Hedge Funds Benefit From Seeding

June 6, 2011

We’ve written before on how prop traders and other talented investment managers are starting hedge funds using “seeder” capital from established hedge funds and private equity firms.

Fortune recently examined the flip side of the issue, and why these big firms are now looking at seeding as a way to continue to pad their asset base and profits.

Seed capital is an early stage injection of money that enables a manager to kick-start his or her new hedge fund. Some seeder funds also provide hedge fund marketing support, risk management, back office help, and, if the investment is from a prestigious firm such as Larch Lane, Blackstone or SkyBridge, there’s an implied stamp of approval that carries the aura sense of success.

In return, the seeding firm gets to cut a handsome deal. Seeders often get a combination of an equity stake in the new hedge fund, plus a percentage of the fee income generated by the assets acquired by the new fund for a period of time.

And that’s the rub. Some hedge fund purists such as legendary investor Michael Steinhardt claim that big hedge funds have become nothing more than asset gatherers. Content to live off management fees and achieve mediocre results, rather than aiming for alpha. By rolling the dice with these new seeded hedge funds and taking a cut of their fees, critics claim they are perpetuating that role.

But the financial crisis has changed the playing field for hedge fund managers. Investors are more wary of giving their money to even established hedge funds. And hedge fund start ups are finding it extraordinarily difficult to raise capital. This environment is giving established hedge funds even more leverage to negotiate lucrative deals when seeding new hedge funds.

And if the seed capital enables a hedge fund startup to balloon to $1 billion in assets, the seeding firm reaps the benefit from their percentage of the management fees.

What’s your take? As markets rebound, do you think more and more big banks, private equity firms and hedge funds will look to seeding as a safe way to add to their bottom line?

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