily agreement about whether this is good or bad for hedge fund managers looking for tickets.

“Quite a few clients are having a really hard time raising money, so the premier seeders are being a lot more discerning with investments that they’re making, and that may be also because some of them made investments that they weren’t really happy with in the past,” notes Meir Grossman, a Seward & Kissel partner.

“We’re very much an alignment of interest group. We’re not changing our terms with managers to squeeze them because the environment is favourable to us, we believe that we’ve got a structure that is sensible and aligns our interests and with managers and future LPs,” Don Rogers, founder and managing partner at Stride Capital, argues.

Those seeders that are being more discerning about future deals can potentially flex greater muscle regarding the agreement terms they strike, say Seward & Kissel’s Anderson and Grossman, pointing to increases in the level of revenue share being asked for by some players.

“We generally operate in the 20% to 25% range. If you start getting north of that, you squeeze the manager too hard and I’m not sure that’s good for the long-term business,” one seeder explains, caveating that where a more hands-on model is employed, providing infrastructure for example, a higher revenue share arrangement would be appropriate.

Anderson also points out that while revenue shares have crept up, there has been a “corresponding adjustment” to when the thresholds apply. “Where we’ve seen successful attempts to increase the top line [revenue] number, there are corresponding adjustments to the fee terms when the manager and its fund is still in a nascent stage, so that the effect kicks in when the business is managing $500m or more, for example.”

 

Future outlook

Regardless of the somewhat muted deal-making this year, many seeders are actually bullish on the year ahead, particularly if the environment remains as volatile.

The seeders tracked in our research have at least $2.5bn to put to work next year, HFMWeek estimates, an 8.7% increase on the dry powder figure recorded last year. That total includes commitments for new funds being raised by Blackstone’s alternative asset management unit and Stable Asset Management. The $70bn Baam unit has already raised over $1bn for its third Strategic Alliance fund and is targeting a final close of between $1.3bn and $1.5bn in the first quarter of 2017, while Stable, which has $150m committed so far, is eyeing a close at $450m over the same period. If their respective maximum fund-raising targets are met, it would take the available dry powder up to $3.3bn.

“Seeding is most attractive when there’s the highest level of discontent with the space, which I think typically coincides with dislocations in which many managers underperform – like in 2008 or during the recent period of volatility in the healthcare sector – or the end of bull runs, like today, where many managers have not kept up with the QE-driven beta bonanza,” says Stable’s Serrano Berntsen.

When there is great uncertainty or dislocation in the space, this also adds to a favourable environment, he says, citing 2008/2009 and now as periods when demand for hedge funds has been particularly low.

Stride Capital’s Don Rogers agrees that when sentiment towards the industry is “bad”, they have the best chances of finding “unique and exciting teams” and that it is the opportune time to back them. He admits that many managers in the space are blighted by poor returns and have been forced into crowded trades, but adds that the whole industry is being tarred with the same brush. “There are opportunities away from the larger parts of the industry, where there are substantial opportunities for fund returns and there firms that are under-financed, and that’s where we look to put our capital to work.”

Another possible driver of activity in the next few years is the potential roll-back of Dodd-Frank, in particular the Volcker Rule, should Donald Trump’s de-regulation plans come to fruition.

“If Dodd-Frank gets pulled back, then you could potentially see a lot of the big [bank] sponsors get back into the game,” Seward & Kissel’s Anderson and Grossman suggest, although priorities for the banks have evolved over the last five years and owning alternative managers may not be the focus.

“Taking a very conservative view of risk, as opposed to using a bank’s balance sheet to generate profits with prop investments, has been rewarded in large financial institutions over the past several years, and we expect banks to continue to promote strategies and personnel who are careful stewards of the institution’s assets who won’t rock the boat,” Anderson says.