Seed From Which Hedges May Grow
By LYNNLEY BROWNING
The New York Times
February 16, 2003
GROWING numbers of investment firms are quietly financing promising hedge fund managers, much as venture capitalists underwrite risky start-ups in the hope that some will strike it rich.
Hedge fund executives estimate that at least 30 providers of seed capital, often called incubators, have emerged the last three years. They include major Wall Street investment banks like J. P. Morgan Chase and boutique firms dedicated to financing young talent, like BRI Partners of Chicago and FrontPoint Partners of Greenwich, Conn.
"You're seeing a great deal of interest in seeding as a means of accessing smaller, undiscovered managers," said Sharissa Y. Jones, a partner at Capital Z Investment Partners, a hedge-fund and private-equity seeding company in New York. Capital Z, backed by the Zurich Financial Services Group of Switzerland, has invested about $800 million since 1998 in at least eight hedge funds, several run by individuals who had never run hedge funds before.
Hedge funds are lightly regulated, private investment vehicles intended for wealthy individuals and institutions; with the poor performance of the stock market, the funds have also gained wide interest among less affluent investors. The funds generally provide little information about their operations and the Securities and Exchange Commission last week warned investors to be wary of fraudulent offerings.
Some of the incubated hedge funds will provide investors with more information than the typical fund. In return for financing, some new funds are being required to reveal to their backers exactly how they invest their capital.
Such information is usually closely guarded by hedge-fund managers, who try to produce gains regardless of market conditions. And because hedge funds often use shorting strategies, which involve borrowing shares for future sale and can result in unlimited losses, an investment in the funds can involve considerable risk.
The funds are generally open only to investors with a high net worth, often a minimum of $1.5 million, and many funds require a minimum investment of $250,000.
The S.E.C. has begun to investigate possible abuses in marketing hedge funds to people who are unaware of their potential risks, and it is contemplating a tightening of its regulations.
"The S.E.C. laws generally prohibit hedge funds from making public statements that could be considered a public offering, or a solicitation to invest," said John J. Nester, a spokesman for the agency. "While public disclosure of a hedge fund's performance might not by itself be considered a public offering, it would depend on the individual facts and circumstances in which the disclosure is made." Any hedge fund executive who publicly discusses a fund's investment goals, track record, or contact information would likely contravene the S.E.C.'s regulations, he said.
Hedge funds suffered their worst year last year, losing an average of 3 percent, according to the Hennessee Group, a hedge fund and tracking firm in New York. Still, hedge funds as a group outperformed the Standard & Poor's 500-stock index, which fell 23 percent last year. As a result, demand for hedge funds remains high.
There are no hard numbers on how many new funds have been incubated in recent years. There were 5,500 hedge funds last year, a record, compared with 4,700 in 1998, according to the Tass Research database at Tremont Advisers, a hedge fund and advisory firm in New York.
Investors that provide seed capital typically receive a chunk of a new fund's revenue, which comes from fees, usually 1 percent of a fund's assets under management and 20 percent of its profit. Some firms, including Capital Z and BRI, also receive a stake of about 30 percent in the new fund.
Many newly seeded funds are required to meet performance benchmarks. If they don't, investors can withdraw their funds, sometimes with substantial loss of capital.
Some of the firms providing capital to new hedge funds offer a variety of services to help put the new ventures on their feet.
"We make fairly sizable investments, in the tens of millions, but we also provide them with help and support and advice — lawyers, accountants, prime brokers, hiring, you name it," said Jeffrey D. Izenman, a managing member of BRI Partners.
BRI, which calls itself a venture capital firm specializing in hedge funds, says Bear, Stearns, the New York investment bank, is among its investors. BRI has backed five managers, some former traders, in hedge-fund start-ups since October 2001. Executives at the firm and at Bear, Stearns declined to provide details.
Most providers of seed capital say they review several hundred fund managers for every few that they eventually back. Ms. Jones said Capital Z meets with about 500 candidates each year but typically invests in only two managers, usually providing each with $25 million to $75 million to start a fund. Capital Z has financed OneWorld Investments, a fixed-income emerging-markets hedge fund in Boston run by former executives of BankBoston, and Palmyra Asset Management, a fund based in Los Angeles, among others.
Some executives warn that putting unseasoned managers into hedge funds is often a recipe for failure. "Not all of these investments in new fund managers are going to do well," said George Van, chief executive of Van Hedge Fund Advisers International, a hedge fund tracking firm in Nashville.
Traditional hedge-fund firms have long used their own money to quietly train their own managers to run larger, traditional funds.
By contrast, the new funds are intended to establish a quick track record that can be used in a year or two to attract other mainstream hedge-fund investors. Once funds are big enough, they can pull in money from institutional investors like pension funds and university endowments, which are seeking to invest in larger funds that can easily absorb their capital.
Most of the new hedge funds are unlikely to reach that stage, some executives say.
"If you incubate 10 new hedge funds, some will fold and others will be O.K.," said Andrew W. Gitlin, chief executive of the Framework Investment Group, an incubation firm in New York that has seeded two commodities hedge funds with a total of $750 million in assets. "Only a small proportion will do really well. It's very parallel in risks to venture capital."
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