Originally appeared in HFM Week on May  15, 2019

Throughout 2018 and continuing for the first [four] months of 2019, seed investment activity achieved historically high levels as an increasing number of institutional firms (often private equity funds with a mandate to make seed investments) and a variety of non-traditional seeders competed to invest in the highest quality new hedge fund managers.

Investment sizing for these transactions continued to climb, with typical seed deals commanding $50m or more of day-one investments and several being struck at well over $100m. Three major trends have become evident in the last 18 months:

• the return of major institutional investors to the seeding game
• increased parity in the negotiations and resulting terms for seed deals
• a willingness by seed investors to share the expense load of the seeded manager’s business.

These factors work together to create a very favourable environment for hedge fund managers seeking seed capital.

Beginning in 2015 and continuing for several years, institutional seeders seemed less active than they had been in prior periods. During that time, the perception of excess market volatility – and ultimately a concern that the markets had become seriously overpriced – created significant headwinds for seeding.

Many of the top institutional seeders scaled back their activity as they waited for more favourable market conditions, and family offices, pension funds and other opportunistic seeders filled the gap.

However, this reticence has given way to a dramatic uptick in activity by institutional seeders, with some of the most prominent legacy names moving decisively back into the marketplace and a few new institutional seeders raising significant amounts of capital to pursue these investments.

In 2018, it was not uncommon for institutional seeders to make three or more investments over a 12-month period, and this pace has continued during the first quarter of 2019.

A classic seed deal involves an anchor investor making a sizeable investment in a new hedge fund where the seeder agrees to initially forego ordinary liquidity rights and instead be subject to a lock-up, generally for two or more years.

In exchange, the seeder is granted an economic interest in the hedge fund business (almost always structured as a top-line revenue share), along with other enhancements such as capacity rights at reduced fees, transparency rights, and a variety of other terms designed to protect the seed investment (particularly during the lock-up) and the revenue share.

Historically, seeders have had tremendous leverage over new managers in negotiating terms; however, in the current environment, a greater parity has arisen between the two, particularly as both sides have sought to better align their interests and leverage the benefits of a good partnership into supercharging the firm’s growth.

This parity is partly driven by the increase in seeders and because investing on terms like those of other fund investors creates better alignment and may help with fundraising efforts.

The lifeblood of a new hedge fund business is AuM growth, and a seed investment is seen as one of the leading ways to ensure fundraising success (by providing tailwinds from the endorsement of a large institutional investor and scale for the fund).

To achieve this, a fund management business needs to attract institutional investors who expect institutional quality management, operations and controls.

Of course, building a business of this quality requires significant working capital, and securing a seed investment can provide the manager with dependable cashflow for the near-to-medium term.

In addition, a major development in seed deals over the last several years is an increased willingness for seeders to share the burden of rising costs by providing working capital – most commonly by deferring their revenue share, and sometimes by providing direct capital infusions.

This provides significant value to the manager by helping to ensure the operating structure is stable and the manager is incentivised to optimise its business for long-term success.

In an environment that increasingly rewards institutional-quality offerings, in which the largest firms often enjoy most of the spoils, securing a high-quality seed partnership can be the difference between success and failure for a start-up.