There is an interesting new phenomenon occurring in the hedge fund industry that we think will end in tears. It’s called first-loss capital and MarketWatch recently published an article on it. It essentially works as follows: Small funds that are looking to grow their AUM accept a significant amount of capital in a separate account structure. The investors have daily liquidity and pay a higher incentive fee than the standard 20%. The managers themselves then put their own capital into the same account, in an amount representing 10 percent of the total amount invested.
So far so good, but here is where it gets tricky. The managers have to take the first losses in the account. So in a theoretical $50 million separate account, the hedge fund’s $5 million investment is at risk first for any losses. With daily liquidity and a separate account structure, we can’t imagine that the investors will stick around long enough for their capital to truly be at risk. Once the $5 million buffer the hedge fund provided goes, so will the investors. So the investors get a free call option on the upside and the hedge funds bear essentially the entire downside risk.
We have heard from several sources that the investors who operate these first-loss capital investments are “shady” and often present themselves as seed investors. Paraphrasing Senator Bentsen in his famous Jack Kennedy quote, we know seed investors and these are no seed investors…
We also understand that these investors are significantly levered themselves. The $45 million they contribute to the separate account may only be a small portion of their own capital – some other bank entity is really funding the bulk of the investment.
So why do we think first-loss capital will end in tears? The limited partners in the main fund are highly likely to be disadvantaged. This is something nobody seems to be talking about and the Market Watch article did not mention. First-loss capital creates an extreme short-term focus for the fund manager. He knows he can’t afford to lose any capital since it’s his own money and he risks having the investor pull the entire separate account if losses get big enough. We wouldn’t be surprised if the short-term focus of the separate account crept into the main fund. At minimum it is likely to take a huge chunk of the manager’s time and mind-share.
We’ve pieced this together from conversations with others in the industry, but the story is still very much incomplete. Have you invested in a fund using first-loss Capital? Do you run a fund that accepts first-loss capital? If so, we”d love to chat with you.