There are inherent risks attached to any business venture. In order to be successful, one must first be aware of them and then take measures to mitigate said risks as much as possible. In the hedge fund world, there is a growing trend called first-loss (FIRLO) capital which is gaining popularity as an alternative way for managers to raise assets. While there are those who are in support of this new trend, there are also naysayers who believe that it is too risky for managers and will only cause trouble in the long run.
The hedge fund industry is a competitive one and statistics have shown that despite studies pointing to the higher success rate of smaller or emerging managers against their counterparts, majority of the assets at play usually end up at the hands of managers who handle upwards of $5 billion in assets.
To get their share of the investment pie, it has become necessary for emerging or smaller managers to look for other asset sources. One way to do this is through what is referred to as risk based managed accounts or first-loss capital.
A typical hedge fund usually charges 2% management fees and retains around 20% of any profit made each year. With first-loss capital, the investor would provide capital if the manager or hedge fund will contribute a fixed percentage of the total managed account, usually ranging from 10%-20% depending on the capital provider. The performance fee received by the hedge fund or manager is more than that of the usual industry standard. In the case of Topwater Investment Management LLC for example, a company that has started providing this type of funding in 2002, the performance fee is paid monthly, if the manager makes a profit in the period. The caveat is that should the manager incur any losses, that money comes out of their capital and the investor’s remains intact. Thus the hedge fund managers are in the position to sustain first-loss. If they should suffer a big monthly loss, then they lose their own money quickly while the first-loss capital providers can withdraw their investment to protect their own interests.
If the risk of losing one’s own money is involved, then why do managers and emerging hedge funds take the gamble? One of the reasons is that first-loss has the power to quickly increase a hedge fund’s assets under management. With first-loss, they could also raise capital without resorting to giving up a stake in their business. As for investors, first-loss capital provides them with access to potentially high returns that new hedge funds and managers could generate, all while keeping their capital intact and protecting their investment should the manager incur any losses. And when the time comes that the investment profits, the manager then receives 100% of all future profits until the amount of capital initially lost is returned. Only after it has been repaid to the manager will the profits be distributed.
There are those who surmise that due to its nature, first-loss capital creates an extreme short-term focus for the fund manager, with the threat of the investor pulling their capital looming over him. However, as Alistair Barr of MarketWatch pointed out, “the benefits seem to be outweighing the risks [of first-loss capital] for many managers.” He added that this is especially the case if said managers “believe strongly in their investment strategy and are willing to put more of their own money on the line to support it.”