Growing AUM with "first loss" funds

Discussion in 'Professional Trading' started by heech, Feb 3, 2011.

  1. heech


    Hi all,

    Again, new to the industry... so this may be a bit of a newb question.

    I've been informed that there may be institutional funds willing to "invest" in my fund, but not as a direct investment. They're looking at a first loss arrangement: I put up $2 million, and they would put up $20 million. Any losses are my responsibility, and gains are split 50/50. (Any numbers described here are just for illustration purposes, not an actual offer.) After a certain amount of time (1-2 years), this converts into an actual investment as a LP.

    They explained it as, an institutional fund may not trust a small-time manager with <$5mm AUM and 1.5 years of operating history, and this is a way to really prove myself.

    When I first heard this... my thought was, isn't this just 10x1 leverage? Except I'm only getting 50% of the profits, rather than 100%? Not interested.

    Then I gave it some more thought... as many know, it's hard growing a fund from a few million to >$10 million through new investment. High net worth individuals aren't that easy to find, and institutional investors really aren't interested in funds in this size. This might be worth the price just to super-charge growth to the next stage.

    So, I'm interested in thoughts from all:

    - Pros? Cons?
    - what are good numbers to aim for? Is 1x10 leverage factor "good"? Is a 50/50 split good?
    - It occurs to me I should insist on a lock-up on the direct investment whenever it occurs... yes?
  2. heech


    And alternatively, rather than someone masquerading as an investor... could I instead find someone willing to lend to me up to 10x1 leverage...? (So that I'm at least keeping 100% of profits minus whatever interest.)
  3. When they say they will put up 20M, is that as a direct investment into your fund or is it a structured finance arrangement?
  4. Interesting dilemma...

    If that "investor" does not require that he be exclusive, you should maybe consider it. (If normal clients are allowed to jump in at any time). It could give you traction to begin...

    On the other hand it is essentially leveraging yourself so losses can mount up quickly. Also if you are too "scared" because of it and it affects your trading strategy, you would be doing yourself a disservice in the longer haul.
  5. LeeD


    Regarding just getting 10x leverage, ask your prime broker and a few others. If prime brokers wouldn't give 10x leverage, I can't see why anyone else would... unless, of course, if you are prepared to pay some seriously crazy interest.

    The good things about the deal:
    1) Running a 20mln fund is a good experience. So, if you consider this as a way to promote yourself, I think it is good.
    2) 50% share of the profits would be superbly good if not for the first-loss rule... Consider if you can negaotiate:
    a) Lock-up on funds for a longer period than the first-loss applies.
    b) That 50%/50% is applied after management fees. Ultimately, you are co-investors and the fund still costs to run... even if you come out flat. This will seriously increase your share of profits.
    c) Make sure the 50%/50% splits stays there after the first-loss period expires.
    3) Compared to an investor who doesn't demand the first-loss rule but instead demands a share of all future fees (in effect becoming a co-owner of the fund), this gives much higher upside... but you get serious downside too - works very much like leverage again.

    The bad things:
    1) The "investor" may pull out at the first sign of lossees. So, you absolutely need a lock-up period (normally it would come with some conditions like it ends if the fund looses 20% year on year based on mothly report or something in that spirit.) Note that if you cover teh first 10% of the fund value in losses but teh fund can't pull out till, say, 20% is lost, this sounds more of a fair deal for you.
    2) Because your money basically serve as investor insurance, there may be a few catches in the legal language. Make sure that the contract does NOT cover any loss over the 2mln which are part of the agreement... even if it's result of your mistake or negligence.
    3) Depending on your fund's riosk profile 10x leverage may be way too large. If you are aiming to generate, say 40% per year, I would consider 10% accepted loss as exceptionally low.
  6. heech


    Can you give me some insight as to what the second means, in practice? Some kind of "commitment" to cover losses up to $20 mil without actually putting in a cent? And what's the significance of one versus the other?
  7. I would restructure it this way:

    1. Maximum 5x leverage

    2. Losses AND PROFITS are BOTH shared 50:50

    3. The Fund Manager's investment and the "Investor's" investment are both locked up for at least two years.

    4. A maximum drawdown trigder can be set to void the two year lock up...but of course this has to be set ABOVE the level of losses that are insured by the Fund Manager's invetsment.

    5. The Investor must agree that if some performance targets are met, that he agrees to automatically extend the lock up for a further two years. The Fund Manager has the option for this lockup extension to either receive the Investor's funds as a typical investment subject to the standard mgmt/perf fee structure or under the initial 50:50 structure.

    In sum, the "Investor" can not have a free ride...thy must be exposed to some pain, albeit well-defined pain

    Anyway, I think the above is hypothetical, as these "Investors" would never accept this and furthermore I doubt they would offer it to you - given that you run an option strategy. From my past expereince they are seeking US equities strategies. Finally, I also veyr much doubt, they would invest in a fund, they want a managed acocunt.

    Bottom line...these offers are of little to no benefit to the Fund Manager in my opinion...if they are serious, they'll agree to the structure I've outlined above or at least will be willing to negotiate that struture. I very much doubt they willl. I'll be glad to know if they do.

    P.S. Is this from Evan and co at HedgeCo Networks?
  8. heech


    AppreciTe the insights so far. I especially like the thought of insisting on the 2% management fee, as well as a 20% loss "cap" beyond my 10% contribution. (Although... From their perspective, after I lose my 10%, I'd have a lot of incentive to take risks to regain my money with their capital, and nothing further to lose.)

    They had said flat out it would revert to 80/20 after first loss expires. That seems fair, yo be honest. But I want a gurantee of a 2-3 year lockup as long as I met certain metrics.

    As far as it affecting me... Good news is that I have about $1.5mm in trading profits in my current "aggressive fund" over the past year (which targets 40% returns and 20% std dev). I am thinking about pulling that out, if this works out, and using it to launch a institutional fund with 15% returns and 7.5% std dev. I would be playing with the markets money, and reduces probability of a 10% drawdown. (And I keep my existing aggressive fund going in parallel!)
  9. Crispy


    I know a few pms that were promised the world in cap intro from hedgeco and not one deal ever transpired.
  10. Not surprised to hear this. Not surprised, at all!
    #10     Feb 3, 2011