Investment Fund Seeding – Structures and Negotiable Terms
With the increasing high costs of launching and managing a hedge or private equity fund, entering into a seed capital arrangement can provide a significant opportunity for an emerging manager to launch a successful fund or for an early stage manager to attract additional capital. Seed capital can provide the much needed critical mass of assets under management (AUM) from the outset of the fund to provide the manager with a working capital base to fund its operations and a means to attract other investors. A seed deal is essentially an agreement by an investor to invest an agreed (often significant) amount of capital in a manager’s fund for a locked-up period in exchange for participation in the manager’s business and/or certain other beneficial investment terms. First loss capital arrangements can provide an alternative means for managers looking to attain a critical mass of funds to start a track record but who may be hesitant to relinquish control over their businesses.
This article examines various structures for seed deals and how they compare to increasingly popular first loss capital arrangements and then explores the terms for participation rights and capital commitments of seed capital providers which are often subject to negotiation.
Seed Capital vs. First Loss Capital
Seed Capital – Revenue Sharing Arrangements. Seed capital arrangements most often take the form of a revenue sharing agreement between the seed capital provider and the manager of the fund in which the seeder is investing. A revenue sharing agreement is a contractual arrangement in which a seeder is entitled to receive a certain percentage (typically ranging from 15% to 25%) of the seeded manager’s gross or top-line revenues and of the carried interest or incentive allocation received by the general partner of the seeded fund. Typically, a seeder is also entitled to a percentage of proceeds on a sale or initial public offering (IPO) of the manager and the general partner.
The percentage share received by the seeder in a revenue sharing arrangement is typically lower than the percentage granted an equity arrangement as the seeder receives a share of the manager’s gross profits rather than its net profits after the deduction of expenses. Since the manager’s expenses do not reduce the seeder’s revenue participation, the seeder is not concerned with monitoring and measuring the manager’s expenses, so the manager can maintain more operational independence in this type of arrangement. However, some seeders are willing to bear certain expenses of the manager or to structure the revenue share to kick in only once the manager has received a threshold amount of revenue over a designated period to ensure the manager has enough capital to cover its operating costs.
For tax reasons, the seeder in a revenue sharing arrangement typically participates in the carried interest or incentive allocation received by the general partner of the funds advised by the seeded manager through a special limited partner participation in the applicable master fund. The seeder receives its share of the carry or incentive allocation as an allocation of the fund’s income to the seeder’s capital account in the fund, which allows the seeder to receive the same long-term capital gain treatment (if applicable) to which the general partner would otherwise be entitled on such income. This structure also protects the general partner from any restrictions on its ability to deduct any revenue share payments to the seeder with respect to the seeder’s share of the carry/incentive allocation.
Seed Capital – Equity Investments. In a smaller percentage of deals, seed capital participation can take the form of an equity-ownership interest in the manager and the general partner entities. In these arrangements, the seeder receives its percentage share of the net profits of the manager and general partner and the net capital proceeds on a sale or IPO of the entities. As the seeder is participating in the net profits, it will be more involved in monitoring the manager’s expenses and will typically seek caps placed on the compensation paid to the manager’s principals and, sometimes, the employees. Seeders receiving equity interests often look for additional transparency and control over the manager, but these rights can also be sought after by seeders through revenue-sharing contractual arrangements.
In recent years, equity ownership has fallen out of favor with seeders due in part to concerns over potential liability issues and increased regulatory scrutiny. Also, as more non-US seeders get into the space, top-line revenue arrangements have become more popular as equity ownership in a US manager can result in US federal and state tax filing requirements and US federal and state tax payment obligations for non-US seeders. Accordingly, the current trend is for non-US seeders and most US seeders to combine a revenue sharing arrangement with respect to the management and other fees earned by the manager with the special limited partner approach for participation in the carry/incentive allocation.
First Loss Capital. First loss capital is an arrangement in which a platform provider allocates capital to a separately managed account for the manager to trade, and the manager is required to contribute capital equal to a fixed percentage ranging from 10% or 20% of the total managed account balance, depending on the provider. The manager receives a higher than industry normal performance fee (up to 50%), and, for this higher payout, the manager’s capital sits in a first position with respect to losses (i.e., if there are losses generated by the managed account, the losses are first allocated to the manager’s capital). The manager is entitled to 100% of future profits until it is made whole for prior loss allocations.
A first loss capital arrangement allows a manager to grow its AUM and build a track record without giving up a piece of its business to a seed investor and enables the manager to maintain autonomy and discretion over its business operations. The costs for the manager of entering into the arrangement are usually minimal as the platform provider typically covers the set-up and administration costs. Also, the higher performance fees or allocations are often allocated to the manager on a monthly basis rather than having to wait until year end, which can help the manager manage its cash flow needs. In exchange for these benefits though, the manager has to be able and willing to put up the high risk capital investment into the established account.
Terms of Seed Support and Revenue/Equity Participation
Seed Support and Control Rights. The degree of operational control and support delivered by seed capital providers varies greatly. Many seeders take passive stakes in a manager and refrain from having any day-to-day involvement in management. One the other end, some seeders look to provide more support to its seeded managers and require governance and control rights over the manager’s business and funds.
There are seeders that offer managers working capital support through a capital contribution, working capital loan or prepayment of management fees to assist the manager with its early start-up costs. In addition to working capital, seeders can provide a range of support for managers in areas such as business development, marketing, risk management and governance and guidance on business operations and issues. Further, certain incubation platforms function to house fund managers in their own offices and provide back-office support during the manager’s start-up period. The goal of these platforms is to help a manager spin-out and become operationally independent, but provide the incubator with a continuing revenue share.
Seeders who are looking for control rights seek to negotiate certain consent or veto rights over certain aspects of the operations of the seeded managers and the funds they manage. Seeders may seek voting rights over certain key business and operational decisions of the manager – including risk management processes, certain hiring and firing decisions of key personnel, issuance of equity in the manager, entering into certain contracts over a specified threshold amount, the annual budget, the incurrence of debt by the manager and designated extraordinary events (i.e., liquidation, merger, or sale of the manager’s business). A seeder may also seek to put restrictions on the manager’s portfolio composition for the fund, limit withdrawals from the fund by key employees, retain consent rights over changes in fund service providers, and may seek to be a voting member or observer on the manager’s investment committee. Often, a seeder of a private equity fund will seek to appoint one or more members of the fund’s limited partner advisory committee.
Participation Rights. A seeder’s participation rights generally include a right to share in the manager’s and its affiliate’s management fees, incentive fees or carried interest and other fees received by the manager and its affiliates, and such rights usually continue after the seeder withdraws its seed capital from the manager’s fund. The duration of a seeder’s revenue share rights or equity interests varies widely, typically ranging from five to ten years or, in some cases, in perpetuity. Certain agreements mark duration by the manager’s ability to attract a threshold level of AUM. Many seeders also negotiate “tail” economic rights which allow them to receive the same revenue participation rights in any new ventures started by key persons of the manager after they leave the manager for a designated period of time (often three to five years).
Sunset/Buy-back Rights. Managers often seek to negotiate the right to end the seed arrangement by buying back the seeder’s equity interests or revenue rights after a specified period of time (generally six to eight years), typically for a purchase price based on a multiple of the manager’s average annual payments to the seeder over the prior two or three years (multiple is typically 4x-5x). Alternatively, the manager can negotiate sunset rights in which the seeder’s participation rights scales down over time or after the manager reaches certain AUM levels. Less frequently, seeders agree to terminate the revenue share after the seeder withdraws its investment following the negotiated lock-up period. Put options may allow the seeder to put the participation rights back to the manager after a designated period of time or the manager meeting certain AUM triggers.
Key Person Covenants. Seeders often look for the manager’s key persons to provide certain protective covenants. These covenants often include a key person’s agreement to devote substantially all of his or her business time and effort to the manager’s business, the retention by the key persons of at least a collective 51% equity stake in the manager, an agreement to invest a designated percentage of the key individual’s net worth or a minimum dollar amount in the fund and/or a requirement to reinvest a percentage of the manager’s net profits back into the fund. Also, standard non-compete and non-solicit covenants by the key persons are often required by seeders, preventing the key persons from walking away and taking other key personnel from the seeded business.
Investment Terms for Fund Seed Capital Investment
Initial investment commitments from seeders are typically 10% to 33% of the overall target fund size of the seeded manager’s fund, providing an anchor for the manager to complete an initial launch of the fund. Seed capital is typically subject to a “hard” lock-up for generally two to three years, which provides an emerging manager a stable asset base to fund its operations and attract capital from outside investors. However, seeders often negotiate the right to withdraw on certain trigger events. Examples of typical trigger events include adverse performance loss triggers (i.e., a decline in performance of 15% to 20%, measured from fund launch), key person clauses, designated “bad-boy” events and breach by the manager of the seed agreement, fund documents or investment parameters.
Seeders will either pay reduced management and incentive allocations/carry on their seed investments or pay full fees but take a revenue share on their seeded capital. Additional terms often negotiated by seed capital providers are most favored nation (MFN) rights to allow them to receive the most favorable investment rights offered to other fund investors. Transparency rights are often sought requiring the manager to provide the seeder with additional information to allow the seeder to verify compliance with investment guidelines and to calculate its revenue share. Further, a seeder often seeks capacity rights to allow the seeder to make additional investments in the manager’s hedge fund platform or successor private equity funds on the same beneficial terms (either expressed as an additional dollar amount or a percentage of the fund’s AUM).
It is also important to note that the existence and certain terms of a seed arrangement must be disclosed to investors in the subject fund’s offering documents.
Seeding has become an important part of the emerging manager market and is increasingly being used as a tool to assist existing managers in accelerating their businesses to the next level. There are pros and cons for both managers and seeders to the various structures of seed arrangements, and first loss capital has become a significant alternative for those managers looking for a capital base to launch or expand their operations without giving up autonomy over their businesses. The terms for seed arrangements are highly negotiable and vary widely among the types of seeders, and any manager looking to explore a possible seed deal should have a sense of the current market for these terms and what economic and control rights over the manager’s funds and business it is prepared to yield to the seeder. The key to an effective seeding arrangement is a trusting partnership between the seeder and the manager where each believes it is being treated fairly and maintains the common goal of launching and growing a successful and long-lasting business.
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