Pentagon Helps Hedge Funds To Jump Over The AUM Hurdle

Aug 11 2006 | 12:00am ET

By Deirdre Brennan

Calling all start-up hedge fund managers: If you are willing to bet on yourself, there may be someone willing to bet on you. Lewis Chester, CEO of global investment management firm Pentagon Capital, provides loans to small hedge funds in order to help them reach the critical mass needed to attract institutional investors.

“We provide leverage when a bank or a prime broker won’t,” said Chester, who began his career as a lawyer at Linklaters before earning an MBA at Harvard Business School and joining Pentagon, which was founded 20 years ago by his father.

The idea to lend money to hedge funds came about after one of the Pentagon’s prime brokers asked Chester to meet with a few men who were leaving the firm to start a fixed-income fund. The prime broker thought that Pentagon may be interested in providing seed capital to the new managers.

“They told us that they needed to get to $20-$25 million, and once they got to that point they knew they would have institutional investors who would come in,” said Chester. “They’d been speaking to some seed equity guys who wanted 25-30% of their business.”

Both Chester and the managers felt that giving up that much equity in the new firm was an extremely expensive way of getting to $25 million. Chester, who at that time was not in the business of funding small hedge fund firms, came up with a simple idea: he would simply lend the managers the money and they could put up the hedge fund units as collateral.

Two years and more than 20 transactions later, Chester is confident that his model of financing small hedge funds makes better business sense than seeding a fund in exchange for equity.

“One of the reasons why we don’t like the seed equity model is that we think it is like giving the manager a free option. In other words, he doesn’t have anything to lose other than the opportunity cost,” said Chester, who added that with Pentagon’s loan option, if a manager doesn’t perform, he loses his money first.

“We like [this structure] because there is an alignment of interests amongst the parties and we think that institutional investors will like that as well,” he said.

In addition to providing liquidity to small hedge funds, London-based Pentagon, plays numerous other roles in the asset management space, including managing funds, market making, and providing loans to larger firms.

“We do a lot of special situations type investing, principally in the form of direct loans to corporates and individuals, and other types of asset based lending structures.”

The multi-billion firm, which manages money for more than 1,500 investors, also provides leverage to larger funds, including those with illiquid assets.

“This could be in structured credit, specially finance, life insurance, private placements, mezzanine debt, all of those types of strategies where it is difficult to get leverage on the underlying assets, we’re providing it,” he said. 

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