First-loss Capital (FIRLO): A New Investment for Hedge Fund Managers

Emerging hedge fund managers find increasing capital not an easy undertaking despite the tremendous influx of industry assets over the last few years. Most of the incoming assets reach managers with at least $5 billion in assets. Indeed, only the elite ones in the realm of hedge funds occupy a large bulk of the capital being managed. In addition, this is a stark contrast from studies that show that smaller, not-so-elite hedge fund managers (Emerging) are capable of working better than them. Because of this seemingly large discrepancy in the distribution of capital, hedge fund managers who are still building themselves from the ground up are looking for capital sources that can help them be on par with the high-asset managers.

In fact, there are a lot of them that are readily available, such as hedge fund seeding, as well as acceleration capital. While these are more popular sources of capital for these hedge fund managers, there is one that is gaining steam as of late that could be of great help for them. This one is called “risk-based managed accounts,” also known as first-loss capital or FIRLO.

The structure of the FIRLO program goes like this: the capital provider distributes towards the manager’s separately managed account through a master feeder. The manager only receives the allocation if the manager contributes to the capital that is the same as 10 to 20 percent of the total managed account, which is dependent on the capital provider. Likewise, the manager receives a performance fee that is greater than the industry standard. In case losses were incurred during the first month of the program, the manager’s capital first absorbs them. The incurred losses would then be returned once the manager obtains 100% of the future profits in the succeeding months. Profits would be shared with the fund once the manager gains those losses back.

This setup is beneficial for startup hedge fund managers for a number of reasons. First of all, payouts for the manager are greater than the normal payout within the industry. Second, the base capital used for distribution towards managers often ranges from $25 to $100 million. Third, managers obtain a cut on the profits and losses every month instead of receiving them on year’s end, thus increasing their risk of posting an audit. Lastly, managers gain ownership on their track record, with capital providers allowing them to operate portfolios that are not the same as their core funds.

Although risked-based managed accounts are becoming increasingly popular as the other capital sources, FIRLO programs are much preferred than hedge fund seeding or acceleration capital setup. This is mainly due to the various restrictions placed on managers who enter seed or acceleration deals, wherein managers are forced to give up their ownership stake to the capital provider. This is absent in FIRLO programs, wherein managers maintain the upper hand in overseeing their respective businesses and growing their assets under management without having to give up something. Considering the abovementioned benefits likewise make risk-based managed accounts a better choice for hedge fund managers. 

About the Author

Jeffrey D. Arsenault has over 25 years of experience in the field of hedge funds, risk and portfolio management. He is currently the principal and owner of Old Greenwich Capital Partners, an investment management company based in New York City.