Experts Discuss Pros and Cons of Hedge Fund Incubation

Feb 3 2006 | 12:00am ET

By Deirdre Brennan 

Emerging hedge fund managers hoping to increase their assets under management may have to relinquish some of their autonomy in order to succeed, according to industry experts gathered this week at the Hedge Fund Incubation and Seeding Conference in Manhattan.

Just as the name implies, hedge fund incubation is when a firm teams up with a fund to nurture it and help it grow. The incubator, or seeder, takes an equity stake in the fund in return for providing capital and other forms of support. An incubator differs from a regular limited partner in that it not only provides a fund manager with capital to invest, but it also takes on more of a private equity role, often funding operational costs, as well as mentoring the managers and advising them on legal, compliance and accounting issues.

Hugh Lamle, president of MD Sass Investor Services and conference chair, said that his firm takes a very hands-on role when seeding a manager. “We enable investment professionals to focus on managing money, not building business operations,” said Lamle, adding that is it often more cost efficient for funds to “rent” back office services rather than build their own. Additionally, he said the funds that MD Sass seeds have a higher probability of success than if they go it alone. “Fifteen out of 18 of the hedge funds MD Sass has backed have been successful,” he said.

In addition to providing capital and operational support, there are other advantages to teaming up with a hedge fund incubator. “Seed capital gives you legitimacy with institutions,” said Anthony Josephson, principal and founder of Carmel CapitalPartners, a San Diego, Calif.-based firm which successfully obtained seeding nine months ago and now has $40 million in assets under management.

“It helped us more than double our assets under management,” said Josephson, who manages a long/short equity fund as well as separately managed accounts.

Other experts agreed that incubation insures that a manger has resources to sustain the business for three years, which should be enough time to build up a critical mass of investors. But partnering with a hedge fund incubator does have its tradeoffs, mainly the equity stake that a manager must fork over.

“In all of our ventures, we have a substantial equity position, usually 50%,” said Lamle, “that’s a share of profits, not revenue.” Others said that they were surprised that MD Sass took such a high equity stake, saying the industry norm was between 20-40%, though they did point out that incubators provide different levels of support and capital raising commitments, so each deal is different.

Vincent Thompson, director of marketing of JP Morgan Asset Management’s incubator funds group, said that a lot of new managers have unrealistic views and expectations. “Be realistic as to what you have to offer the marketplace,” Thompson advised. “We are looking to partner with people who don’t have the brand or the high profile, but have something unique.”

He said that JP Morgan will only back managers who have a solid track record and business acumen, as his group’s model for seeding is more passive than other hedge fund incubators. “We are looking for grown-ups,” Thompson said, adding that managers are free to choose their own vendors. Since starting the incubation group three years ago, the team at JP Morgan has received over 1,500 proposals from funds seeking an incubator and has seeded just 10. “A misnomer is that people think that [an emerging manager] is two guys and a Bloomberg terminal, that’s not what we are into,” Thompson said.

According to experts, consistency is key. “Managers need to be consistent with their strategy, business plan and philosophy,” said Josephson. “You need to be able to articulate a long-term plan, including your asset base and infrastructure.”

All of the panelists agreed that teaming up with an incubator was a long-term relationship that needed to be considered carefully. “Seeding and incubation is a partnership, so the question to ask yourself is, ‘do you really want to have a partner?’” said Robert Leonard, partner at Bingham McCutchen’s Investment Management Practice Group, where he maintains a hedge fund practice. “Another question that you should ask yourself is, ‘can you do it on your own?’”  


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