Hedge Fund Seeding: Why the Interest?

Transcription

1 Prepared by Larch Lane Advisors LLC July 2012 This paper is for informational purposes only and is not intended to be, and should not be construed as, an offer to sell, or the solicitation of an offer to buy, any interest in any hedge fund seeding vehicle or any other investment vehicle. The performance examples, illustrations and discussions set forth in this paper are for illustrative purposes only and do not represent the performance of any actual seed vehicle. This paper contains statements which constitute forward-looking statements. These statements include statements regarding the intent, belief or current expectations of Larch Lane Advisors LLC and are characterized by words such as could, will, tend, intend, may, believe, potential, possible, and expect, among others, or the negatives thereof or other variations thereon. Actual results or outcomes may differ materially from those in the forward-looking statements.

2 PAGE 1 Executive Summary 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 and other factors have created a robust pipeline of new fund launches. However, as most allocators increasingly focus on larger hedge funds, there is a shortage of capital available to new funds. Hedge fund seeding may appeal to investors who 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.* Many hedge fund seeders use private equity structures to provide long-term, stable capital to the funds they seed. As a result, seeding strategies have both hedge fund and private equity characteristics. For this reason, institutional investors often struggle to decide which bucket to allocate from when contemplating a hedge fund seeding strategy. To benefit from a hedge fund seeding strategy, prospective investors should have a multiyear investment horizon and be willing to tolerate short-term volatility. Larch Lane Advisors LLC ( Larch Lane ) is one of the first dedicated providers of hedge fund seed capital. Starting in 2001, Larch Lane has seeded 26 hedge funds through three investment vehicles. 1 * There is no guarantee that any of these benefits will be achieved. As with any investment, an investment in a hedge fund seeding vehicle could lose value. Please refer to Important Disclosures at the end of this paper.

3 PAGE 2 Introduction Over the past few years, there has been a significant increase in both the number of hedge fund seeders and the amount of capital available for hedge fund seeding. According to HFMWeek research, in November 2011, seeders had approximately $4.6 billion in available capital, compared to approximately $1 billion just one year earlier. 2 The favorable environment for this investment strategy is a major driver of the recent boom. There is a deep talent pool as the Volcker Rule is leading many experienced investment professionals to flee bank proprietary trading desks to launch funds. Despite the recent growth in available seed capital, there remains a shortage of capital for new funds because most capital allocators increasingly focus on larger established hedge funds and a larger talent pool is now competing for the available seed capital. Hedge fund seeding is a way for investors to potentially capture hedge fund returns while also sharing in hedge fund revenues. High quality hedge fund managers require long-term, stable capital from potential seeders, who typically provide such capital through a private equity vehicle. Consequently, hedge fund seeding is a hybrid investment incorporating both hedge fund and private equity features. In this paper, we provide background on how Larch Lane approaches hedge fund seeding, including a discussion on the structuring and return components of a hedge fund seeding vehicle. We then compare the return, volatility and liquidity profiles of seed funds, traditional hedge funds and private equity investments. Because there is no publicly available data on the historical performance of seeding strategies, we explain and apply a simple model we have constructed to project returns and cash flows for a seed fund. We then incorporate features of our seeding strategy to create a more accurate seed fund return profile. Finally, we discuss where a hedge fund seeding strategy fits into an institutional portfolio. Background: The Larch Lane Model Larch Lane uses a model in which we create private equity-like funds that accept capital commitments from investors. This capital is then drawn over time to make hedge fund seed investments. 3 Unlike a private equity fund that would typically invest in operating or public companies, we invest 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 where the seeder receives a share of management and incentive fee revenues, rather than an ownership or equity interest. We believe a revenue share is the fairest deal for the manager. Also, owning a passive revenue share rather than an equity stake involves less reputational risk for the seeder. 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. Potential Hedge Fund Seeding Returns A seeder may have greater return potential than other investors in a hedge fund precisely because the seeder receives a share of the hedge fund s revenues. Thus, the seeder s return increases in tandem with any asset growth of the seeded hedge fund. Figure 1 compares the potential returns of a typical limited partner ( LP ) in a hedge fund to the potential returns of a seeder who shares in the fund s revenues. In this example, the seeder is allocated 20% of the manager s gross revenues from the fund in exchange for $100 million of initial capital. The illustration assumes the fund earns a gross return of 10%, has asset growth of up to $1 billion, and charges a management fee of 1.5%, with an incentive fee of 20%.

4 PAGE 3 F I G U R E 1 Seeders May Enjoy Enhanced Return Opportunities 4 Net Return 14% 12% 10% 8% 6% 4% 2% 0% $100 $200 Net return to seeder Net return to regular LP investor $300 $400 $500 $600 $700 $800 $900 Seeded Fund AUM ($millions) These are model results for illustrative purposes only and do not represent the actual performance of any seeded hedge fund or hedge fund seeding vehicle. Actual results will vary from fund to fund. There can be no assurance that a seed investor will realize such enhanced return or that a seeded hedge fund will be able to raise capital. The model results do not include any management or incentive fees that a seeding vehicle may charge its investors. As with any investment, an investment in a hedge fund seeding vehicle could lose value. F I G U R E 2 $1000 As shown in Figure 1, which applies the above assumptions, the net return on investment to the seed fund is always higher than that of a regular LP in the same hedge fund. Even in unusual cases where a fund raises no additional third-party assets, the seeder generally receives a fee rebate through a share of the management and incentive fees applied to the seed capital. A more detailed comparison of returns between a seed fund and a traditional investor can be found in the Appendix. Figure 2 highlights how the return of a successful seed investment varies over time. Typically, in the first several years after seeding a fund, the fund s performance provides the vast majority of the investor s return. Over time, assuming that the fund s assets under management ( AUM ) grow, more of the return comes from the seeder s share of the fund s revenues. Assuming continued operation of the seeded fund, the seeder generally continues to receive a revenue share even after redeeming the initial seed capital. These annuity-like payments may continue as long as the seeded manager operates profitably. Also, depending on the deal terms, there may be a provision for the manager to buy out the seeder s interest or for the seeder to participate in a monetization event such as a sale or public offering of the fund. This could significantly enhance the seeder s return. Composition of a Seeder s Return Over Time RELATIVE CONTRIBUTION TO RETURN Capital is returned and investment risk ceases Seed Monetization Seed Investment Return Seed Revenue Share Revenue Share increases with third-party AUM in seeded funds and may continue as long as the fund remains active. Year 1 Year 5 Year 10+ Seed capital invested Seed capital redeemed Monetization event These are model results for illustrative purposes only and do not represent the actual performance of any seeded hedge fund or hedge fund seeding vehicle. Actual results will vary from fund to fund. There can be no assurance that a seed investor will realize such enhanced return or that a seeded hedge fund will be able to raise capital. As with any investment, an investment in a hedge fund seeding vehicle could lose value. Source: Larch Lane Analysis

5 PAGE 4 Methodology for Calculating the Return of a Model Seed Portfolio Returns for hedge fund seeding vehicles are not generally reported publicly. 5 In order to analyze a seeding fund s potential performance and compare it to other investments, we developed a model for the return profile of a seeding strategy. We assume that the seed fund provides $100 million of seed capital to nine funds, each of which follows one of the strategies represented by the Dow Jones Credit Suisse Hedge Fund Index ( DJCS Index ), excluding a dedicated short equity strategy. 6 We exclude the dedicated short equity strategy from the model seed portfolio based on Larch Lane s view that such a strategy is not generally appropriate for seed capital. Next, we assume each seeded fund (i) launches with an additional $50 million in third party assets; (ii) generates the return reported for the applicable DJCS strategy index for the 10-year period ending September 30, 2011; (iii) increases or decreases its assets under management annually at a rate equivalent to the applicable strategy asset flows reported by HFR for the 10-year period ending September 30, ; and (iv) charges investors a 2% management fee and a 20% performance fee, with the seeder fund receiving 20% of those fees as its revenue share. These assumptions form a base case for the model seed fund performance. We also present more and less optimistic scenarios by adjusting the asset flow assumptions to reflect growth at either twice or half the rate reported by HFR. We use the HFR data on industry asset growth because the DJCS Index does not report asset data. We use the DJCS Index for strategy performance because it is a longer time series, which allows for better comparison to other benchmarks. We used the assumptions outlined above to generate the modeled performance presented in Table 1 below. To show the impact of the revenue share, we compare the seed fund s performance to an identical hedge fund investment without the benefit of a revenue share. Table 1 shows that the return achieved by a traditional investor (as represented by the DJCS Index) remains static regardless of fund asset growth, while the seeder s return increases as assets grow. Depending on asset growth, a seed fund investor can generate excess returns ranging from approximately 100 to 240 basis points per year compared to a traditional hedge fund portfolio. TA B L E 1 : Comparing Seed Fund Performance to Traditional Hedge Fund Investment Performance 10 Years Ended September 30, 2011 AUM Growth Assumption Seed Fund Investment Annualized Rate of Return Volatility Limited Partner Hedge Fund Investment Annualized Rate of Return Volatility Excess Return of Seed Fund Base case 8.12% 7.74% 1.35% Strong AUM growth 9.15% 7.78% 6.77% 7.60% 2.37% Weak AUM growth 7.77% 7.71% 1.00% These are model results for illustrative purposes only and do not represent the actual performance of any seeded hedge fund or hedge fund seeding vehicle. Actual results will vary from fund to fund. There can be no assurance that a seed investor will realize such enhanced return or that a seeded hedge fund will be able to raise capital. The model results do not include any management or incentive fees that a seeding vehicle may charge its investors. As with any investment, an investment in a hedge fund seeding vehicle could lose value. Source: Larch Lane Analysis

6 PAGE 5 It is important to note that we have not adjusted the hedge fund index returns to reflect the potential outperformance of early stage funds (defined by age and/or AUM) relative to older and more established funds. Funds in the DJCS Index are generally large, established hedge funds. In contrast, a seeding vehicle invests in smaller early stage hedge funds. Several studies have found that early stage hedge funds (those with smaller AUM and shorter track records) have historically outperformed established funds by anywhere from 2.3% to 5.6% per year during their first two years. 8 Such potential outperformance, if realized, would increase the excess return available to seed investors. Volatility of a Model Seed Portfolio The model seed portfolio, which includes a revenue share, may have marginally higher volatility than a similarly concentrated portfolio of direct investments in those same hedge funds. This additional volatility results from accruing a revenue share on positive performance and giving back a share of unrealized incentive fees on negative performance. Using a single seeded hedge fund as an example, in positive performing periods, the seed investor earns higher returns than a traditional fund investor due to the seeder s participation in the accrued incentive fee. Conversely, in negative performing periods, the seed investor earns lower returns than a traditional fund investor due to the reduction in the accrued incentive fee. 9 Liquidity Most hedge fund seeding vehicles are structured like private equity committed capital funds. As seed investments are identified, capital is called from investors and invested for a defined lock-up period, typically three to four years. If the seeding vehicle combines multiple seed investments in a single portfolio, it may take several years to identify and negotiate deals with a high quality group of managers. 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. Seeded hedge funds typically hold liquid securities, which distinguishes seeding vehicles from private equity funds where the underlying investments are normally illiquid. The sponsor of a seeding vehicle can further improve liquidity by negotiating the right to redeem the seeded assets early if the seeded hedge fund violates certain terms, such as risk constraints or drawdown limits. For these reasons, a seeding investment is generally more liquid than a typical private equity fund. Though seed investments are less liquid than direct hedge fund investing, the potential for added return from revenue sharing may be sufficient to compensate hedge fund seed investors for this reduced liquidity. In fact, hedge fund seeding vehicles may offer higher return potential precisely because they fill a liquidity gap between traditional private equity funds and hedge funds. A More Accurate Return Model Our goal in constructing the seed fund performance model was to apply conservative assumptions to publicly reported data. The seed model we presented above differs from an actual seed portfolio in many respects, the most significant of which is that in the model, all seed investments occur at one time, rather than being staged throughout the investment period. The model portfolio also assumes that initial capital, along with profits and losses, remains invested for the duration of the reporting period. In reality, Larch Lane seed funds call for capital over a three-year period and return capital to investors as

7 PAGE 6 lock-up periods with the underlying seeded funds expire. This feature enables investors to continue to benefit from any asset growth and performance of a successful seeded fund even after their invested capital is no longer at risk. This results from the fact that if the seeded fund continues operation, the seeder will generally receive a revenue share even after redeeming its initial seed capital. Because seeding vehicles have this particular characteristic, measuring their performance based on annual rate of return, as we did in our initial model, is insufficient. We believe a model using an internal rate of return ( IRR ) calculation is more appropriate. 10 To illustrate the potential effect the revenue share can have on returns, we modify the model seed portfolio presented above in Table 1 by assuming seed capital investments are withdrawn after four years. All other assumptions and the time frame (the 10-year period ending September 30, 2011) remain the same. We compare these results to a model of a traditional (nonseed) hedge fund portfolio by using the same strategies and returns as the model seed portfolio, but omitting any revenue share provided by the seed investment. 11 Table 2 shows the results of this analysis using the IRR calculation. (Note that the traditional hedge fund return is the same as in Table 1 because the IRR and annualized rate of return calculations produce the same result when capital remains invested for the full period and there is no revenue share.) Table 2 shows that the revenue share the seeded funds typically provide to the seed fund portfolio, combined with positive asset growth, may increase the IRR relative to an identical hedge fund portfolio without a revenue share. Even when we conservatively assume that AUM in the seeded funds grows at half the historical industry rate, the model seed portfolio could generate an IRR nearly double that of a traditional hedge fund portfolio. TA B L E 2 : Comparing Seed Performance to Traditional Hedge Fund Performance Using Internal Rate of Return 10 Years Ended September 30, 2011 IRR Model Seed Portfolio (with capital withdrawn after four years) Limited Partner Hedge Fund Portfolio Base Case (industry average asset growth) 12.94% Strong AUM growth (twice industry average) 14.96% 6.77% Weak AUM growth (half industry average) 12.19% These are model results for illustrative purposes only and do not represent the actual performance of any seeded hedge fund or hedge fund seeding vehicle. Actual results will vary from fund to fund. There can be no assurance that a seed investor will realize such enhanced return or that a seeded hedge fund will be able to raise capital. The model results do not include any management or incentive fees that a seeding vehicle may charge its investors. As with any investment, an investment in a hedge fund seeding vehicle could lose value. Source: Larch Lane Analysis.

8 PAGE 7 TA B L E 3 : Comparing Seed Fund Volatility to Private Equity Index Volatility of quarterly returns 13 DJCS Index 3.78% Model Seed Portfolio Base Case 3.87% Cambridge Associates LLC U.S. Private Equity Index 5.51% These are model results for illustrative purposes only and do not represent the actual performance of any seeded hedge fund or hedge fund seeding vehicle. Actual results and volatility will vary from fund to fund. There can be no assurance that a seed investor will realize such volatility. Please refer to Important Disclosures at the end of this paper regarding index comparisons. Source: Pertrac; Larch Lane; Cambridge Associates F I G U R E 3 : Where Could Hedge Fund Seeding Fit in a Portfolio? Expected Return Traditional Hedge Fund Portfolio Source: Larch Lane Analysis. Hedge Fund Seeding Expected Volatility Traditional Private Equity Comparing Seed Fund Volatility to Private Equity We explained why we believe that an IRR rather than a simple rate of return is a more appropriate metric for measuring performance of a seeding vehicle, where capital is drawn and returned over time. One advantage of calculating a monthly or quarterly rate of return, however, is that it allows you to calculate the volatility of returns. Although most private equity indexes do not report rate of return or volatility, we use the Cambridge Associates LLC U.S. Private Equity Index, a representation of diversified exposure to private equity strategies, to calculate the volatility of private equity returns. Table 3 compares the volatility of private equity to our initial model seed portfolio and the DJCS Index. 12 Table 3 shows that a seed portfolio may exhibit volatility that falls between the hedge fund and the private equity index. This is consistent with our expectations given that seeding vehicles combine aspects of both private equity and hedge funds. Where Could This Strategy Fit in a Portfolio? 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. Based on the seed model we outlined above and publicly reported data on private equity and hedge fund performance, we illustrate where we believe seeding is likely to fall along a risk/return spectrum. Figure 3 shows that a seeding strategy exhibits a risk/ return profile between traditional hedge fund and private equity strategies. This is not surprising as seeding shares characteristics of both strategies.

9 PAGE 8 To determine where hedge fund seeding fits in a portfolio, investors should also consider the strategy s liquidity and its expected correlation to other investments. Table 4 summarizes how hedge fund seeding vehicles typically compare to other alternative investments in terms of liquidity, investment risk and correlation to traditional investment assets. TA B L E 4 : Risk and Liquidity Characteristics of Various Alternative Investments Strategy Typical Lockup Period Liquidity of Underlying Asset Investment Risk (volatility) Correlation to Traditional Assets Venture Capital 6-10 years Highly Illiquid Medium Low Infrastructure 5-8 years Highly Illiquid High Low Mezzanine 5-8 years Highly Illiquid High Medium Hedge Fund Seeding Passive Hedge Fund of Fund Investing 3-4 years Varies Low/Medium Low/Medium Varies Varies Low Low/Medium Actual investment terms and risk may vary from fund to fund. Source: Prequin Hedge, Larch Lane Analysis Conclusion The capital shortage faced by new hedge funds in the aftermath of 2008 continues today. At the same time, the quality of new hedge funds seeking seed capital is significantly better than we have seen in the recent past. Consequently, we believe that the current market environment is very attractive for seeders. Investors who believe hedge funds will resume their growth trajectory and continue to play an important role in the investment landscape should consider a seeding vehicle as a possible way to capitalize on any growth in the hedge fund industry. We believe a hedge fund seeding vehicle is particularly appealing to investors who 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 returns approaching those of private equity, with potentially better liquidity* Our analysis suggests that seeding vehicles fall between hedge funds of funds and private equity funds in terms of reward/risk and liquidity profiles. Investors considering a seed investment strategy should have a multi-year investment horizon and be willing to tolerate short-term volatility. No seeding investments and no two seeding vehicles are identical. Every transaction is a highly structured, carefully negotiated transaction. In the end, the success of individual seed investments and the performance of seeding vehicles depend on many factors, most notably, prudent manager selection, fair and informed negotiations and effective implementation. When evaluating a seeding vehicle, carefully consider the sponsor s history because prior seeding experience adds value at every stage of the process. * There is no guarantee that any of these benefits will be achieved. As with any investment, an investment in a hedge fund seeding vehicle could lose value. Please refer to Important Disclosures at the end of this paper.

10 PAGE 9 APPENDIX 4 Illustration of Seed Economics Non-Strategic Investor Seed Capital Provider $200 M AUM Growth $400 M AUM Growth $900 M AUM Growth Capital Invested $5,000,000 $100,000,000 $100,000,000 $100,000,000 Current Fund AUM $400,000,000 $400,000,000 $500,000,000 $1,000,000,000 Seed Capital Provider's Share of Gross Revenues N/A 20% 20% 20% Management Fee 1.5% 1.5% 1.5% 1.5% Incentive Fee 20% 20% 20% 20% Gross fund return 10% 10% 10% 10% (Less management fee) 8.5% 8.5% 8.5% 8.5% Incentive Fee = (8.5% x 20%) 1.7% 1.7% 1.7% 1.7% Net fund return 6.8% 6.8% 6.8% 6.8% Return on capital invested ($) $340,000 $6,800,000 $6,800,000 $6,800,000 Management Fee Share (20% x 1.5% x AUM) Incentive Fee Share (20% x 1.7% x AUM) N/A $1,200,000 $1,500,000 $3,000,000 N/A $1,360,000 $1,700,000 $3,400,000 Total return on investment ($) $340,000 $9,360,000 $10,000,000 $13,200,000 Total return on investment (%) 6.8% 9.36% 10.00% 13.20% These are model results for illustrative purposes only and do not represent the actual performance of any seeded hedge fund or hedge fund seeding vehicle. Actual results will vary from fund to fund. There can be no assurance that a seed investor will realize such enhanced return or that a seeded hedge fund will be able to raise capital. The model results do not include any management or incentive fees that a seeding vehicle may charge its investors. As with any investment, an investment in a hedge fund seeding vehicle could lose value. Important Disclosures Performance Examples are for Illustrative Purposes Only and are Not Indicative of Actual Results The performance examples, illustrations and discussions set forth in this paper are for illustrative purposes only and do not represent the performance of any actual seed vehicle. There can be no assurance nor should it be assumed that the investment performance of any seed vehicle will conform to any performance examples or illustrations set forth in this paper or that any such investments will be able to avoid losses. In particular, there can be no assurance that a seed investor will realize any enhanced return or that a seeded hedge fund will be able to raise capital. The investment terms, composition, size, risks and returns of an actual seed vehicle may differ substantially from the examples set forth in this paper. Information Only - No Offer to Buy or Sell any Security This paper is for informational purposes only and is not intended to be, and should not be construed as, an offer to sell, or the solicitation of an offer to buy, any interest in any entity or other investment vehicle. Any such offer or solicitation will be made to qualified investors only by means of a final offering memorandum and only in those jurisdictions permitted by law. If such an investment opportunity should become available, a confidential private offering memorandum outlining such investment opportunity

11 PAGE 10 Hedge Fund Seeding: A Compelling Alternative would be provided to you together with the governing documents of the relevant investment vehicle, and the information in this paper would be qualified in its entirety by reference to all of the information and terms, including the risk factors, in such confidential private offering memorandum and governing documents. Forward-Looking Statements This paper contains statements which constitute forward-looking statements. These statements include statements regarding the intent, belief or current expectations of Larch Lane with respect to, among other things: (i) the revenue sharing and returns of seed fund investing; (ii) the potential growth of the hedge fund industry; (iii) the potential performance of any seed investment vehicle; (iv) the potential risk and volatility of a seed investment vehicle; and (v) the potential liquidity of any seed investment vehicle. Any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties and actual results may differ materially from those in the forward-looking statements as a result of various factors. Index Comparisons The DJCS Index (the Dow Jones Credit Suisse Hedge Fund Index) is a diversified, asset-weighted, rules-based hedge fund index that seeks to represent the liquid and investable hedge fund universe by capturing the performance of a core group of leading hedge fund managers. Cambridge Associates LLC U.S. Private Equity Index is an end-to-end calculation based on data compiled from 905 U.S. private equity funds (buyout, growth equity, private equity energy and mezzanine funds), including fully liquidated partnerships, formed between 1986 and 2011, net of fees, expenses and carried interest. The indexes discussed herein (the indexes ) are not subject to any of the fees or expenses to which an actual fund offered to investors would be subject. References to the indexes are for comparison or discussion purposes only and are not a projection, prediction or guarantee of performance. It should not be assumed that any seeded fund will invest in any specific securities that comprise any of the indexes. It is not possible to invest directly in any of the indexes. Information Subject to Change; No Warranty Any opinions expressed in this paper may be subject to change without notice. Although statements of fact and data contained in this paper have been obtained from, and are based upon, sources that Larch Lane believes to be reliable, Larch Lane does not guarantee their accuracy, and any such information may be incomplete or condensed. No representation is made that the information contained herein is accurate or complete, and it may not be relied upon as such. This paper is not a complete summary of the terms of the investment management services offered by Larch Lane and is qualified in its entirety by, and must be read in conjunction with, more detailed information regarding Larch Lane, including Part 2 of its Form ADV.

12 PAGE 11 Hedge Fund Seeding: A Compelling Alternative Endnotes 1 Larch Lane Advisors LLC ( Larch Lane ) acts as the investment manager for Hedge Fund Investment Company L.P. and Hedge Fund Investment Company Ltd. and HFIC II, LP and HFIC II, Ltd., and manages Select Plus Onshore Fund, L.P. via a management company established by Larch Lane and PineBridge Investments LLC in a joint venture. Affiliates of Larch Lane also act as the general partner and investment manager for Hedge Fund Investment Company L.P. and affiliates of Larch Lane and PineBridge also act as general partner for Select Plus Onshore Fund, L.P. 2 The HFMWeek Seeding Top 10, 3-9 Nov 2011, p For purposes of this paper, we focus on hedge fund seeding strategies executed through committed capital vehicles that call capital for seed investments, a model used by Larch Lane and a majority of other prominent seeders. 4 The following equation is used to calculate the data in Figure 1 and in the table Illustration of Seed Economics in the Appendix. GR = Gross Return of Fund MF = Fund Management Fee IF = Fund Incentive Fee RS = Revenue Share received by seeder AR = Ratio of non-seed assets to seed capital invested= (Third-party capital Fund AUM) Return to Seeder can be calculated as follows: R= {Fund Net Return} + {Management Fee Share} + {Incentive Fee Share} R = [(GR-MF) x (1-IF)] + [RS x MF x (1+AR)] + [RS x ((GR-MF)x IF) x (1+AR)] 5 Reasons why there are no publicly available databases reporting performance of seeding vehicles include: the small number of dedicated seeding vehicles; the varied structures used in seeding vehicles (for example, acquisition of ownership stakes versus revenue shares), which would hamper apples to apples comparisons; the periodic call for and return of capital, which limits the usefulness of comparisons between seed funds except in the unlikely event that two funds launched and returned capital at the exact same times. 6 The DJCS Index is a diversified, asset-weighted, rules-based hedge fund index that seeks to represent the liquid and investable hedge fund universe by capturing the performance of a core group of leading hedge fund managers. 7 The HFR asset growth data comes from the HFR Global Hedge Fund Industry Report First Quarter Studies showing early stage fund outperformance include: (i) Emering Manager Out-Performance: Alpha Opportunities from the Industry s Newest Hedge Fund Managers. HFR Asset Management, (ii) An Examination of Fund Age and Size and Its Impact on Hedge Fund Performance, by Meredith Jones. PerTrac Financial Solutions. Data from January 1996-December 2008; and (iii) The Performance of Emerging Hedge Fund Managers, by Rajesh K. Aggarwal and Philippe Jorion. American Finance Association Meeting Paper. January 23, 2008, page In economic terms, the seed investor can only benefit from receiving a revenue share. However, for purposes of monthly reporting, performance will fluctuate based on the accrual of potential incentive fee shares, which will increase reported volatility. 10 IRR is calculated by listing all fund contributions and distributions and calculating the discount rate that makes the net present value of these cash flows add to zero. 11 Model returns do not reflect fees and expenses that would be incurred at the seeding fund level. Additionally, using index and strategy data in our model mutes the effect that an individual seed fund can have on a seed portfolio, whether positive (through outperformance and/or growth) or negative (through investment losses, zero growth or shutting down). We attempt to compensate for this variance by incorporating different AUM growth scenarios. 12 Cambridge Associates LLC U.S. Private Equity Index is an end-to-end calculation based on data compiled from 905 U.S. private equity funds (buyout, growth equity, private equity energy and mezzanine funds), including fully liquidated partnerships, formed between 1986 and 2011, net of fees, expenses and carried interest. Pooled return aggregates all cash flows and ending NAVs in a sample to calculate the dollar-weighted return. The end-to-end performance calculation is similar to the IRR; however, it measures the return between two points in time, taking into account the beginning NAV as the initial investment. 13 We calculate volatility based on quarterly, rather than monthly returns, because Cambridge Associates LLC U.S. Private Equity Index reports performance on a quarterly basis.