Hedge Fund Seeding for Institutional Investors

A white paper from Larch Lane Advisors contends a hedge fund seeding vehicle is particularly appealing to investors that desire greater return potential than a typical hedge fund portfolio; diversification of a large multi-manager portfolio; an ability to capitalize on any potential growth of the hedge fund industry, not just its return potential; and returns approaching those of private equity, with potentially better liquidity.  

Hedge Fund Seeding  

A seeding vehicle commits capital to individual hedge funds, typically for three to four years. As those commitment periods expire, money is typically returned to seed vehicle investors. Capital that remains invested may be eligible for periodic withdrawal from the seed fund or may be subject to the standard liquidity terms of the seeded hedge fund. Specific liquidity terms vary depending on the seeding vehicle’s structure.  

Hedge fund seeding vehicles have characteristics of both hedge funds and private equity funds. This hybrid feature makes it more difficult to determine their proper role in an institutional portfolio. However, investors who are willing to consider an opportunistic strategy that does not fit neatly into a pre-defined investment silo may reap rewards. Larch Lane’s model found a seeding strategy exhibits a risk/return profile between traditional hedge fund and private equity strategies.  

To benefit from a hedge fund seeding strategy, prospective investors should have a multi-year investment horizon and be willing to tolerate short-term volatility, said David Katz, president and chief operating officer of Larch Lane Advisors LLC. 

Seeding Appeal  

Katz suggests hedge fund seeding is best for underfunded defined benefit (DB) that must identify other methods of generating returns to close the funding gap besides equities and bond funds, such as alternative assets, hedge funds, private equity and real estate. Larch Lane’s model shows a seed portfolio will generate quarterly returns +/- 3.87% from expected returns. (This compares to +/-3.78% from the Dow Jones Credit Suisse Core Hedge Fund Index and +/-5.51% from the Cambridge Associates LLC U.S. Private Equity Index.)  

Hedge fund seeding may appeal to investors that desire higher return potential than a direct investment in a hedge fund or fund of hedge funds, better liquidity than a typical private equity fund and overall portfolio diversification benefits. This strategy’s higher return potential stems from participation in the seeded fund’s revenue stream. A seeding strategy may exhibit lower volatility than private equity investments, while typically offering more liquidity.  

Larch Lane uses a model in which it creates private equity-like funds that accept capital commitments from investors. This capital is then drawn over time to make hedge fund seed investments. Unlike a private equity fund that would typically invest in operating or public companies, Larch Lane invests in new or early stage hedge funds. In exchange for a substantial capital commitment, the seeder typically receives either an ownership or equity interest in the seeded fund’s management company or a share of the seeded fund’s management and incentive fee revenues.   

Larch Lane focuses on investments in which the seeder receives a share of management and incentive fee revenues, rather than an ownership or equity interest. It believes a revenue share is the fairest dealfor the manager. Also, owning a passive revenue share rather than an equity stake involves less risk for the seeder, Katz said. Owning an equity stake in a hedge fund management company may subject the owner to potential liability, something that is much less likely in a revenue share deal.  

According to Larch Lane’s paper, the environment for hedge fund seeding is very attractive as high-quality, experienced investment professionals are leaving existing hedge funds and proprietary trading desks to start new funds. The Volcker Rule, legislation to limit banks’ trading of proprietary capital and to better monitor the banks, and other factors have created a robust pipeline of new fund launches.