Incubation Exit Strats: Consolidation Comes Into Play

May 25 2006 | 8:32pm ET

Traditionally, when an emerging hedge fund manager teams up with an incubator and exchanges equity for operational capital, the manager's long-term plan is to buy back control of the fund. While this is still a common goal, consolidation in the hedge fund industry has caused some savvy incubation firms to structure deals which they believe will be more profitable to both them and the managers in which they invest —selling the firm to a third party.

Westport, Conn.-based Weston Capital, which was founded by Albert Hallac in 1993, launched its first incubation fund in 2004 and has thus far seeded around eight managers. Chris Kelley, chief executive officer, explained that Weston Capital selectively seeds managers with proven track records and solid business plans, but one thing that sets the firm apart from other hedge fund incubators is its vision for an exit strategy.

"We have a bigger vision on exit scenarios," Kelley said, refer-ring to the usual practice of managers buying back the equity in their own firms. "Instead, we like to sell them to third parties." He explained that the "enormous boom" in hedge fund acquisitions in recent years has made hedge fund firms valuable entities unto themselves. "There is a huge institutional demand for buying single manager firms," he said According to global financial firm Man Investments, proof of consolidation is in the numbers.

The firm has published figures revealing that the top 50 hedge fund managers in the world now account for about 40% of industry assets, up from 35% in 2003, while the next 50 managers have seen their share of assets grow to 17% from 19%. Figures also show that the remaining 8,500managers have fallen from holding 51% of assets to about 43%.

Recently, big name institutions have been snapping up stakes of hedge fund firms and their related services. Earlier this year, JP Morgan, which bought a large stake in hedge fund firm Highbridge Capital Management in 2004, purchased hedge fund firm Paloma Partners' middle and back office services.  However, experts note that big names firm's like JP Morgan are not likely to buy small firms. Jeff Kuchta, founder and managing partner of Hedge Fund Launch —an online service that matches hedge fund managers seeking seed capital and investors who are specifically interested in becoming seed partners —said this leaves an opportunity for mergers and acquisitions among the smaller players.

"The larger firms are buying the multi-billion dollar guys," Kuchta said. "That leaves a little niche, consolidation of what we call the middle-tier of managers that the big guys just aren't going to buy." He said that by consolation, small firms can obtain a scale and efficiency for their businesses that will allow for monetization.

This is the niche Weston Capital is filling with its incubation exit strategy. Kelley said that the firm receives 500 to 700inquiries each year, 100 of which will make it to round two, meaning a meeting. The firm, which has $2 billion in assets under management, will continue to partner with around 10 emerging managers each year.

"We look for top traders coming out of top banks with proven track records who want to build their own firm," he said.

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