First Fund Fundamentals: Seed Investments
Seed investments can be a crucial source of capital for emerging hedge funds, enabling them to launch and build momentum. A seed investor provides initial funding, typically in exchange for a share of the management fees and incentive allocations earned by the manager. Seed investments can play a transformative role in the early stages of a hedge fund’s development, allowing the fund to gain the resources needed to execute its strategy, attract other investors, and establish a track record. This article is geared to emerging fund managers and discusses how seed investments work, the benefits and risks involved, and the typical seed investment structure.
What is a Seed Investment?
A seed investment is a form of capital provided to a newly formed or emerging hedge fund to help it establish operations, develop its investment strategy, and attract additional investors. In the current challenging fundraising environment, a new fund manager may do well to consider seed investment options when attempting to launch their first fund. Typically, seed capital is provided by institutional investors, high-net-worth individuals, or family offices who are willing to take on a higher level of risk in exchange for the potential for enhanced returns on their capital. Seed investments are usually made at the very beginning of a hedge fund’s lifecycle, often before the fund has a proven track record or significant assets under management. Seed investors are essentially betting on the fund's investment strategy, the skill of its investment team, and the potential for growth.
The Role of Seed Investors
Seed investors play several important roles when providing capital to a hedge fund. Seed investments are primarily used to launch the fund’s initial expenses with respect to operations (e.g., legal fees, administrative expenses, and risk management infrastructure). In addition, a seed investment may galvanize fundraising efforts by signaling confidence in the manager to other potential investors.
Aside from providing much-needed capital to a new fund, seed investors may also offer strategic advice and guidance. A strategic seed investor is often an institutional investor, a wellestablished family office, or a large financial firm with substantial experience in hedge fund operations. These investors can help the hedge fund develop a network of relationships and clients, provide industry-specific insights, and offer long-term guidance.
Structuring a Seed Investment
Seed Lock-Ups
A common feature of seed investments is the “Seed Lock-Up.” The Seed Lock-Up refers to seed capital that cannot be redeemed for a specified period after the investment is made, even if non-seed investors have more frequent liquidity terms. Seed Lock-Ups typically last two to three years and provide the stability a new fund needs to establish a track record and attract other investors. However, certain exceptions to Seed Lock-Ups are usually negotiated and can be triggered by events such as poor investment performance, material withdrawals of capital, and bad acts by the manager or key personnel.
Seed Capital Revenue/Profit Share
Seed investments are typically structured in ways that provide seed investors with the potential for enhanced returns by granting the seed investors a share of the revenues or profits of the manager.
Profit or Revenue Sharing: Seed investors are typically granted a share, generally 10-15%, of the gross revenues earned by the manager. This can also be structured as a profit share. However, negotiations with respect to a profit share may be difficult. Obviously, a seed investor will want both insight and consent rights with respect to the expenses that the management company may incur that would reduce the net profit shared with the seed investor. Of principal concern to seed investors is preserving the alignment of interests between the managers and the investor, such that the manager’s compensation from a fund is limited to the profits of the management companies. Seed investors will be aggressively skeptical about a manager earning compensation from a fund or funds before the profit share split with the seed investor.
Limitations on Revenue Sharing: Seed investors generally view their investment as an investment in the manager of the fund. Therefore, seed investors will negotiate not only for a portion of the management and performance fees generated by the manager’s initial fund, but also future funds launched by the manager. The starting point for this will generally be any pooled vehicle or managed account that the manager launches in the future. Typically, managers will try to limit this scope to accounts launched in the future with the same or similar strategy to the initial fund. There is also the question of when the seed investor’s rights to revenue generated by the manager terminate. Often managers will negotiate for a “sunset” period after they leave the initial fund, typically 18-months to two years, after which they can launch a new platform free of the seed investor’s revenue share or they will negotiate a right to buy out the revenue share at a multiple of such revenue share at some point in the future, typically seven to ten years after the seed investment.
Repurchase Obligations: Seed investors may also negotiate for a “put” right on its revenue share, requiring the manager to repurchase the seed investor’s revenue or profit share after a certain amount of time has elapsed or upon the occurrence of a specific event. Such events may include the termination of the Seed Lock-Up period, or an agreed-upon amount of
revenue being generated. Furthermore, the repurchase price can be calculated based on a specified formula or an independent appraisal.
Other Preferential Terms: Seed investors might negotiate for other preferential terms, such as operational controls over the manager, including approval requirements for launching new funds and service provider changes. Other preferential terms in favor of seed investors include information access rights, management time commitment requirements, and minimum investments by the manager.
Conclusion
Seed investments are an important source of funding and support for emerging hedge funds. For fund managers, these investments provide the necessary capital to launch and operate funds, while also offering access to expertise and credibility. For seed investors, providing capital at an early stage can yield enhanced returns, but it also carries considerable risk. The structure of a seed investment varies depending on the negotiation between the parties involved, but it generally includes favorable terms for the seed investor in exchange for the higher risks associated with funding a new and unproven fund. Sadis & Goldberg LLP offers a full suite of legal services for sponsors launching new funds, including creating the structure and terms of seed investments. If you would like assistance with anything related to this article, please contact David Fitzgerald at (212) 573-8428 or dfitzgerald@sadis.com.